The Benefits of a Roth IRA

Traditional retirement accounts benefit contributors by deferring tax which would normally be paid on contributions until the money is taken out of the account. Along the way, both the principal amount and the earnings of the investment grow within the account, and the earnings part isn’t subject to a tax calculation or tax payable until it is withdrawn as well.

There are many benefits of this, especially if the contributions are made pre-tax. This way, the tax savings immediately become incorporated into the account, where the amount that is contributed reduces your overall tax payable on the spot.

Contributions after tax do so as well but on a delayed basis, as it reduces your net tax payable but only at the time of filing. This will either reduce your net tax payable or increase your refund by the amount of the tax deferral on your contributions, the amount that you would have paid in income tax on what you ended up contributing to the retirement account.

Roth IRAs are always post tax because there is no tax deferral at the time of contribution, and no tax is actually ever deferred with these accounts. The tax benefit here is one of avoidance, where your money grows tax free in the account.

Non-retirement accounts also use post tax contributions, meaning that there is no tax savings when you put money into one of these accounts, and the earnings that you make in the account are also subject to taxation.

With traditional retirement accounts, earnings are also subject to tax, but at the rate that is in effect when withdrawn, preferably at a point in time, like in retirement, where your marginal tax rate has declined, due to your income being reduced.

With Roth IRAs, aside from the withdrawal rules that are in place, you can take money out of it at any time without any direct consequences, because the tax has already been paid on your contributions and anything over that simply is not ever taxed.

This is one of the things that sets Roth IRAs apart from traditional ones, where you don’t have to concern yourself about the timing of withdrawals in relation to your income and tax rates, and this does serve to simplify decisions surrounding IRAs due to this not being a consideration.

Tax Deferral vs. Tax Avoidance

This difference between Roth IRAs and traditional retirement accounts leave us wondering which of the two strategies may yield a higher overall benefit, setting aside paying taxes on amounts or paying the tax on the principal and not paying any tax on its earnings.

In essence, we are deciding between getting a partial tax benefit on the entire amount, what we put in and whatever our investments within the retirement account has earned over the years, and saving the entire amount on these earnings.

To understand how these two distinct elements compare with one another, we need to look at what the net effect of each will be assuming the same rate of return in a retirement account and how the magnitude of that return will affect our decisions.

The earnings will always be the smaller of the two amounts of course since we’re adding on our contributions to whatever amount this is, but this ratio will vary depending on what one’s overall return ends up being.

In essence, Roth IRAs forego the tax treatment on contributions in order to seek out an even bigger amount of tax savings, although we’re going to need to see a big enough return over time to overcome this and yield a net gain of tax money saved.

Let’s say we put $100,000 in a traditional retirement account and are expecting a 10% savings in tax when we withdraw it. We’re going to save 10% on the $100,000, or $10,000, plus 10% of the amount that we grow our account by.

If we end up making nothing in our account or have a net investment loss on it, we still will save our $10,000 with the traditional account, but we will not have any tax savings with a Roth IRA because there are no earnings present to avoid paying tax on.

In the curious case of when we have a net loss, we actually benefit further from the traditional IRA, for instance if our amount went down to $80,000 and we withdraw that, we will only pay tax on this reduced amount, so in a real sense our tax obligation has been further lowered versus the $100,000 we contributed to the Roth IRA which has already been taxed at our full rate.

This doesn’t occur very much and people generally end up with a positive return over time with their retirement accounts. We then need to have an idea of which strategy may produce the largest benefit.

If we average a 5% return on our money over a period of 30 years, that’s a 150% return on investment over the period, and we’ll now end up with a total of $250,000. Assuming that all the money was contributed while we were in the higher tax bracket, and the same 10% reduction in taxes, we’ll save $25,000 with this approach.

How Tax Brackets Greatly Influence this Decision

With a Roth IRA, we’ll avoid paying taxes on this $150,000 that we earned, and how this will all come out will depend on what our tax bracket will be upon retirement. In our example, we have been paying a 22% marginal tax rate while working, with our income in the range of $38,700-$82,500, and then see our income drop below $38,700 when we stop working.

The Benefits of a Roth IRAThis will place us in the 12% tax bracket and 12% of $150,000 is only $18,000, and we would have been better off with the traditional IRA, at least in this respect.

However, if we stay in the 22% tax bracket, meaning that our income stays within this pretty wide range before and after retirement, then we’re not getting any tax savings with our traditional IRA, but will save 22% of $150,000 with a Roth IRA, or $33,000.

If our income is over $82,500, this would put us in a higher tax bracket, 24% for that amount up to $157,500, but this measly 2% is not going to be anywhere near enough to make a traditional IRA competitive with a Roth one. This will only yield a $5000 tax savings instead of our $33,000 with a Roth.

While there is more to this than just looking at the tax brackets, for instance if we have the deferred tax in the account over these years, this will increase our principal amounts, but nowhere near enough to overcome only getting a small percentage of tax reduction.

Therefore, a very good rule of thumb, and one that a lot of people don’t practice, is to prefer a traditional IRA if your income will not only drop but actually drop to a tax bracket that will make enough of a difference, and specifically, going from a marginal federal tax rate of 22% down to 12%, meaning that your income drops below the current maximum amount for this bracket of $38,700 per year.

Otherwise, a Roth IRA will be far more beneficial overall, and with a traditional IRA, if our income goes down in retirement but our tax bracket remains unchanged, this will actually have no effect on the rate of tax we will pay, assuming that tax brackets remain unchanged.

Therefore, instead of our pretty much just assuming that lower income means less tax, and then saying that this would indicate that a traditional IRA or 401(k) would be the way to do if that happens, or at least would make it competitive with a Roth IRA, if the tax savings overall end up to be minimal, or in many cases non-existent, we have made a mistake here.

With that said, a lot of taxpayers do see their income drop down to where they can enjoy this 10% reduction in taxation. Where the Roth IRA is a clear winner if our income in retirement ends up being over the $38,700, if it is less, traditional IRAs win hands down. This is like the great divide of retirement accounts actually.

The Greater Flexibility of Roth IRAs

While those with a higher retirement income will end up saving a lot more in taxes with a Roth IRA, it also has the benefit of more flexibility. While we wouldn’t really want to go with a Roth IRA merely based upon this, as the tax calculation is always going to be paramount, the greater flexibility of the Roth IRA can offer additional benefits.

The big difference between these two types of IRAs is that with a traditional one, any withdrawal at all is going to be subject to withdrawal rules and withdrawal tax implications, where with a Roth IRA, the principal can be withdrawn at any time with no consequences whatsoever.

With traditional IRAs, it’s not just the penalty you need to worry about if you take money out prior to age 59 ½ without being able to use one of the several exclusions, you also need to be concerned about having to pay tax at your full tax rate, instead of withdrawing it after retirement presuming that you will be in a lower tax bracket then.

Tax brackets don’t really matter with Roth IRAs, because there is no tax paid at all with it. Roth IRAs are characterized in fact by a lack of tax considerations, and a complete lack. We do use tax rates to calculate our savings over contributing to something else, but there is no tax paid on withdrawing either principal or earnings from one.

Should one need to withdraw from a Roth IRA at any time, we do have access to the money we put into it. While it’s always better to let the money stay in the account and continue to generate tax free earnings, if we really need it, we can access quite a bit of what’s in our accounts.

After age 59 ½, the entire amount in a Roth IRA becomes accessible to us without penalty or tax, with the only consideration being, once again, withdrawals limiting the future growth of the account.

Once we turn 70 ½, with a traditional IRA, we not only cannot contribute more to the account, not that we’d really want to at this point anyway, but we also need to make prescribed minimum annual withdrawals from it. With Roth IRAs, there is never a requirement to do this nor any maximum age restrictions for anything.

It really all comes down to how much tax we’ll be saving though, which all comes down to how much tax savings, if any, that a traditional IRA is expected to provide and then seeing how this stacks up to a Roth IRA, which will guarantee a significant amount of savings in any case according to one’s return on investment.

Choosing one or the other should not be that difficult of a decision really, as all we really need to do is make a good prediction of where we think our income will be in retirement in current dollars, and while tax rates can and do change, we can just use the current ones to get a good idea of what might happen, how much we will save.

The way tax brackets are structured is to benefit those whose income is quite modest, like being below $38,700 in 2018, and if we expect to do better than this and are fairly sure of this, then a Roth IRA is a great choice.



Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.

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