Analysis of Roth vs. Traditional IRA’s Using Pralana’s Retirement Calculator
by Stuart C. Matthews, Pralana Consulting LLC
I’ve often wondered which was better: traditional IRA’s or Roth IRA’s. My gut feel has always been that traditional IRA’s were preferable because they paid immediate benefits through the reduction in current-year taxes, but I’ve heard some people suggest that Roth IRA’s might be better in the long run, particularly if Congress raises our taxes prior to taking withdrawals. To analyze this objectively, I decided to run the numbers using Pralana’s Retirement Calculator.
For my analysis, I compared two married couples across three test cases. Both couples are assumed to have $300,000 in their savings accounts when the test begins, with none in IRA’s, and the other basic facts as shown in the tables below. To help keep the results straight as we go through the analysis of each test case, let’s call the couple with the traditional IRA “The Trad’s” and the couple with the Roth IRA “The Roth’s”.
As you can see, everything is identical between both couples and across all three test cases except for the cells highlighted in yellow. The Trad’s put 5% of their income in traditional IRA’s while the Roth’s put 5% of their income in Roth IRA’s. In Case 1, both couples quit working 5 years prior to taking Social Security benefits; however, they do have nice defined benefits pensions, so they always have income. In Case 2, neither couple has a pension but they continue working until they start taking Social Security benefits, so they always have income. In Case 3, however, the couples stop working 2 years prior to taking Social Security but don’t have pensions, so they have to go 2 years without any income.
The graph below shows the result of Test Case 1. The orange spike indicates the couples’ retirement year. The two nearly overlapping lines reflect the total savings (401k’s, IRA’s and taxable savings) of both couples and are measured using the left vertical axis. The curved blue line reflects the magnified difference between the two savings lines and is measured using the right vertical axis. When the difference is negative, the Trad’s have more money in savings; when the difference is positive the Roth’s have more. You can see that the Trad’s (with their traditional IRA) have higher overall savings up until about 2049, after which the Roth’s have an ever-increasing advantage (over $150,000 at end of life). It may be worth noting that in this case neither couple ever had to make withdrawals from either tax-deferred or Roth IRA accounts, other than minimum required distributions, during their lifetimes.
The graph below shows the result of Test Case 2, which has a similar look to Test Case 1 except that the Trad’s have the advantage until within about 3 years of end of life.
The graph below shows the results of Test Case 3 and you’ll quickly notice dramatically different results relative to the previous cases. In this case, there’s barely a hint of the Roth’s even beginning to gain an advantage over the Trad’s. A significant point to be made in this case is that both couples have an average 7% withdrawal rate through their retirement years, so they’re making withdrawals at a higher rate than the commonly recommended 4%.
Here are my observations:
Takeaway #1: All else being equal, the longer you work and contribute to an IRA, the longer it will take for the Roth IRA to overcome the pre-retirement advantage established by the Traditional IRA.
Takeaway #2: Takeaway #1 is impeded if your taxable savings are depleted and you are forced to tap your tax-advantaged savings to meet current expenses. This will always occur to the Roth’s before it happens to the Trad’s because the Roth’s have less in taxable savings. So, for a while, the Roth IRA is being consumed and the Traditional IRA is still growing untapped. The greater the extent of this, the less chance the Roth IRA has of overcoming the initial advantage of the Traditional IRA.
Takeaway #3: The sooner you can retire with enough residual income and taxable savings to avoid having to tap your tax-advantaged savings to meet current expenses, the more beneficial the Roth IRA is likely to be.
Takeaway #4: Each of the previous takeaways will be amplified if tax rates are changed in the future. If taxes are increased in the future, it will take less time for the Roth IRA to gain an advantage. If taxes are decreased in the future, any potential long term advantage of the Roth IRA may evaporate altogether.
Want to run your own numbers and see which IRA is best for you? Here’s how.
Pralana’s Retirement Calculator (PRC) models traditional IRA’s and Roth IRA’s as investment options and, consequently, enables you to investigate the relative advantages of one versus the other for your specific case. To begin with, though, you’ll need to go through the process of establishing a baseline financial plan for your family, including a tentative selection of either a traditional or Roth IRA. For now, let’s say you’re going to choose the traditional IRA for your baseline plan. So, start on the General tab and enter all the requested information about you and your family, including ages, target retirement dates, Social Security start dates, assumed inflation and rate of return on your aggregate savings, and so on. Program in an across-the-board tax hike at some point in the future if that makes sense to you. Then go to the Income tab and describe your income and how you expect it to progress over the years as well as the percentage of your salary (and your spouse’s salary) that will be contributed to a tax-deferred retirement plan (traditional IRA and/or 401k). Then, enter the information on your Major Assets, College Expenses and Other Expenses on the respective tabs. That concludes the initial data entry process and, so, establishes a baseline plan. The Graph will give you the results at a glance, and the Projection (Current$ or Future$) will give you the results in great detail in tabular form. You’ll be able to see the growth of your investments over time in each of these views.
Now you’re ready to investigate the alternative of the Roth IRA instead of the traditional IRA. To do this, go back to the Graph tab and click the Option 1 and Option 2 buttons to tell PRC to remember your current plan as a graphed option. Then, go back to the Income tab, subtract out the percentage of your income you want to contribute to the Roth IRA from the tax-deferred retirement plan cell and add that number to the Roth IRA contribution cell, for both you and your spouse. Then, go back to the Graph tab and a new curve will have appeared representing the plan associated with the numbers you just entered. Armed with this graph, you can do a relative comparison to see which option yields the best results for you.
Pralana Consulting LLC, Plano, TX
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