In Part 1, we introduced what an IRA is and the differences between a Traditional and a Roth. Although each one has its own unique tax benefits, you were probably left wondering which one is better. In this post, we’ll put some numbers to paper to illustrate what will happen to our money depending on which route we take.
Crunching the Numbers – An Example:
This example comes to us from a truly great book called “Your Money Ratios: 8 Simple Tools for Financial Security at Every Stage in Life” by Charles Farrell. In the chapter on IRA’s, Farrell weighs in his opinion on which type of fund he feels is better:
• Neither! They are both exactly the same.
Farrell then walks his readers through an example that demonstrates his conclusion.
The first time I read this, I didn’t believe it either! So I sat down at the computer and crunched the numbers using Microsoft Excel. (Don’t worry about doing this yourself. You can download my spreadsheet here: TRADITIONAL VS ROTH IRA Example)
The example goes like this:
• Let’s say you’re 45 years old and have $15,000 to invest (Lines 2 and 1). Your tax rate is 25% (Line 3). If you pick the Traditional, you won’t have to pay taxes so you’ll invest the whole $15,000 (Line 4). If you pick the Roth, you’ll be taxed and only have $11,250 to invest.
• 20 years pass and now you’re 65 years old (Lines 8 and 9). During that 20 years, your investments returned an annual compound return of 7.50% (Line 7). The Traditional fund is now worth $63,718 while the Roth is only worth $47,788 (Line 11).
• You decide to cash out and withdrawal the entire amount. In the future, your tax rate is still 25% (Line 10). As you already know from Part 1, you’ll now pay taxes on the Traditional but not the Roth. As a result, both funds are now worth the same $47,788 (Line 12)!
Conclusion: Yes, if you do the math, Farrell is right. Both funds are the same. However, these assumptions are very simplistic. Let’s advance this example by adding introducing a few more “what-ifs”.
Adding the “What If” of Future Withdrawals:
That’s a pretty good example Mr. Farrell, I thought as I read his book, but there has to be twist. So I decided to take his example one step further by seeing how long the money would last you if you didn’t take it out all at once. Surely if I have $63,718 in one fund versus $47,788 in the other, the first one should last me a lot longer, right?
• As I’ve already mentioned, let’s say you don’t completely cash out of both funds, and you keep the $63,718 in the Traditional fund and the $47,788 in the Roth (Line 13).
• You decide you will need $1,000 each month for expenses. For simplicity, let’s say that’s an annual withdrawal of $12,000 (Line 14).
• Now to actually receive $12,000, you’ll need to consider how much money you’ll be paying to taxes first. Again, our tax rate is 25% (Line 15). So in the Traditional account, you’ll really need to withdrawal $16,000 to get that $12,000 (math: $16,000 x (1 – 0.25) = $12,000). With the Roth, there won’t be any taxes, so you can just withdrawal $12,000 (Line 16).
• Just like before, we’ll assume our investment continues to grow at 7.5% (Line 17). Crunching the numbers again, both funds run out of money at exactly the same time = 4.91 years (Line 18).
Conclusion: Nope, that doesn’t make a difference either. Both funds run out of money at exactly the same time.
Adding the “What If” of Annual Contributions:
Okay, I’m still going to find the twist! Notice that in Farrell’s example, you only add money to the fund once (in the beginning). Hopefully you’ll be a more diligent saver than that! A more likely scenario is that when you open an IRA you’ll probably contribute a little bit of money each year (or month). So how does that affect our results?
• To stay consistent, let’s keep everything the same as in the previous examples.
• In the previous examples, between ages 45 and 65, we didn’t add any money. So now, let’s say we’ve got an extra $2,000 each year to add to your IRA (Line 5).
• From our definitions of Traditional and Roth, you’ll be able to contribute the whole $2,000 to your fund. But with the Roth, you’ll lose $500 to taxes (math: $2,000 x 0.25 = $500). So in effect, you’ll really only have $1,500 to contribute (Line 6).
• Crunching the numbers again, we once again find that both funds are the same! If the whole amount is withdrawn again at age 65, you would have the same amount of money (Line 12). If the money was left in each fund and small withdrawals were made, they would both run out of money at the same time (Line 18).
Conclusion: Making small annual contributions doesn’t make a difference either.
So What IS the Difference?
At this point, you might be saying “What’s the point?” “Why so much fuss over choosing the better one?”
The short answer: Taxes.
In every example, we assumed your tax rate would be the same now (age 45) as it is later (age 65). Is that really likely to happen? Not exactly:
• You could be richer (you hope!) or poorer when you’re older, and this would change your tax bracket.
• Politicians could change the tax codes at any point in the future meaning you may pay more or less regardless of your own situation.
With that said, the difference is this:
• If you assume that when you’re older you’ll be in a higher tax bracket = the Roth IRA is the better deal.
• If you assume that when you’re older you’ll be in a lower tax bracket = the Traditional IRA is the better deal.
Let’s illustrate an example where the Roth IRA is the winner. We’ll run the numbers again using our same example and same variables, but raising our future tax bracket from 25% to 30%.
Conclusion: As you can see, the Roth leaves me with more money regardless of whether I cash out (Line 12) or slowly withdrawal the money over time (Line 18). You can also illustrate the same point with the Traditional if you lower the future tax bracket from 25% to 20%.
Don’t worry, I’m going to reveal the twist! In Part 3, I will share with you my reasons for why the Roth IRA gets my vote as the better option of the two.