Deductible vs. Nondeductible; Traditional vs. Roth - IRAs and 401Ks

Is your financial advisor giving you the correct answer to this question?

Once a financial planner asked me what my opinion was on Roth IRAs vs. Traditional IRAs. He gave me a clue what he expected my answer be when he added: “what is better than completely tax free?” He was advising his clients to always go with Roth’s because the income was tax free.

Most Americans cannot make the maximum contributions to IRAs (and 401Ks), and they will be in a lower tax bracket upon retirement, therefore, they should make deductible contributions whenever possible (traditional wins!)

Let me give you an example:

Assume you are in the 33 1/3 tax bracket and you have an extra $1,000 to invest. You could put $1,000 in a Roth or you could put $1,500 in a traditional IRA. If you put $1,500 in a deductible IRA you would save $500 in tax; the tax savings plus the $1,000 you already have gives you $1,500. Now let’s assume your money triples by the time you take it out, and you are in the 20% bracket. The Roth would now grow to $3,000, and you would not owe any tax, isn’t that great? No! The Traditional would grow to $4,500, and you would pay $900 in tax; leaving you with $3,600, which is $600 more than the Roth.

Politicians love to vote for bills expanding Roths because it actually is a tax increase (it brings in more money in the current year), but, they can tell voters in it a tax decrease (it will save taxes in the future). What a great way to balance a budget! That is why they have expanded the Roth concept to 401Ks.

In the above example the taxpayer did not have enough savings to make maximum contributions therefore they could put the tax savings into the IRA and hope that it grew to more than what the future taxes. It did, the $500 grew to $1,500 and the tax was $900, thus a savings of $600.

Now let’s take a look at what happens when you have the funds to make the maximum contribution and pay the tax now:

Assume you are in the 33 1/3 tax bracket and you have substantial savings. Your have a choice of investing $5,000 in a Traditional IRA or Roth IRA. If you invest $5,000 in the Roth you total investment is $6,667 ($5,000 invested the IRA and $1,667 in taxes that you paid because you did not get a deduction).By making the Traditional IRA investment you have an extra $1,667 in your savings account. Let’s assume you earn 4% on your money. The table below shows how much your investment would be worth after tax in 20, 30, 40, and 50 years assuming you are now in the 20% or 33% tax bracket.

The Roth wins when you are in the same tax bracket at retirement. The longer time the investment is in the IRA the more the Roth wins by. The reason is that the $1,667 extra savings grows very slowly because taxes have to be paid each year on the interest.

Note that the Traditional won by less after 30 years ($428) than it did in 20 years ($630). After 30 years it won't even matter if the taxpayer is in a lower tax bracket. So Roths are great for young people who can leave their money in longer.

Most Americans see their tax bracket decline when they retire. Their earnings decline; some, or all, of their Social Security will not be taxed. Most states don’t tax Social Security and some states do not tax a portion of their retirement. Many people retire to states like Florida that does not have an income tax. For these people deductible contributions are best, especially if they can also contribute the taxes they saved by making a deductible contribution.

American’s with substantial assets do not necessarily see their income decline in retirement. Often they do not need the retirement funds; the funds eventually go to their children who also are in a high tax bracket. Since they do not need the funds, interest compounds for several decades. Another advantage of a Roth is that you don’t have to start withdrawing the funds at age 70 1/2. The investment could grow for 60 or more years.

For most retirees it is helpful to have some money in Roth’s and some in Traditional pretax plans. They take their living expenses out of the Traditional pretax plans. When they need something expensive, like a new car, they take it out of the Roth, therefore, they can avoid the upper tax brackets.

If you have a Roth 401k at work, and you cannot make the maximum you should elect the traditional method on most, if not all of your contribution. The fact that you cannot make the maximum indicates that you are a typical American who will see their tax rate decline upon retirement. You will be able to contribute more because your withholding will be less. You may want to put a small amount (say 10% of you contribution) in a Roth.

Summary by Age:

20 to 40:

• The Roth seems to be the answer; there could be 50 or more years of compounding. 

40's:

• If you are going to need your retirement funds, it is a good time to start taking advantage of tax deductions; Traditional IRAs and 401Ks should get a good portion of you retirement savings.

50 and up:

• If you are going to need your retirement funds to live on you will want tax deductions now and taxable income later. You want some income taxed at the lower tax brackets. Traditional IRAs (assuming you can deduct them) and 401Ks should get most, if not all, of your contributions.
• If you have sufficient savings and income that the retirement funds will not be needed to support you, Roths are for you.

If your are covered by a plan sponsored by your employer and your income is above certain levels, a contribution to an IRA is not deductible. Also, if your income is too high and you are covered by an employer’s plan you may not be eligible for a Roth. In conclusion, if you are covered by an employer’s plan and cannot deduct the contribution then a Roth is for you. The only time it makes sense to make a non deductible IRA contribution is when your income is just too high for a Roth.