Traditional or Roth IRA?

 

Present vs Future Value

When planning for retirement, choosing the right retirement account is a common dilemma: a Traditional IRA or a Roth IRA? Both types of IRAs offer tax advantages, but they serve different purposes and can benefit individuals differently based on their income, age, and financial goals. There are a lot of useful articles on this topic, such as this, so I’m going to go beyond the general and basic information and deal with a more realistic story.

The fundamental difference between these two is when you harvest the tax savings: present vs. future. With a traditional IRA, when you contribute $7000 for 2024, you can harvest the tax saving of $1,680 now, assuming your marginal tax rate is 24%. In the case of a Roth IRA, your contribution of $7000 is included in your taxable income, (hence, you have to pay tax of $1,680 for the tax year of 2024), however, in the future after retirement (or anytime after your age of 59 ½), its distribution is tax-free. How much would be its tax benefit in this case? It depends: Let’s say you’re 25 years old now and after 35 years at age 60 you would withdraw and this $7000 grows handsomely with an annual growth rate of 10% over 35 years to $196,717; the future tax benefit is $28,458, which is calculated as [$196,717-$7000]*15%, assuming the capital gain tax rate of 15% to simplify. If you discount this future value of $28,458 to the present value with the current market rate of 5%, it would be $5,159.

As you may notice, there are many assumptions to calculate the actual savings of Roth IRA. And then, to compare between these two types, we also need to know what you would do with the present tax saving of $1,680 in case you chose the traditional IRA. You may invest it in a next superstar, like NVDA in 2023, or use it to save a family or friend who is in trouble now. It’s not easy or clear to compare these two types in terms of monetary benefits.

Then, why do so many financial advisors advise Roth IRA better than a traditional? Roth has other benefits in the future as it’s not subject to No Required Minimum Distributions (RMDs) and it is simpler with the estate planning (which will be discussed in another article). For this reason, as you may get older, approaching your retirement, you may face the question of whether converting your traditional IRA to Roth is a good idea or not. This will be shown with a case in the next article.

Conclusion:

It would be a good idea to utilize all retirement saving options. As I mentioned in the previous article, Retirement Savings Options in the U.S., if you’re employed with Roth 401(k) programs, you can contribute to it without income restrictions; also, if you receive 1099-NEC or you’re self-employed, you may open a Roth Solo 401(k). In addition, for an IRA, you may have both traditional and Roth for the tax diversification and flexibility.

*Learn financial terminology: Backdoor Roth IRA

This involves contributing to a traditional IRA and then converting it to a Roth IRA. This method bypasses the income limits.

For 2024, Roth’s income phase-out ranges for single filers with Modified Adjusted Gross Income (MAGI) $146,000-$161,000 and for married couples filing jointly $230,000-$240,000. If your income is above this threshold, you can’t contribute to Roth. With a traditional IRA, there is no income limit to contribute. You may not reduce your taxable income if your income is above its threshold.