Comparing a Roth to a Traditional IRA
This calculator can be used by individuals planning for retirement to compare a Roth IRA to both a before and after-tax Traditional IRA. The calculator needs a total of eight inputs, including:
- The current age of the user, or the age the user will start contributing to their IRA
- The user’s projected retirement age. This is the age the user will stop making contributions to their account
- The age of any existing IRA funds, stated in years
- The amount of funds currently placed in an IRA, if the user has already set up a fund
- The annual contribution made to the account
- An estimate of the annual rate of return earned on the IRA funds
- Finally, an estimate of the incremental tax rate the user will be in, once retired. A good proxy for this would be one of the federal income tax brackets
The calculator then provides the user with thirteen outputs, including three sets of four values for each of the before-tax, after-tax ,and Roth IRAs:
- The total amount of funds in their IRA, regardless if the money was before tax, or after tax
- The taxable balance in each of the three fund types
- The annual income derived from each of the three funds, which will be the same in each case
- The annual income taxes owed, if any
- Finally, the after-tax income supplied by each of the three fund types
Individual Retirement Arrangements (IRAs)
While some financial “authority” websites claim IRA stands for Individual Retirement Accounts, it doesn’t. Individual Retirement Arrangements (IRAs) allow individuals to set money aside for retirement. Unfortunately, the contribution and tax-deductibility rules for these retirement funds can be complex and to make matters even more frustrating, IRAs come in three flavors! (That’s why our calculator supplies three sets of results.) As we get into those differences, keep in mind there is one thing all three IRAs have in common – taxes are paid on the money contributed to these funds at some point in time.
Traditional IRAs account for the first two types of retirement funds allowed in the United State under the rules set forth by the Internal Revenue Service (IRS). These two IRAs are different in their treatment of contributions:
- Tax-Deductible Traditional IRA: the individual making contributions to the IRA may be able to claim a deduction on their federal income tax return for the amount contributed to the IRA if their Modified Adjusted Gross Income (MAGI) is below the deductibility threshold published by the IRS. These thresholds are different if the individual is covered by a retirement plan at work (such as a 401(k) plan).
- Non-Tax-Deductible Traditional IRA: if the individual contributing to the IRA exceeds the MAGI limits for making a tax-deductible contribution, they can still make an after-tax contribution to a Traditional IRA.
Both of these funds have one thing in common – earnings on the funds placed in a Traditional IRA are subject to federal income taxes when they are withdrawn.
The third type of IRA is the Roth. This type of fund is like the non-tax-deductible Traditional IRA in that contributions to the account are not tax deductible. However, earnings on the funds placed in a Roth IRA are not subject to federal income taxes when they are withdrawn. This is an extremely attractive feature of a Roth IRA. While both forms of the Traditional IRA defer the payment of income taxes on earnings until the funds are withdrawn, owners of Roth IRAs do not owe taxes on those earnings.
Understanding the Results of our Calculator
Now that we’ve explained the difference between these three IRAs, the results of our calculator should be easier to understand. The Before-Tax Funding results represent the results of the tax-deductible Traditional IRA. Since income tax was not paid on the contributions (they were tax-deductible), 100% of the funds withdrawn are subject to federal income tax. This includes both contributions and their earnings. (Remember, we said that taxes are paid on contributions for all three IRAs.)
Owners of Traditional IRAs funded with after-tax income (non-tax-deductible income) already paid federal income tax on their contributions. For this reason, when funds are withdrawn, income taxes are only paid on earnings. That is why the after-tax income calculation for this type of IRA will be higher than that of the before-tax funded IRA.
Finally, since federal income taxes were already paid on the money placed into a Roth IRA and the earnings on those contributions are not subject to federal income taxes, no income tax is owed on those funds when withdrawn. Said another way, 100% of the income derived from a Roth IRA is tax-free.