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Woman contemplating her Roth and Traditional IRA options.
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In this third article of my series on traditional IRAs and Roth IRAs, I provide comparisons to show the dynamics between these two instruments in the hope of answering whether a traditional IRA or Roth IRA is best for you. It may come as a surprise that, while no one can accurately predict future tax rates, many scenarios place the Roth IRA ahead of the traditional IRA in terms of income provided during retirement.
But before I get into that, I need to explain a wrinkle on the traditional IRA, which typically is hyped for its tax-deductible contributions. That wrinkle is a traditional IRA without tax-deductible contributions. Both IRA versions offer the often-misunderstood benefit of tax-deferred growth. While there’s no upfront tax advantage on your contribution to the lesser-known tax-deductible IRA, you still benefit from the tax deferral on your earnings. That benefit is lost on many people unfamiliar with investing outside of their retirement plan. (If you invest outside of a retirement account, you are subject to capital gains taxes each year on your earnings.)
Like the more familiar tax-deductible, traditional IRA, the non-tax-deductible, traditional IRA comes with required minimum distributions at age 70 ½. But unlike the traditional IRA with deductible contributions, your contributions are not taxed when you withdraw money (or are required to withdraw money) from a non-tax-deductible, traditional IRA, since you’ve already paid taxes on the contributions. This non-tax-deductible, traditional IRA will become one of your options if you are phased out of contributing to a traditional IRA or a Roth IRA.
Considering the overall impact of taxes on IRAs
The effect of taxes can be significant. Many people, you may be included, assume that their tax rate in retirement will be less than their tax rate today. While I understand the hopefulness of that comment, that may not be true. Consider the current federal tax rates that started in 2018. They are scheduled to expire in 2025 and return to their previous marginal tax rates, which were higher. Also, consider the effect of state tax rates. Currently, the state of Illinois doesn’t tax retirement accounts. Will that continue?
I have created some hypothetical cases using MoneyGuidePro’s IRA Contributions Calculator* to help illustrate the effects of taxes and of whether you are participating in an Employee Retirement Income Security Plan (ERISA) 401(k) or ERISA 403(B) through your job. MoneyGuidePro is a software package used by many Certified Financial Planners. I have used the 2025 income tax rates to show what is currently scheduled to happen with future tax rates. The illustrated cases are segmented by active participant status in an ERISA retirement plan and then by income to show the effects that phaseouts have on your options. The illustrations are then further broken down into the current and scheduled 2025 rates. Finally, I show how much of a tax rate cut would be required to tilt in favor of the traditional IRA.
General assumptions for scenarios
A female, starting to save at age 45, whose state of residence is Illinois
Yearly Contribution: $6,000 until retirement
Hypothetical Rate of Return: 7%
Distributions starting at age 65 and ending at age 94
Not currently participating in an Employer-Sponsored Retirement Plan
Total Adjusted Gross Income of $50,000
Current Federal Tax Rate: 22%; State: 4.95%
Scheduled 2025 Retirement Federal Tax Rate: 25%; State: 0%
Because the income is less than the phaseout amounts for the Roth and the traditional IRA with tax-deductible contributions, both types of IRAs are possibilities. With a Roth IRA, she could withdraw $21,693 each year from ages 65 to 94. With our current assumptions, that withdrawal would decrease to $20,179 if she had saved the same amount in a traditional IRA. That translates to total Roth IRA retirement withdrawals of $650,794 and total traditional IRA withdrawals of $605,378. It’s important to note that if she had not used either of these tax-advantaged retirement accounts and had used a taxable savings instrument instead, she would only have accumulated $435,184 based on today’s capital gains tax rates.
Combined Federal and State Rate Drop Needed in Retirement for the IRA to Best Roth: 8.95%
The combined federal and state tax rates would need to be reduced by 8.95 percentage points before the traditional, tax-deductible IRA would have an advantage over the Roth IRA. Assuming that reduction were to occur, she could then withdraw $21,896 each year from a traditional, tax-deductible IRA from ages 65 to 94.
Total Adjusted Gross Income of $100,000
Current Federal Tax Rate: 24%; State: 4.95%
Scheduled 2025 Retirement Federal Tax Rate: 28%; State: 0%
All previous IRA options remain open. The Roth IRA results remain unchanged, with annual withdrawals of $21,693 for a total of $650,794. However, because of her higher marginal tax bracket, the traditional IRA would only allow for annual withdrawals of $18,440 for a total of $553,207.
Combined Federal and State Rate Drop Needed in Retirement for the IRA to Best Roth: 9.95%
The combined tax rate would have to reduce from 28.95% to 19% before the traditional, tax-deductible IRA—paying $21,879 each year at that point—would have an advantage over the Roth.
Total Adjusted Gross Income of $150,000
Current Federal Tax Rate: 24%; State: 4.95%
Scheduled 2025 Retirement Federal Tax Rate: 28%; State: 0%
At this income level, she is phased out of contributing to a Roth IRA. Her choice is between a non-tax-deductible IRA and a taxable account. The IRA would provide $19,659 each year. That number would fall to $13,955 if she had elected to use a taxable investment instead. The non-tax-deductible IRA would allow her to withdraw a total of $589,770, whereas a taxable investment would yield only $418,645. The traditional IRA with non-deductible contributions is always better than the taxable account using the current tax rates on earnings.
Participating in an Employer-Sponsored Retirement Plan
Total Adjusted Gross Income of $50,000
Current Federal Tax Rate: 22%; State: 4.95%
Scheduled 2025 Retirement Federal Tax Rate: 25%; State: 0%
At this income level, the results are the same as those above for someone not participating in an employer-sponsored retirement plan.
Total Adjusted Gross Income of $100,000
Current Federal Tax Rate: 24%; State: 4.95%
Scheduled 2025 Retirement Federal Tax Rate: 28%; State: 0%
The Roth IRA remains an option. In fact, the results from saving in the Roth IRA remain the same as those above for someone at this income level who is not participating in an employer-sponsored retirement plan—$21,693 each year from ages 65 to 94. Her income is now above the $74,000 income phaseout for a tax-deductible IRA, but she is eligible for a non-tax-deductible IRA. Unfortunately, the non-tax-deductible IRA would only allow her to withdraw $18,276 each year. That translates to total Roth IRA retirement withdrawals of $650,794 and traditional, non-tax-deductible IRA withdrawals of $503,852.
Combined Federal and State Rate Drop Needed in Retirement for the IRA to Best Roth: 28.95%
The tax rate must become 0%—an unlikely 28.95 percentage point drop—for her traditional, non-deductible IRA withdrawals to equal her Roth withdrawals of $21,693 annually.
Total Adjusted Gross Income of $150,000
Current Federal Tax Rate: 24%; State: 4.95%
Scheduled 2025 Retirement Federal Tax Rate: 28%; State: 0%
In this case, her income is now above the $137,000 income phaseout for contributing to a Roth IRA. She remains qualified for the non-tax-deductible IRA, though. This IRA would allow her to withdraw $18,276 each year. If she were to bypass this option and simply go the taxable route, her withdrawal number would reduce to $13,955. Hypothetically, she could withdraw a total of $503,852 from her traditional, non-tax-deductible IRA versus $418,645 from a taxable account. Again, the traditional IRA with non-tax-deductible contributions is always better than the taxable account using the current tax rates on earnings (i.e., capital gains taxes).
Are your retirement tax rate hopes realistic?
Overall, this analysis shows that some significant tax reductions would have to occur for a traditional IRA to outpace a Roth IRA. In some cases, however, due to phaseouts, one can’t contribute to a Roth IRA, leaving a traditional IRA as your only option. If you have a workplace plan, you should ask your employer about adding the Roth feature. We saw in some cases that the option of a tax-deductible IRA is not available to active participants in employee-sponsored retirement plans. In those cases, the non-tax-deductible, traditional IRA is the only IRA option. While that might feel like a loss, it still offers tax deferral on the earnings, which significantly outpaces a taxable investment, since you don’t face capital gains taxes every year.
Another option you may have is saving and investing in a health savings account (HSA). There are no phaseouts and no taxes if the money is used for healthcare expenses in retirement. Let’s face it, some of your retirement expenses will be healthcare related, so it becomes a triple tax-free option for paying those expenses. To learn more, check out Want a Discount on Your Retirement Health Care: Use an HSA,” which was part of my three-part series on health savings accounts.
Hopefully this has given you a better appreciation of the types of IRAs available and the benefit of tax deferral. And I hope this will help you make smarter money moves on the path to the life you envision.