Econintersect: The Roth IRA, with contributions made with after tax dollars and never to see the taxman again, have become by far the retirement savings vehicle of choice over the past five years. Since 2007 Roth contributions have exceeded traditional IRA contributions by more than 60%. Conversions of traditional IRAs have also been increasing rapidly in recent years. A significant part of the logic is likely due to the feeling that tax income tax rates are likely to increase in the future.
If one is in a 28% bracket today, for example, and ends up in a 33% bracket in retirement, it is better to pay the current tax rates and be tax free forever after. The alternative is to take advantage of a low rate tax deduction now (traditional IRA contribution) and risk paying a higher tax later, not only on what was originally contributed but on all the earnings as well. Two examples follow.
Case 1: Let's just take a simple example of someone who is 40 and in the 28% tax bracket. The assumption will be a 6% compounded return for thirty years to age 70. Assume 33% tax bracket when age 70 is attained.
Traditional IRA contribution of $3,000.
- No tax paid.
- Value at 70 is $17,230.
- Value after tax at 70 is $11,544.
Roth IRA contribution of $3,000.
- Tax paid is $840, remaining balance in the Roth is $2,160.
- Value at 70 is $12,406, not taxable.
- This saver has an extra $860 after tax value at age 70 (7.47% more).
- If the tax bracket at age 70 is 36% the difference becomes $1,378 or 12.50% more.
One feature of the Roth IRA is that it has no required distributions for the beneficiary who started it. (There are distribution requirements in the next generation for inherited Roths, but we won't discuss that here.) So if the retiree doesn't need income from the Roth until age 80 the advantage keeps increasing.
Given the same 40 year old, currently 28% tax bracket and 36% in the future, the advantage of the Roth at age 80 is $2,468 (also 12.5% more).
Case 2: The advantage of the Roth is even greater if the funding is at a younger age. Let's consider a 20 year old in the 15% bracket and $1,000 for retirement savings. Also assume the future tax bracket is 36%.
Traditional IRA contribution of $1,000.
- No tax paid.
- Value at 70 is $18,420.
- Value after tax at 70 is $11,789.
- Value at 80 is $32,988 and after tax is $21,112.
Roth IRA contribution of $1,000.
- Tax paid is $150, remaining balance inRoth is $850.
- Value at 70 is $15,657, not taxable.
- Value at 80 is $28,040, not taxable.
The advantage for the Roth is $3,868 at 70 and $6,928 at 80 (b0th 32.8% better after tax than the traditional IRA).
What if the tax brackets don't change? There is no advantage for the 40 year old to use a Roth. The result in our simple example is the same for as for a traditional IRA.
Obviously, if tax brackets are lower upon withdrawal the traditional IRA has an advantage.
An article by Donald Jay Korn in Financial Planning says that Roth IRAs are popular for all age groups. Korn says that recently 84% of IRA contributions for 20-somethings have been Roths and 85% for those over 70.
Note: It is not surprising that Roth contributions are so high for those over 70 since contributions cannoy be made starting with the year one turns 70 1/2 and every year thereafter. There is no age limit for Roth contributions - all that is needed is sufficient earned income to cover the amount of the contribution.
Korn also gives some additional data:
Average IRA contributions for 2011 were $3,930, up from $3,420 four years earlier. Every age group posted increases over 12%, with the largest increases coming from the 40-49 and the 70+ age groups.
Among those IRA contributions, investors have consistently preferred the Roth to the traditional version for the last several years. According to Fidelity, "on average, contributions to Roth IRAs have surpassed those made to traditional IRAs by 62.7% since tax year 2007." Fidelity also reported that Roth IRA conversions in the first half of 2012 were more than double (up 109%) from the number conducted within the same time period in 2009: before income limits on conversions were removed in 2010.
- Roth IRAs Spearhead Retirement Savings Surge (Donald Jay Korn, Financial Planning, 16 August 2012)
- Individual Retirement Arrangements (IRAs) (IRS Publication 590)