New Math for IRA Savings

Usually, the last thing anyone giving financial advice needs to do is to tell Americans to dodge taxes. Tax our tea unfairly and we’ll start a revolution. Give us a holiday from sales tax and we’ll buy all kinds of clothes and appliances we don’t need. Launch single-state muni-bond funds whose yields are exempt from income taxes in jurisdictions that don’t even have income taxes and we’ll plow our money into them.

If all the other rules governing traditional IRAs and Roth IRAs were identical, there would be no reason to favor a Roth. Algebra says it shouldn’t matter whether taxes are applied to contributions or a compounded total. But there are three big reasons why a Roth can be better.

First, since creating Roth IRAs in 1997, Congress has never distinguished between the limits on making contributions to them and on making deductible contributions to traditional IRAs. In 2009, for instance, you can put a total of $5,000 into IRAs of both kinds ($6,000 if you’re 50 or older). And that equivalence means Roth IRAs give you more bang for your buck. To take a simple example, let’s say you put $5,000 into a Roth IRA this year and leave it untouched for 30 years. If it grows at 6 percent a year, you would end up with $28,717, tax free. To get that much from a traditional IRA in 30 years at 6 percent, you would have to invest $6,944 initially, let it grow and then pay income tax on the total (assuming you’re in the 28 percent federal bracket). But you can’t—you can invest only up to $5,000.

Now, with a traditional IRA, you do get an up-front deduction. In this case, that would be worth $1,400. But even if you invest your deduction in a taxable account for 30 years, the total will still fall short of the Roth IRA’s. It may seem paradoxical that after-tax dollars make for a better tax shield, but the combination of equal contribution limits and tax-free withdrawals gives the Roth an edge.

The second advantage to a Roth is easier to understand: no mandatory distributions. In contrast, you face stiff penalties if you don’t start drawing down a traditional IRA by age 70½.

Third, since you can accumulate large sums in Roth IRAs without having to worry about taking distributions, they make excellent vehicles for estate planning. You can pass a Roth IRA to your heirs and they will never have to pay taxes on the amounts they withdraw. They will have to make mandatory distributions according to IRS timetables but can stretch out drawdowns over their lifetimes, which makes Roth IRAs a particularly good asset to leave to grandchildren.