Key Points:
- Tax Timing Is Crucial
- Small Tax Rate Gaps Add Up Over Time
- Tailor to Your Tax Bracket
Nuanced Retirement planning is critical for long-term financial security
An Individual Retirement Account is a tax-advantaged way to save for retirement. The difference between setting up the correct retirement plan will likely be the difference between tens or even hundreds of thousands of dollars difference in retirement savings. This is largely because of a few factors.
First, tax timing. There is a tax deduction that comes with a Traditional IRA, which means you get a benefit upfront (lower taxable income), but withdrawals in retirement are taxed as ordinary income. In the case of a Roth IRA, taxes are paid on contributions now, but retirement withdrawals (including gains) are tax-free. This results in a massive benefit, enabling investors to capture massive upside over many years without paying tax on the gains.
Second, compounding over decades represents another issue. If you choose the incorrect IRA type for your situation, then you may pay unnecessary taxes either now or at some future date. Very small differences in effective tax rates can add up over time and will compound to large sums. For instance, For a 30-year timeline at a 7% annual return, contributing $6,500 each year yields a future value of approximately $615,000 if invested pre-tax. You effectively pay taxes later, when you withdraw at a lower bracket (let’s say 22% bracket as of 2024), leaving about $480,000 net.
Using the same 7% growth formula but with $4,420 per year instead of $6,500 (taxes paid upfront at the current 32% bracket), you get [4420*(1.07)^30 - 1]/0.07 = $418,000 with 0% on qualified withdrawals since the Roth IRA is tax-free. Hence, the after-tax nest egg is $418,000 in the Roth IRA case versus $480,000 for the Traditional IRA. Now, comparing the 2 outcomes, $418,000 vs $480,000 results in a difference of $62,000. In this scenario, the investor who chose the Roth IRA instead of the Traditional IRA would have left $62,000 on the table. This is mainly because the investor ended up in a lower tax bracket in retirement (22% versus 32%).
Thus, the nuances regarding tax brackets and when you plan to retire also matter. In essence, small tax rate gaps compound, and every extra dollar you contribute now grows exponentially over time. Losing a portion of your retirement balance to higher taxes upfront can significantly reduce your final balance.
Points to Consider
There are other points to consider while deciding on a Roth IRA vs Traditional IRA. For example, tax brackets can change over time, hence, it is always important to perform the calculations and map out the full numerical analysis to determine which IRA account is best. Ultimately, your current tax bracket versus your retirement tax bracket will always be important, but there are some other points to consider:
- Contribution limits typically change from year to year
- If you are in a higher bracket in retirement, then the Roth IRA will outperform
- Roth IRA allows for buying/selling within the account without incurring capital gains taxes
- Roth IRAs provide tax-free withdrawals in retirement, but contributions aren’t deductible now
- Traditional IRAs offer immediate tax deductions but require taxes on future withdrawals
The most important item to be aware of is that very small differences in effective tax rates end up making the difference between tens of thousands of dollars or, in some cases, even hundreds of thousands of dollars in retirement.
Learn more: Why Traditional 401(k) Accounts Fall Short
Key Differences
Pay taxes now (Roth) or later (Traditional). The bottom line, young earners expecting higher future tax brackets are better off investing via Roth IRA. The taxes are paid upfront, and the upside is tax-free. This presents a tremendous advantage for those looking to capitalize on growth (recommended for any individual less than 50 years old).
Those seeking immediate tax breaks or anticipating lower retirement tax rates will benefit from investing via a Traditional IRA. If you want an immediate tax deduction on your contributions or if you anticipate being in a lower tax bracket during retirement, then the Traditional IRA option may work best. To illustrate via another concrete example, if you earn $70,000 and contribute $6,000 to a Traditional IRA (assuming you meet all eligibility requirements), then your taxable income drops as low as $64,000.
The reduction from $70,000 to $64,000 in taxable income will not only save $6,000 in taxable income, but also represent the amount of cash that can be reinvested or allocated for a different purpose such as paying down high-interest debt, building an emergency fund, investing in additional assets such equities, or placed toward a down payment. Thus, by strategically deploying your tax savings, you can effectively manage your money such that retirement will be a breeze.