Roth IRA vs Traditional IRA - Calculator Explained

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Today is the first post, in a series of posts, where I’ll be reviewing the functionality of 6 financial calculators. I will explain, in plain language, how each of these calculators works and how to integrate the results of each, into your personalized ‘down home’ financial plan.

As promised, I will be creating a lot of hypothetical scenarios to use as references, too. I will also be adding more calculators as time goes by.

Roth IRA v Traditional IRA Calculator

The purpose of this Roth IRA calculator is to figure out which type of IRA is best for you. Now, as you may know, I’m a big fan of the Roth IRA and tend to favor it over a traditional IRA. Below is a screen shot where I’ve inputed some data and calculated the results…

Current Age

Your current age.

In this example I’m using 35 yrs old

Expected Rate of Return

This is the rate of return that the calculator will grow the annual contributions and the underlying asset base. This calculator assumes the return is compounded annually and contributions are made at the beginning of each year. The actual rate of return depends largely on the type of investments you choose. It’s also important to note future rates of return can’t be predicted.

But historically speaking, a more aggressive portfolio will put you in position to attain better results; the trade off being greater risk, mainly in the form of market volatility. From January 1970 to December 2006, the average compounded rate of return for the S&P 500, including reinvestment of dividends, was approximately 11.5% per year (source: www.standardandpoors.com).

During this period, the highest 12-month return was 61%, and the lowest was -39%. Savings accounts at a bank pay as little as 1% or less.

For the purposes of this example I’m using 8.00%.

Annual IRA Contribution

The amount you will contribute to an IRA each year. This calculator assumes that you make your contribution at the beginning of each year. In 2007, the maximum annual IRA contribution is $4,000 per individual. It is important to note that this is the maximum total contributed to all of your IRA accounts. This maximum will increase to $5,000 in 2008. Beginning in 2009, the contribution limit will adjust annually for inflation in $500 increments.

In 2007, if you are 50 or older, you can make an additional “catch-up” contribution of $1000. In order to qualify for the “catch-up” contribution, you must turn 50 by the end of the year in which you are making the contribution.

You can no longer make contributions to a traditional IRA in the year you reach 70 1/2.

It is important to note that Roth IRA contributions are limited for higher incomes. If your income falls in a “phase-out” range you are allowed only a prorated Roth IRA contribution. If your income exceeds the phase-out range, you do not qualify for any Roth IRA contribution. For the purposes of this calculator, we assume that your income does not limit your ability to contribute to a Roth IRA.

In 2007, the maximum annual IRA contribution is $4,000 per individual, which is what I used for this example. You will notice at the bottom of the chart I have checked off the box to allow for the maximum future contributions, taking advantage of the ever increasing contribution limits. The more we put in, the more opportunity for tax deferred/tax free growth.

Current Tax Rate

Your current marginal tax rate.

I’m using 30%

Age of Retirement

The age you wish to retire. This calculator assumes that the year you retire, you don not make any more IRA contributions. I would play around with this field a bit. Remember you can make Roth IRA contributions no matter what age you are, as long as you have enough taxable income to cover the contribution amount. With a traditional IRA you are forced to start taking taxable distributions when you reach age 70 1/2.

I’m using age 66, which allows us to make our last contribution at age 65.

Adjusted Gross Income

On your tax return, the calculation of AGI is the last line you see on side one of your Form 1040. This is used to calculate whether you are able to deduct your annual contributions.

In 2007, our volunteer, Thomas Plumtree had AGI of $80,000.

Total Contributions

The total of your Roth IRA contributions or Traditional IRA contributions (that were deposited without a tax deduction in our case.)

Traditional IRA contributions are normally tax-deductible. However, if you have an employer sponsored retirement plan, such as a 401(k), your tax deduction may be limited. In 2007, for single tax filers with an employer sponsored retirement plan, an IRA contribution is fully tax-deductible if your income is below $52,000. It is then prorated between $52,000 and $62,000.

If your income is over $62,000 and you have an employer sponsored retirement plan, such as a 401(k), you receive no tax deduction. For married couples, the same rules apply except the deduction is phased out between $83,000 and $103,000.

In our example, for 2007, since Thomas Plumtree is participating in an employer planned (which is checked off in the above screen shot) and makes 80K a year (AGI), if you were to make traditional IRA contributions they would be non-deductible, which the calculator has figured in. Which is still OK, especially if converting to Roth IRA in 2010.

This calculator automatically determines if your tax deduction is limited by your income. However, there are two unusual situations not automatically accounted for where additional tax phase-outs are applied. First, if your spouse has an employer sponsored retirement plan but you do not, your tax deduction is phased out from $156,000 to $166,000. Second, if you are married filing separately and have an employer sponsored retirement plan, the income phase-out is from $0 to $10,000.

Retirement Tax Rate

The marginal tax rate you expect to pay on your investments at retirement. This is a very important part of the whole equation and can have the biggest impact on the calculator’s results. Not knowing where future tax rates are going to be, makes it hard to know what to put in this field.

The classic assumption is since you are retired and you no longer earn a wage that your taxes drop. This may be the case, but with taxable pensions, social security and traditional IRA distributions treated as ordinary income, the opposite could be true in the future.

When I model retirement plans for clients, we generally look to maintain 80-85% of pre-retirement income during the retirement years. So logically, in the above example, I’ve chosen to model a proportionate tax rate during retirement.

For the purposes of the calculation, it’s better to model a worse case scenario (or more conservative approach) so that way you’re not surprised later on.

In the above example, I chose to use a retirement tax rate of 25%, which is 83% of the pre-retirement rate used (30%), in line with the 80-85% of pre-retirement income we try to maintain.

Are you married?

Check this box if your married. This is used to determine how you file your taxes and whether you can deduct your annual contributions to a traditional IRA. (for the purposes of our comparison study)

In our example, Thomas is still single.

Totals at Retirement (lower right of screen shot)

For the Roth IRA, this is the total value of the account.

For the Traditional IRA, the total is the sum of two parts:

1. The value of the account after you pay income taxes on all earnings and tax-deductible contributions and
2. what you would have earned if you had invested (in an ordinary taxable account) any income tax savings by staying with a traditional IRA all these years.

Now if you ask me there is a little room for ’slippage’ in the assumptions for the traditional IRA totals, that’s not accounted for in the calculation.

For instance, in Part 1 (directly above) its assumed all the earnings are taxed at a 25% retirement rate. Who’s to say the distribution amount, which is fully taxable, doesn’t increase the tax rate applied, especially in large accounts, like these have grown into to?

Secondly, in Part 2 (directly above) it assumes you invest any tax savings in “an ordinary taxable account.” In that case, we can assume in a diversified portfolio there may be dividends and capital gain distributions that are taxable in the same year. Why not? this account is not insulated from slippage taxes like the IRA itself.

In any case, it would be unreasonable (and beyond the scope of this calculator) to add these hypothetical (but very real) possibilities. For the purposes of our results it would only serve to increase the difference between the Roth and Traditional IRA account totals. And since its important to air on the conservative side we can be happy with the assumptions.

In Conclusion

It’s obvious, based on our answers, that the Roth IRA was the right choice for our dear Mr. Plumtree. His contributions grew to $688,000 vs $558,000. These numbers would only widen over time, especially since the monies in the traditional IRA have to be distributed at age 70 1/2.

I’ve included a screen shot (below) of the same example, except the age of retirement has been changed to age 68. Look at the difference between the Roth and Traditional accounts now…

Back tomorrow with an analysis of the Roth IRA Conversion calculator…

Tags: 'Down Home' Financial Calculators, Financial Planning Retirement and Now!, Roth IRA Calculators, Roth IRA Contribution Limits, Traditional IRA