Roth vs. Traditional IRA: Which is Right for You? A Case Study

This week, we'll explore a common retirement planning question: Should you contribute to a Traditional or Roth IRA?  We'll use a hypothetical example to illustrate the key differences and factors to consider.

Let's imagine a 40-year-old individual earning $50,000 annually and aiming to save 10% of their income ($5,000 per year).  We'll analyze the long-term impact of contributing to each type of IRA.  For simplicity, we'll assume no employer match on a 401(k), making it functionally equivalent to a Traditional IRA in this scenario.

The Setup:

• Age: 40
• Annual Income: $50,000
• Annual Savings: $5,000 (10%)
• Retirement Goal: Age 67
• Desired Monthly Income (after taxes): $4,600 (in today's dollars)

Traditional IRA:

With a Traditional IRA, your contributions are tax-deductible in the current year, reducing your taxable income.  In our example, a $5,000 contribution would lower their taxable income, resulting in a slightly lower out-of-pocket cost compared to a Roth. However, withdrawals in retirement are taxed as ordinary income.

Roth IRA:

Roth IRA contributions are made with after-tax dollars, meaning no immediate tax deduction.  However, the significant advantage comes in retirement: qualified withdrawals are completely tax-free. Therefore we will be contributing $4,400 a year instead of the $5,000 for the traditional IRA. 

The Analysis:

We'll assume both IRA investments grow at the same rate.  At age 67, the Traditional IRA balance might appear higher initially (around $400,000 vs. $353,000 for the Roth). However, this doesn't tell the whole story.

The Roth IRA's tax-free withdrawals allow our hypothetical individual to withdraw $4,600 per month without any tax implications.  With the Traditional IRA, they'll need to withdraw more than $4,600 to cover taxes, resulting in a smaller net income.

The Break-Even Point:

Our analysis suggests a break-even point around age 84.  At this age, the cumulative effect of taxes on Traditional IRA withdrawals roughly equalizes the overall value compared to the Roth IRA.

The Long Game:

By age 100, the Roth IRA's tax-free growth becomes significantly advantageous, potentially holding $125,000 more than the Traditional IRA.

Inheritance Considerations:

Roth IRAs also offer advantages for beneficiaries.  Inherited Roth IRA funds can be withdrawn tax-free, while inherited Traditional IRA funds are taxed as ordinary income, potentially pushing beneficiaries into higher tax brackets.

The Verdict (for this specific scenario):

In this particular case, the Roth IRA appears to be the more favorable option. However, it's crucial to understand that this is just one example.

Your Personalized Retirement Plan:

Retirement planning is not one-size-fits-all.  Factors like your current income, future income projections, retirement goals, existing savings, and whether you have access to a 401(k) with an employer match all play a significant role in determining the best strategy for you.

Don't leave your retirement to chance.  Contact me today to schedule a consultation. We'll discuss your unique circumstances and create a customized retirement plan to help you achieve your financial goals and secure your future.

Disclaimer:

This blog post is for informational purposes only and does not constitute financial advice. Case studies are hypothetical examples of the various approaches that can be taken to assist clients with their planning needs.  The results depicted within this communication are unique to the case presented and should not be construed as a guarantee of future results. Each client has unique circumstances and this may not be indicative of all client experiences with our firm.