Comparing the Roth Ira to Traditional Ira: an After-Tax Cash Flow Analysis

Comparing the Roth IRA to the Traditional IRA:

An After-Tax Cash Flow Analysis

By

Nicholas Eddy

February 23, 2013

This article compares the Roth IRA to the Traditional IRA in terms of which gives investors the best after-tax returns.

IRA stands for individual retirement account. The traditional IRA was first introduced in 1974. Simply put, a traditional IRA is an account you put money into without paying taxes upfront-usually by payroll deduction. When you withdraw money from the account, you then pay the taxes due on it. Roth IRAs were introduced in 1997. With a Roth IRA, you pay taxes on your contributions upfront, therefore, when you withdraw the funds, they are tax-free as long as you meet the guidelines for the withdrawals. As of 2012, individuals age 49 and younger can invest up to $5,000 per year and individuals age 50 and older can contribute $6,000 per year.

Comparing the investment performance of the two types of IRAs indicates that the investor’s marginal income tax rate during the working years and during the retirement years is a key factor in the appropriate IRA selection. The Roth IRA is a better fit whenever an investor anticipates a higher annual income tax rate during retirement years than during the contribution years. The traditional IRA is preferable whenever a lower income tax rate is expected during the retirement years. Investors who are in the same marginal income tax bracket during the contribution time period and during the retirement years should be indifferent to either the Roth or traditional IRA.

In short, in most cases, “whenever the estimated income tax rates during the IRA investment time and the IRA withdrawal time are relatively close, the Roth IRA outperforms the traditional IRA in after-tax cash flow performance” (Grossmann & Rose p. 61).

Reference

Grossmann, A., & Rose, C. (2012). Comparing the Roth IRA to the...