When planning for retirement, considering the tax impact of a Roth IRA, Traditional IRA, or a taxable account can significantly affect your long-term financial outcome (tax-adjusted returns). While each option has its benefits, the tax implications vary greatly and can play a key role in maximizing returns. Let’s dive into a comparison of these accounts, focusing on tax-adjusted returns over time.
1. Roth IRA: Tax-Free Growth and Withdrawals
One of the most appealing features of a Roth IRA is its tax-free growth. Contributions to a Roth are made with after-tax dollars, meaning you pay taxes upfront. (Do you call your checking account or savings your after-tax accounts?) If you fund your Roth IRA from those accounts, you’ve already paid the taxes., However, “qualified” withdrawals during retirement are tax-free, making it an excellent option if you are expecting to be in a higher tax bracket in the future.
To help with crunching the numbers for this article, I used Envestnet’s MoneyGuide Elite software, a financial planning program for financial planners. Based on calculations from the Money Guide Elite IRA Contribution Calculator, the Roth IRA offers significant advantages in tax-free growth, particularly when considering long-term gains. With no taxes on withdrawals, the Roth IRA provides stability and predictability for retirees who want to minimize their tax burden in retirement.
2. Traditional IRA: Tax-Deferred Growth with Future Tax Liabilities
A Traditional IRA allows contributions to grow tax-deferred. Contributions are made with pre-tax dollars, which reduces your taxable income today, but withdrawals in retirement are taxed as ordinary income. If you fund your IRA from your checking or savings account, the taxes that were withheld through your paycheck are adjusted back to you when you file your income tax. The traditional IRA is a powerful vehicle for individuals who expect their income (and therefore their tax rate) to be lower in retirement.
The tax-deferred growth of a Traditional IRA means that contributions can compound more quickly during working years. However, it's important to remember that all withdrawals will be subject to taxation, and depending on your future tax rate, this could diminish the overall value of your retirement savings.
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3. Taxable Accounts: Flexibility With Annual Taxation
So-called taxable investment accounts don’t have the same tax advantages as IRAs, but they offer more flexibility. However, these accounts are subject to annual taxes on dividends, interest, and capital gains, which can erode returns over time. Unlike Roth and Traditional IRAs, contributions can be withdrawn at any time without penalty.
While taxable accounts may have higher flexibility, they are less tax-efficient. Investors must factor in the capital gains tax on appreciated investments and income taxes on dividends, which can significantly reduce the long-term growth of the account compared to tax-advantaged IRAs.
Same Investment, Different Returns: What Gives?
You invest in the same mutual fund, except each one is placed inside of different account types: traditional IRA, Roth IRA and taxable. Let’s say you make 10% on a $1,000 investment within one year. If your account is taxable, the $100 gain is taxable at your current marginal tax rate. If you’re single making $150k that means that Federal taxes will take $24, leaving you with a $76 dollar gain or 7.6% return. If you saved in a Roth or Traditional IRA, there is no taxation on the gain if you’re not withdrawing the money or subject to required minimum distributions. If you are withdrawing the Traditional money and you’re over 59 ½, the tax situation is the same as the taxable account. If you are withdrawing the Roth IRA money, have satisfied the 5-year holding rule and you’re over 59 ½, you maintain the 10% return and net $100.
A Practical Example: The Impact Over Time
Let’s bring these ideas to life with a more complete example. Consider a 35-year-old woman living in Illinois with no prior savings. She saves $7,000, 2.5% inflation adjusted per year until she reaches age 70, with her investments earning an average annual return of 7%. Upon reaching age 70, she starts Social Security, stops saving, and begins withdrawing funds to cover living expenses, which start at $150,110 in her first year of retirement and increase by 2.5% each year. She lives until age 93. Here's what we found:
Scenario 1: Roth IRA
With the Roth IRA, she pays taxes on her contributions upfront, but her investments grow tax-free. By the time she reaches 70, her account has accumulated a substantial balance, which she can withdraw without paying taxes during retirement. By the time she reaches 70, her IRA would have grown to about $1,144,408. Based on the projections from the Money Guide Elite IRA Contribution Calculator, her account would continue to grow even after covering her rising living expenses, and by age 93, her ending balance would be approximately $1,141,856.
Scenario 2: Traditional IRA
With the Traditional IRA, she avoids paying taxes on contributions today, allowing her to invest pre-tax dollars. By the time she reaches 70, her IRA would have grown to about $1,144,408, same as the Roth. However, withdrawals during retirement are taxed as ordinary income. After accounting for taxes on withdrawals and covering her increasing living expenses, the net balance at age 93 would be approximately $465,905. This is about a million dollars less than the Roth IRA.
Scenario 3: Taxable Account
In a taxable account, the woman’s savings would be subject to taxes on dividends and capital gains along the way, which slows down the compounding effect compared to the IRAs. By the time she reaches 70, her taxable account would have grown to about $839,052. However, unlike other accounts, after factoring in ongoing taxes and covering her living expenses, at the age of 91 she would run out of funds. This leaves her with almost 3 years of unpayable bills or a dramatic decrease in her lifestyle in her last several years of life.
State Tax Considerations
State taxes can further complicate the comparison between these accounts. For example, Illinois, where our hypothetical investor resides, has a state income tax rate of 4.95% (However this would not apply to the Traditional IRA withdrawals as IL does not execute state tax on IRA’s. It is important to note that most states do tax Traditional IRA withdrawals, but not Roth withdrawals as mentioned earlier). This makes the Roth IRA particularly appealing for residents in higher-tax states, as it protects the retiree from future state and federal tax hikes.
Conclusion
This practical example highlights how the choice between a Roth IRA, Traditional IRA, and a taxable account can affect your long-term retirement savings. For our 35-year-old investor, the Roth IRA provides a balance of tax-free growth and flexibility, while the Traditional IRA offers upfront tax savings but carries future tax liabilities. The taxable account, while flexible, is the least tax-efficient and results in the lowest final balance after accounting for taxes and living expenses.
Understanding how these vehicles align with your retirement goals and tax strategy is key to making an informed decision. Each person’s situation is unique, and it’s crucial to consider your current tax bracket, expected future taxes, and long-term financial goals when choosing the best savings vehicle for your future.
(This Part 4 of an ongoing investment adjusted series – you can read Risk adjusted, Values adjusted and Fee adjusted)