Money Management and the Economy

Sunday, May 1, 2011

Traditional IRA and Roth IRA Contributions are Not Equivalent

The Minneapolis Star-Tribune financial advice columnist, Chris Farrell has an article in the Sunday May 1, 2011 edition that epitomizes the results of over-simplified financial analysis. For some reason, most of the media's financial advisers seem intent on ignoring the complexity of comparing Roth and IRA contributions and the result is often poor advice. Let's take a look at the media's conventional wisdom and how it compares to reality.

Most media financial columnists will say that an IRA and a Roth contribution are equivalent assuming that your tax rate is the same on both ends. If you expect your taxes to be lower in retirement, then the IRA will give you a better return. If not, then the Roth is probably a better investment. On one level this is accurate.

If you put $100 into a Roth IRA and are in the 25% tax bracket, you will have spent $125 including the taxes. Lets assume your investments break even over the next ten years and then you withdraw the balance of the account. You will have $100.

If you put that $100 into a Traditional IRA. You will save $25 in taxes, but you will have to pay $25 in taxes when you take the $100 out if you are still in the 25% tax bracket.

Assuming you saved the $25 you would have paid in taxes, this is a wash and you end up in exactly the same spot with $100 to spend. (Whether your investments do better or worse than break even doesn't effect the comparison, they will have the same effect on either choice.)

Unfortunately the assumption that you will save the tax savings never seems to get dealt with. And if you don't save the money you would have paid in taxes, that investment in a traditional IRA is going to be worth 75% of the same investment in the Roth IRA.

Now what happens if, as in the article above, you decide to maximize your contributions to each? For the example in the article that amount is $6000 per year. If you save this amount in a Roth IRA you will have $6000 when you withdraw it. If you save it in a traditional IRA you will have $4500. Again, that assumes the 25% tax bracket. To have an equivalent amount in retirement, you need to put the $1500 you saved in taxes into a traditional savings account to be saved for your retirement along with your IRA contribution.

Essentially for someone in the 25% tax bracket, a quarter of their traditional IRA (or 401(K) and other tax-deferred accounts) belongs to Uncle Sam. When they withdraw their money, they are going to have give Uncle Sam his share by paying the taxes on both the principal and earnings for that 25%. With the Roth IRA, it is just like any other savings account, the money is all theirs and there are no taxes when money is withdrawn.

I suspect one reason this rarely gets discussed is that it makes explicit the fact that you aren't really "saving" anything on your immediate taxes by putting money into an IRA or 401(k). To get the same results as a $6000 contribution into a Roth IRA, you will need to save $1500 in addition to the $6000 contributed to traditional IRA. These tax deferred accounts are simply kicking the tax bill down the road. Its "tax-deferred", not "tax-free", and there are no "tax-savings".

There are still benefits to retirement accounts. There are real tax savings from earnings on the deferred taxes. But a $6000 contribution to a traditional IRA is not equivalent to the same contribution to a Roth IRA, no matter how often the media gurus tell you otherwise.