As we discuss in our guide to investing under 20, saving on taxes will be a major key to your investing success. And there may be no more universally-held belief in all of personal finance than the idea that a Roth IRA is the sure-fire best way to do that.
By reading or listening to some of the more popular finance gurus, it’s easy to come to the conclusion that only a fool would choose to invest in a Traditional IRA. I must admit that even I, before doing a little deeper research, never suggested anything to anyone but a Roth. But is a really so much better than a traditional IRA? Let’s take a closer look and see.
What the Math Has to Say
The quick answer is…yes and no.
Yes, I know that sounds like a huge cop-out. But there are a ton of different variables that need to be considered to say definitively which IRA would be better for you, and your personal situation is the critical factor.
The Math That Your Normally See
Let’s first take a look at this question from a mathematical standpoint. Most people who are proponents of Roth IRA’s will no doubt focus in on the most well-known feature of Roths – that you pay tax on the money ahead of time so that the money can grow tax-free and be withdrawn tax-free in retirement.
You may hear an example given like this:
Imagine if you invested $200 a month from age 20 until age 67, and let’s allow a growth rate of 7%. At age 67, you would have $845,447. But only $112,000 of that total would have been from your actual contributions. The rest is all growth. Now if you invested in a Traditional IRA, all that growth would be taxed, so you can kiss about a third of that money goodbye. But if you invested in a Roth, all that growth would be yours tax-free!
Now when the situation is explained in this way, it certainly does seem like the Roth is the obvious winner. But this generic explanation of the benefits of using a Roth doesn’t really do justice to our poor old Traditional IRA sitting in the corner feeling unloved.
The problem with our example above is that in order to pay the same $200 to the Roth as you would the Traditional IRA, you would actually have to allocate MORE of your annual income towards retirement.
Why? Because you must pay taxes on all the money that you contribute.
The Truer Math
So, using our basic example again:
- In order to pay $200 a month to a Roth, it would really cost you around $230 ($200 in contributions and $30 in taxes), assuming that you are in the 15% tax bracket.
- For the entire year, that’s a difference of $360. You would have essentially paid a total of $2,760 in order to contribute $2400 to your retirement account.
Now, if you had contributed to a Traditional IRA, that $360 in taxes would have been saved. So you could take the full $2,760 and invest it, which of course compounded over time, would cause you to have a much larger lump sum, which would then be taxed in retirement.
And if you did just that, guess what? As would be expected, the end total ends up being very close to the same as what you would have had with the Roth.
Now, a LOT more variables can skew the math slightly in either direction, and most of them have to do with the concept of marginal and effective tax rates. Matt Becker, from Mom and Daddy Money, does a great job of explaining marginal and effective tax rates in his break-down of Roth vs Traditional IRA’s.
But while diving into the minutiae of tax rates and countless other variables could swing the ultimate victory in either direction, the fact that you would even need to dive into those details proves my point: that the race is closer than many think.
What Reality Has to Say
Ok, so that’s the math behind why the Traditional IRA is not as bad of a retirement investment vehicle as you may think. But now it’s time to get down to reality.
The truth is that the vast majority of Americans will NOT take the money that they save in taxes from their Traditional IRA and invest it.
It takes an unusually disciplined person to think through the math that I explained above, and then decide to add $30 to their monthly retirement contribution, knowing that they’re going to get that money back on their tax return.
Instead, most people have a number set in mind for how much they want to contribute each month to retirement, and they would contribute the same amount to a Roth as they would a Traditional IRA.
In this scenario, the Roth will always win, because you are effectively paying more each month without realizing it.
Be Honest With Yourself
But what if someone were to take the full $360 from their tax refund each year and just invest it at all at one time? Again, mathematically, this would work. But, again, it’s a rare breed who is disciplined enough to do this. Most people already have plans in mind for their tax return, and “contribute extra to my retirement account” typically doesn’t make the list.
Now, if you’re the type of person who would be able to exercise enough self-restraint to contribute extra to your Traditional IRA each year, then I applaud you. You’re my kind of guy or gal and I say, “Go for it!”
However, I also want to remind everyone that one of the first steps to being successful with your personal finances is to be honest about your tendencies and weaknesses. And for the majority of us, we would be better off using a Roth, where we are effectively contributing more each month to our retirement without having to even think about it.
The basic principle is this: whenever annual contributions are equal, the Roth always comes out on top.
It’s important to note that, for this article, we’ve only focused on how the Roth and Traditional IRA handle taxes. I focused on taxes because this is what most people talk about when they compare the two products.
However, there are other benefits to the Roth IRA that may truly make it a slam dunk for you.
The greatest driver of your success in the stock market will not be which retirement account you choose. This will only make a slight difference in your overall return.
The most crucial requirement is that you practice the3 keys to investment success. If you follow those investment principles and turn them into lifelong habits, you will end up just fine in retirement. So don’t let someone shame you based off the kind of IRA that you happen to use.