Quizmaster, Doug Hutchinson, presents his quiz for the month. Here, Doug compares traditional IRA versus Roth IRA contribution strategies.
Consider this Scenario:
Your friend Max would like to contribute money to a retirement account and he is determining whether to contribute to a traditional IRA or a Roth IRA. Assume Max is eligible to contribute to either of these options.
Max has a current income tax rate of 25% and he expects to face an income tax rate of 25% after he retires.
Max has analyzed his budget and has determined that he is willing to give up $3,000 in consumption in order to contribute to his retirement account. He could contribute $3,000 after-tax dollars to his Roth IRA. Alternatively, he could contribute $4,000 to a traditional IRA. This contribution would save Max $4,000 x 0.25 = $1,000 in taxes so his consumption would be reduced by $3,000 in this scenario as well.
Assume that an investment in either account will have an annual return of 6% each year over the next 20 years.
Is Max better off with the Roth IRA contribution or the traditional IRA contribution?
- Max is better off with the Roth IRA contribution
- Max is better off with the Traditional IRA contribution
- Max should be indifferent between the Roth IRA contribution and the Traditional IRA contribution
Solution:
C is probably the best answer
The future accumulation in after tax dollars of the Roth IRA and the Traditional IRA are equal because the current and future tax rates are equal. For the traditional IRA, Max will owe 25% in taxes on the amount that he withdraws.
Roth IRA value after 20 years = $3,000 x (1+ 0.06)20 = $9,621.41
Traditional IRA value after 20 years = $4,000 x (1+ 0.06)20 x (1- 0.25) = $9,621.41
If Max’s current tax rate was greater than his tax rate in retirement, the future value of the Traditional IRA would be greater than future value of the Roth IRA (and vice versa).
A Roth account has additional advantages over a traditional IRA such as the ability to take early distributions without penalty (in certain scenarios) and the lack of required minimum distributions. Max should consider working with a financial planning professional who can help him analyze all of these complexities to build a comprehensive financial plan.
Click here to learn more about the difference between roth IRA and a traditional IRA.
The financial advisors at WrapManager can provide expert advice about IRA contributions and rollover IRAs. Give them a call at 1-800-541-7774 or contact us here to connect with a Wealth Manager today.
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This quiz is intended for informational and illustrative purposes only. This material is not intended to be relied on as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information presented is general information that does not take into account your individual circumstances, financial situation or needs, nor does it present a personalized recommendation to you. The information and opinions contained in this material are derived from sources deemed reliable, are not all-inclusive and are not guaranteed as to accuracy.
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