Full Disclosure Finance

By Andrew

In honor of this past weekend’s UFC event UFC 78 Validation I decided set up my own card to settle once and for all the dispute between two of today’s more popular retirement plans. More and more Americans these days are beginning to realize that their company pension plans and Social Security will not be adequate to provide for them during retirement. Instead of playing the cynic and blaming Congress for failing us in our time of need we need to realize that it may be up to us as individuals to fund our retirement accounts. Hey, if you want something done right you’ve got to do it yourself. In this post I’ll focus on one of the most popular and flexible options for retirement savings; the Individual Retirement Account or IRA. For you Canucks out there an IRA (especially the Traditional variety) is very similar to a Canadian RRSP. Although there are a number of different types of IRAs (11 at last count), the two most popular seem to be the Traditional IRA and the Roth IRA. Many people are unclear on the differences between these two options and which plan is best for them. To settle the dispute we’ll match the two plans up in the octagon to see which option taps out first. Just no eye gouging, head butting, or low blows please.

Tale of the Tape

The maximum contribution for both plans in 2007 is $4000 (in 2008 this value increases to $5000) so there is no advantage or disadvantage here. The contribution can be made in whatever increments you like (i.e. $333.33 per month for 12 months or a $4000 one time payment, both max out your contribution). There is no minimum contribution requirement either, so you don’t need to max out your plan every year. Both plans are very versatile in that they can be used to purchase a variety of investments such as stocks, bonds, options, and even real estate in certain cases. For both plans withdraws can begin at age 59 ½, however, with a Traditional IRA they become mandatory at age 70 ½ whereas with a Roth IRA there is no mandatory distribution age. Advantage Roth. A Traditional IRA is available to anyone regardless of their income. In contrast, a Roth IRA is only available to single filers making less than $95,000 or joint filers making less than $150,000 annually. Advantage Traditional. If you withdraw any funds from your Traditional IRA before you turn 59 ½ (including the principle contributions) you will be hit with a 10% penalty plus any applicable taxes. The 10% penalty also applies to your Roth IRA but in this case only to the gains from the investment. This means that you can take out your original contributions without penalty. Advantage Roth. The main difference between the two plans is when you incur the tax savings. With a Traditional IRA the contributions are tax deductible meaning that you get the tax savings up front. With a Roth IRA the contributions are not tax deductible but all withdraws (earnings and principle) are 100% tax free as long as the IRA has been open for at least five years and you are 59 ½ or older. So who gets the advantage here? To find out lets match the two plans up head-to-head.

Let’s Get It On

Let’s say that you’re 25 and you have $4000 (the max contribution for 2007) that you want to put into an IRA plan. If you put the $4000 into a Roth IRA your investment will be worth $59,141 when you turn 60 (assuming a modest 8% return). Not too bad, and the best part is that you can now take that money out tax free. If you put that same $4000 into a Traditional IRA your investment will still be worth $59,141 but you’re going to have to pay tax when you withdraw the money. Assuming that you’re in the 25% tax bracket you’ll have to pay Uncle Sam $14,785 dropping your net to only $44,356. So the Roth wins hands down right? Not quite. Remember we got a tax deduction with the traditional IRA. So the $4000 deduction saves us $1000 in the 25% tax bracket. That $1000 invested with an 8% return would grow to $14,785 by the time you turned 60. Assuming a 15% capital gains tax rate on the $1000 investment, you’re total takeaway including the IRA money would now be $56,924. Still over $2000 less than the Roth IRA and that’s assuming that you’re disciplined enough to invest that $1000 tax savings rather than putting it towards that new LCD. Let’s be honest, it’s hard enough to put the initial $4000 away never mind the money you eventually save on taxes.

Some people might argue that when you take the money out of the Traditional IRA you will be in a lower tax bracket making the Traditional plan more appealing. In the above analysis we assumed that you were in the 25% tax bracket at the time of contribution and withdraw. If you dropped down to the 15% tax bracket that would mean that you’re annual income would have to be under about $32,000. I don’t know about you, but choosing a retirement plan based on making less money when you retire isn’t the deciding factor for me.

The Judge’s Decision

For me it’s unanimous. As long as you meet the annual income requirements I think the Roth IRA wins hands down. It’s a great option for young adults who are just starting out with their retirement savings. Most likely you’ll be in a lower tax bracket anyway so the tax savings with a Traditional IRA won’t be as great. Even if eventually you end up exceeding the annual income levels the money that you contributed up to that point can continue to grow tax-free. Unlike a Traditional IRA you can leave your money in the plan as long as you like. If you choose you can even pass along the tax-free IRA plan to your heirs. If during retirement you are also pulling money from a taxed source such as a 401(k) or Social Security a Roth IRA plan gives you more flexibility for managing your withdraws and the taxes you pay on them as compared to a Traditional plan. Technically, the better plan is determined based on what your tax bracket will be during contribution and during withdraws. However, it’s pretty hard to predict which bracket you will fall into throughout your lifetime. In my opinion the Roth IRA is simpler and requires less discipline in that you don’t need to worry about investing all your incurred tax savings from your contributions. Having access to a chunk of tax-free cash at retirement is always going to be a good thing.

Some links…

A great article on The Motley Fool comparing a Traditional vs. Roth IRA. The entire section All About IRAs is a great resource on IRA plans in general.

An interesting calculator that allows you to visualize the difference between the two IRA plans. The calculator also assumes that you invest the incurred tax savings from the Traditional IRA plan.

A great article on I Will Teach You To Be Rich about retirement savings and IRA plans including a Q&A with a CPA.