The One Thing All IRA Investors Must Know

Pop quiz time!

Two little piggies each have $5,000 pre-tax to invest in their IRAs. Piggy A decides to invest the entire $5,000 in a Traditional IRA. Piggy B decides to invest in a Roth IRA. Both piggies are in the 25% tax bracket.  After paying $1,000 in taxes on his $5,000, Piggy B only has $4,000 to invest in the Roth. Both piggies invest in the exact same S&P 500 Index Fund, and each of their accounts grow at 8% over 30 years. When they retire, both piggies remain in the 25% tax bracket (for simplicity, assume a flat tax instead of marginal tax brackets).

If they both take all the money out of their accounts, and Piggy A pays the taxes on his Traditional IRA, which piggy is left with more money?

a. Piggy A with the Traditional IRA

b. Piggy B with the Roth IRA

c. Pigs can’t make IRA contributions, so this is a dumb question

Okay, okay. C may be correct, but play along. Is the answer A or B? I’m gonna guess most of you picked Piggy B, the piggy with the Roth IRA. If you picked answer B, you are wrong.

Oh, so the answer was A? Actually, option A isn’t right either. Maybe I was a little unfair, but the correct answer wasn't even an option. The right answer is they will both have the same amount.

Some of you might be really confused right now. “How could they both have the same? All of Piggy B’s earnings were tax free. Over 30 years the Roth IRA should be worth a lot more. What gives?” I’ll tell you what gives. You may have never seen a fair, apples to apples, comparison of a Roth IRA vs. a Traditional IRA (until now!).

Most people (lazily?) compare Roth IRAs to Traditional IRAs without adjusting the initial investment downward for the Roth IRA (to account for taxes). No doubt a Roth IRA will look better, if you don’t account for the fact that the Roth IRA is funded with after-tax money. For those of you still not tracking, I’ll walk you through the scenario listed above.

IRA Basics Infographic

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Taxes are the only relevant variable in the scenario. If taxes are higher in retirement (than when contributing), the Roth IRA wins out. If the opposite is true and taxes are lower in retirement, the Traditional IRA wins out. If taxes stay the same, its a draw.

Future tax rates are impossible to predict. At this point, we don’t even know what this year’s tax rates will be, so it’s foolhardy to think we’ll know what tax rates will look like many years into the future. Given the future uncertainty, how does an investor make the right decision? First, everything I’m discussing here only looks at one aspect in the Roth vs. Traditional battle. I’ll put together another post showing all the pros and cons each have to offer. But, what if the decision comes down to what account would produce the highest after-tax value in retirement?

Go with what you (currently) know, and adjust (if necessary) when changes happen. Estimate what you think your expenses will be in retirement, and determine how much income you’ll need in retirement to meet those needs. Compare your retirement income to your current income. Will your income go up or down in retirement? Either way, the infographic can help you with your decision.

Keep in mind, retirement gives you more flexibility with your income. In your working career, you’ll (probably) be focused on making as much money as possible, and hopefully your income will far exceed your expenses. In retirement, you can match your income to your expenses, which should make it easier to lower your income. You won't have to save any of your income (you'll be living off your savings), which should cause income to decline. 

While I'll cover most of the pros and cons discussion in another post, I will mention one Roth benefit, as it is relevant to this discussion. While the maximum contribution limit is the same for Roth and Traditional IRAs, Roth IRAs have a higher effective contribution limit.

What does that mean? In 2017, the maximum contribution is $5,500 for either a Roth or Traditional IRA (if you do both, total combined contributions cannot exceed $5,000). A pre-tax contribution to a Traditional IRA of $5,500 requires $5,500 of gross income to max out. For someone in the 25% tax bracket, a $5,500 Roth contribution takes approximately $7,333, since you have to pay taxes on the money before contributing. In this example, the Roth allows you to contribute $7,333 in pre-tax income, while the Traditional IRA only allows you to contribute $5,500 in pre-tax income. As you can see the Roth IRA has a higher effective contribution limit. (If none of this paragraph made sense to you, don’t worry, it’s not critical to know.) 

While I’ve been focusing on IRAs, the logic here also applies to 401(k)s. If you don’t have a clue on whether your taxes will be higher or lower in retirement, consider another option. You could choose both. Doing both, could mean pre-tax 401(k) contributions and Roth IRA contributions, or vice-versa. Having Roth and pre-tax money acts as a hedge against uncertainty.

One of the main goals with NinjaPiggy is to help people make educated decisions. I’m convinced the more educated people are, the more likely they are to make a good decision (at least most of the time). Roth IRAs and Traditional IRAs each have their own advantages, and its only right we compare them on a fair basis.

The purpose of this post isn’t to hate on Roth IRAs. Roth IRAs have plenty of advantages and can still be the right option for a lot of people, but they have been placed on an unfair pedestal, due to a misunderstanding of the tax benefit. 

I hope this post was eye opening for a lot of you. I posed the pop quiz question above to a couple people I consider well versed in personal finance, and they both got it wrong. Many have been led astray by an unfair Roth vs. Traditional comparison. I wanted to set the record straight.

Was this something you already knew? Are you a pre-tax or Roth investor, or do you do a little of both?