An informative new report from NerdWallet argues that for most savers at largely allincome levels, utilizing a Roth individual retirement account (IRA) can generate significantly more retirement wealth compared with a traditional individual retirement account (IRA).
Outlining the research results for PLANADVISER, Arielle O’Shea, co-author of “Roths Top Traditional IRAs by up to Six Figures in Retirement Savings Analysis,” suggested she and her colleagues were surprised by just how well the Roth approach performed in the comparative analysis.
“Using a Roth individual retirement account nets investors more retirement dollars in many cases,” she observes. “The difference is well over $100,000 in the vast majority of tax scenarios.”
O’Shea, who penned the analysis with Jonathan Todd, says she was “surprised to see such a widespread gap in performance across so many tax scenarios. That was striking.
“No matter what your tax rate is now and what you might expect it to be in retirement, if you’re making the maximum contribution, we measure that Roth essentially always outperforms, because of the strong benefit of pre-paying your taxes,” she continues. “You don’t really think about it this way, but you are pre-paying the taxes in the Roth, so in a sense you are investing more money than you otherwise would be able to. It costs you a little more to make those contributions in the moment, of course, but you are doing your future self a huge favor in retirement by taking this approach.”
NerdWallet’s research might raise an eyebrow among IRA enthusiasts, because the conventional wisdom is that an investor should go with a traditional IRA unless they have sat down and done a very serious analysis of what their individual tax rate is now and what they believe it may be in the future. But these results argue basically the opposite; the Roth approach almost always results in more ending wealth.
“I would make one caveat,” O’Shea warns. “It is important to note that we looked at maximum contributions.”
If the “net cost” of the pre-tax contribution to a Roth IRA is under $5,500, taking the traditional or Roth IRA approach will be more or less equivalent, assuming the tax rates stay the same now and at retirement. Consider the case in which a saver has 30 years until retirement, a 20% tax rate now and at retirement, and wants to make a $2,000 contribution to a Roth IRA.
“That will cost a net $2,500 in pre-tax income,” O’Shea observes. “This investor could instead opt to put an equivalent $2,500 in pre-tax income into a traditional IRA. At retirement, the saver will have the same amount, or $167,603, assuming a 6% annual return, whether he saved with the Roth or traditional IRA. It is only as long as the pre-tax cost of the Roth contribution (the contribution you make plus taxes you will pay on that amount of income) is greater than the $5,500 limit, then the Roth advantage holds.”
NEXT: Digging into the results
O’Shea adds that “lower down on the contribution scale below the maximum, things get a little muddier, certainly. But we think it is important to highlight this as a goal for people—to represent what the ideal might be so that people can work towards that. If you are maxing out contributions, most likely it will make sense to go with Roth.”
The analysis offers some additional examples: For someone with a current effective tax rate of 20%, the cost of making a $5,000 contribution to the Roth would be $6,250. Another way to think about this is to say that the individual has saved $5,000 and at the same time pre-payed some of the tax he would otherwise owe in retirement. So the trick is that this after tax account is allowing the individual to save more on net than he could in a traditional IRA, through which you aren’t able to pre-pay taxes.”
Even in cases where an investor isn’t very eager to change their investing approach, this is important stuff to consider—how significant the impact of taxes will be on net wealth in retirement. It can be hugely significant.
“One other aspect that impacts the analysis is whether or not you invest the tax savings you see in the short term when using a traditional IRA,” O’Shea adds. “Say, if you take the equivalent of the $1,250 that you would have had to pay in taxes to make a $5,500 Roth contribution and put that into an after-tax brokerage account.”
This can go a long way to making up the performance gap and matching the performance of the Roth approach. But, of course, this requires an annual commitment to fund and manage the brokerage account, which is far from a given over a 30-year time horizon.
“In a way it feels less painful to make the $5,500 Roth contribution, even though it is costing you more because you are not getting a tax deduction—but you aren’t actually physically putting that extra money into a separate account,” O’Shea concludes. “Instead, it is just absorbed into your taxes and you don’t really have to feel that loss as much. We have seen a lot of evidence that the behavior element is very important.”
The full analysis is available for download, along with a helpful Roth-versus-traditional calculator, at www.NerdWallet.com.