How well do you understand the difference between investing with taxable, tax-free or tax-deferred retirement plans? Do you know the tax differences between a Traditional and a Roth IRA? We’ve touted the benefits of Roth IRAs many times in the past – here
to list a few.
However, a recent study
by T. Rowe Price analyzed the difference between the two types of IRAs in terms of spendable income in retirement and their findings on the Roth IRA are certainly worth highlighting again. Here’s a snapshot of the key findings:
The Case for a Roth IRA – 3 Benefits of Tax-Free Accounts
1. A Roth IRA offered more spendable income than a Traditional IRA in 90 percent of the scenarios.
“The benefits of tomorrow’s tax-free retirement withdrawals with a Roth IRA far outweigh the benefits of today’s tax-deduction and other possible benefits with a Traditional IRA,” says T. Rowe Price senior financial planner Stuart Ritter. “Even though the Roth IRA contribution doesn’t qualify for an income tax deduction, decades of compounding tax-free money can generate more spendable income in retirement.”
Another illustration from Equity University’s Roth IRA series
compares the benefits of a tax-free Roth IRA, a tax-deferred Traditional IRA and taxable money. In this hypothetical example, each tax scenario started with $5,500 and earned a 20-percent average rate of return, compounded once annually, for the next 10 years:
As shown in the image above, the tax-free Roth IRA scenario accumulated approximately $6,000 more than the tax-deferred Traditional IRA and over $14,000 more than a taxable scenario. This again demonstrates the power of tax-free compounded interest.
2. A Roth IRA was more valuable, even if the investor’s tax bracket drops in retirement
in 84% of the scenarios.
One common reason investors select a Traditional IRA over a Roth, other than the potential tax deductions, is the expectation of a lower tax bracket during retirement. Logically it makes sense at first – to benefit from the tax deductions during the working years (when the tax bracket is typically higher) and then pay tax on withdrawal from the account when taken in retirement (when the tax bracket is assumed to be lower.)
While the study found this may still hold true in certain situations, the Roth IRA still outperformed the Traditional IRA in a majority of the scenarios, even when the investor’s tax bracket was reduced in retirement. “If an investor’s tax bracket drops by at least 9 percent and she is 50 years old, the Traditional IRA becomes more valuable. A 65-year old would only need a 6 percent drop in her tax bracket for a Traditional IRA to be more advantageous than the Roth IRA in retirement,” the report states.
The study also notes most investors remain in the same tax bracket during retirement, so the Traditional IRA’s benefit of a reduced tax rate in retirement may be overstated. As always, it is important to consult with a qualified financial professional to determine the best options for your specific situation.
3. A Roth IRA is most powerful when you contribute a lump sum at the beginning of the year (prior to tax filing deadlines)
Deciding when to contribute to your retirement plans may also impact your account’s performance. According to the study:
o Beginning of the year contributions outperformed end-of-the-year and monthly contributions over 3-, 5- and 10-year rolling periods.
o Investing a lump sum contribution at the beginning of the year outperformed end-of-the-year contributions 96 percent of the time in an analysis of 10-year rolling periods and 87 percent of the time in 3-year rolling periods.
o Investing a lump sum contribution at the beginning of the year outperformed monthly investing 91 percent of the time for 10-year rolling periods and 82 percent of the time for 3-year rolling periods.
The Roth IRA is one of the most powerful tools available to investors today. It allows investors to contribute after-tax money with the hopes of tax-free income in retirement. In essence, the Roth IRA allows you to pay tax on the seed so that, when harvested in retirement, you do not pay tax on the crop. This environment of tax-free compounded interest is one of the most powerful options available to you today.
“People used to use sulpha drugs to treat infections before World War II, but a far more effective solution came with penicillin. Likewise, the Roth IRA’s advent over 15 years ago offered a more effective way to save for retirement,” Mr. Ritter adds.
Is now the time to consider a tax-free Roth IRA?
Watch this exclusive video and discover more benefits of a tax-free Roth IRA