Retirees are often lured into a Roth IRA. The idea of not paying an income tax on withdrawals is almost irresistible. I had the same thought my self so I decided to examine the pros and cons of an Roth IRA vs a Conventional IRA.
What I determined was not exactly what I expected. I put together a spread sheet using the examples of a Roth IRA initially taxed at both 15 percent and 25 percent. And the same amount invested into a conventional IRA at the same tax rates.
The problem with a Roth IRA is that the initial tax must be paid either from your income, or from another IRA sets you back by the amount of the tax. Given the same investments and term of the investment, the one with the lesser initial value will be forever behind the one that grew without taxes withdrawn. That can be seen clearly in the table below. If the initial tax bracket is higher than the withdrawal tax bracket of a conventional IRA the difference is even greater.
One the positive side, one never knows what a future Congress will do to the tax brackets. With the Roth IRA you know the rate of taxation from the time you make the initial withdrawal or conversion. You cann’t make the same statement on what the tax brackets will be 10 or 20 years from now. History has shown that the lower brackets tend to expand upward with inflation, that is they are indexed. But if a financial crisis were to occur all bets are off as to what the tax brackets might be some years from now.
If your current marginal tax bracket is 25 percent that $1000 becomes $750 to invest, and in 10 years at 7 percent growth you will net $1475. A conventional IRA will accumulate $1967 of the same period, but taxes on withdrawal (assuming a 15 percent rate) will be $295, netting $1672 or $197 more than the Roth IRA. While higher total taxes are paid on the Conventional IRA, the net is likely to be higher than with a Roth IRA.
Longer investment periods or rates of growth will have no effect on the outcome, assuming that both types of IRA are invested in the same investments.
|Comparing a Roth IRA to Conventional IRA|
|Description||Roth IRA 15||IRA 15||Roth IRA 25||IRA 25|
|Tax Rate on Invested Amount||15.00%||0.00%||25.00%||0.00%|
|Assumed Growth Rate||7.00%||7.00%||7.00%||7.00%|
|Years to maturity||10||10||10||10|
|Proceeds before Tax||$1,672.08||$1,967.15||$1,475.36||$1,967.15|
|Tax Rate on Proceeds||0.00%||15.00%||0.00%||25.00%|
|Tax on Proceeds||$0.00||$295.07||$0.00||$491.79|
|Total Taxes Paid||$150.00||$295.07||$250.00||$491.79|
|Equivalent Tax rate||8.97%||15.00%||16.94%||25.00%|
|I was comparing a Roth IRA to a Conventional IRA, and was surprised that maybe a conventional is better in some ways.|
A Roth IRA does have some advantages over a conventional IRA however. They are not subject to the MRD – Minimum Required Distribution that an IRA starting at age 70½, and there are no penalties for early withdrawal. My plan when I hit the MRD age is to take the MRD, and roll the excess amount into a Roth at the end of each year.
For more information on a Roth IRA see here.