Deciding whether a traditional individual retirement account (IRA) or a Roth IRA is the better investment vehicle can be a more complex choice than it initially appears. Many investment planning websites offer calculators that show investors how much they can save for retirement with each type of IRA—but how useful are they at helping investors choose between them? The authors provide an overview of the different factors that affect this decision and an analysis of how well various online calculators weigh these factors.
The typical advice regarding the choice between a traditional IRA and a Roth IRA is deceptively simple; most of the time, a Roth IRA is the best option for younger individuals with lots of time until retirement, while a traditional IRA might work better for those closer to retirement or who are currently in a high income tax bracket. But this conventional wisdom implicitly includes a number of assumptions, not all of which may be true for a given individual. The choice between a traditional IRA and a Roth IRA is a complex one that should consider many factors beyond the investor’s age and current tax bracket.
Many online calculators are available to assist with the analysis of the benefits of a traditional and a Roth IRA. Given the range of possible considerations, it is not likely that any single online calculator can pick the optimal IRA for an investor. For example, most calculators assume that an investor in a traditional IRA will invest the tax savings generated in a taxable account. Recent evidence, however, shows that most investors instead spend the deduction generated (Saul Adelman and Mark Cross, “Comparing a Traditional IRA and a Roth IRA: Theory Versus Practice,” Risk Management and Insurance Review, August 2010, http://bit.ly/2p4xlA4; John Leonard Beshears, James J. Choi, David I. Laibson, and Brigitte Madrian, “Does Front-Loading Taxation Increase Savings? Evidence from Roth 401(K) Introductions,” Journal of Public Economics, July 2017, http://bit.ly/2ICEnms). For these investors, the calculators may incorrectly favor the traditional IRA over the Roth.
In addition, most online calculators use a constant rate of return on investment that significantly undervalues the risk that investors will face in their portfolio, especially those who seek higher rates of return and thus face more year-to-year variation in the returns they experience. Thus, the future values for these calculators are likely very different from what an investor will actually receive. For example, the midlevel return on many calculators is a constant 6% rate per year; however, if an investor’s actual portfolio has a 10% standard deviation and a normal distribution, then in approximately two out of three years the investor can expect to earn between −4% and +16%. Constant return calculators do not incorporate this year-to-year variation, although calculators that employ Monte Carlo simulations do; when inputting the same data for a $5,500 per-year investment, the differences in future values for both types of IRA can be more than $100,000. Although the calculators that employ Monte Carlo simulations provide a good explanation of the process on their websites, it is not clear that the typical investor will be able to understand and interpret the outcomes.
This article examines the various factors investors should consider when choosing an IRA type, then analyzes a number of available calculators to see how well they aid investors in making that choice.
Factors to Consider when Choosing an IRA
Both major types of IRA allow investors to grow their money tax-free until retirement. For many investors, the contributions to a traditional IRA are tax deductible when made, and contributions and earnings are taxed upon withdrawal. Roth IRA contributions are not tax deductible, but withdrawals are not taxed. Investors who believe their tax rate will be lower in retirement than during their contribution years are often told they should prefer a traditional IRA; in this case, investors receive the tax deduction at the higher tax rate during their working years and can expect to have a relatively lower tax rate on withdrawals during retirement. In contrast, higher expected tax rates in retirement would favor the Roth IRA, all else being equal.
This analysis, however, has been criticized as too simplistic because of the additional factors that should be considered (Qianwen Bi, “Three Essays on Financial Technology and Personal Financial Planning,” Doctoral dissertation, 2015, http://bit.ly/2MvS2gg). An investor’s income and tax status can affect whether a contribution is tax deductible or even allowable; for example, if the investor’s tax status is married filing jointly with more than $199,000 in income for 2018, the investor may not be able to directly contribute to a Roth IRA. (The investor may still be able to create a “backdoor” Roth IRA by contributing to a traditional IRA and then rolling that over to a Roth IRA; there will normally be tax consequences to such a rollover.) Filing status, having a retirement plan at work, and income level also determine whether contributions to a traditional IRA are fully or partly deductible. When an investor is married filing jointly and either spouse has a retirement plan at work and makes more than $121,000 in 2018, contributions to a traditional IRA cannot be deducted; however, there is no income limit on tax deductibility if no work retirement plan exists. Calculators that check for eligibility of contributions and deductibility status for both types of IRA are available, but there are still more factors to consider.
Traditional IRAs have required taxable minimum distributions (RMD) beginning at age 70½; Roth IRAs have no RMDs. Thus, if an investor will not need the money to live on during retirement but instead wishes to leave more for her heirs, a Roth IRA may be preferable. Withdrawals from both types of IRAs before age 59½ can generate additional tax liabilities, although both have hardship exceptions. Nevertheless, withdrawals of contributions from a Roth IRA before age 59½ are not taxable as long as they have been invested for at least five years, whereas withdrawals of any funds from a traditional IRA before age 59½ are taxable and may face a 10% penalty. This means that individuals who may have liquidity requirements due to health expenditures or uncertain income due to job loss may be better off with a Roth IRA.
The presence of other income during retirement, such as pension plans, part-time work, or inheritances, can also affect the choice of IRA type. An investor in a traditional IRA may have other income that, coupled with IRA withdrawals, could push the investor into a higher tax bracket; this is not a concern with Roth withdrawals because they are not taxable. Similarly, withdrawals from traditional IRAs can cause Social Security payments to be taxable or taxed at a higher rate, whereas Roth IRA withdrawals do not trigger taxes on Social Security payments.
Investors who want to retire early are likely to maximize the amount invested and seek investments with higher returns; either of these strategies can lead to a higher tax rate in retirement and thus may favor a Roth IRA, as long as income level does not prevent that choice. Those who are willing to wait longer to retire and have a greater need for spending power during their working years may prefer the traditional IRA because of the tax deduction for contributions, which can be invested or spent. Many investors need to be advised to invest the deduction, and a planner who is concerned that the individual lacks the discipline to invest the difference may recommend a Roth IRA on that basis alone.
Finally, investors who are willing to manage their withdrawals to minimize their overall tax liability over the retirement years may find it advantageous to have both types of IRA. For example, a retiree with both types of IRA can withdraw more from the traditional IRA in years when income is low and deductible expenses are high, and withdraw more from the Roth IRA in years when the situation is reversed. These types of strategies can materially affect the length of time retirement funds will last.
A summary of the above factors, which financial advisors are encouraged to discuss with their clients, is provided in Exhibit 1.
Factors to Consider when Choosing between a Traditional IRA and Roth IRA
Comparing Online Calculators
Given the complexity of the decision, can any online calculator be expected to provide typical investors with a realistic choice without the aid of a financial planner? It may seem unlikely, but many calculators are useful for encouraging investors to save for retirement, and many try to show investors how much they should be saving. Previous research covered 36 online calculators and found that only 11 of them successfully helped investors know how much they really needed to save to fund their retirement (Taft Dorman, Barry S. Mulholland, Qianwen Bi, and Harold Evensky, “The Efficacy of Publicly-Available Retirement Planning Tools,” Feb. 18, 2016, working paper http://bit.ly/35nJ0e0; Karen Damato and Anne Tergesen, “New Study Questions Retirement Planning Calculators’ Accuracy,” Wall Street Journal, Feb. 22, 2016, https://on.wsj.com/2OBXAsu; neither paper named the successful calculators, and neither was specifically concerned with type of IRA).
The authors’ purpose is to consider whether the online calculators can be expected to provide investors with enough information to choose between a Roth and a traditional IRA, or the 401(k) versions of the same. Exhibit 2 lists the various calculators the authors studied and the URLs where they can be found. Exhibit 3 compares the characteristics of selected online calculators that an investor could use to decide between the two types of IRAs. Some of the sites also contain a useful tool to determine whether investors are eligible to invest in a Roth IRA based on their income and filing status. In addition, the John Hancock calculator allows investors to choose whether to invest or spend the tax savings generated by using the traditional IRA. The remaining calculators assume that the tax savings will be invested, even though research shows that many investors choose not to do so.
Internet Calculators That Can Be Used to Choose IRA Type
Evaluation of Selected Internet Calculators Used to Choose IRA Type
Approximately half of the calculators in Panel A of Exhibit 3 do not allow investors to choose or change their asset allocation over time and do not account for risk in the return calculations. For instance, the Your Roth calculator finds the future value of the amounts invested at retirement at the investor-supplied interest rate. Others, such as the Schwab calculator, ask investors to choose to invest in a “conservative,” “moderately conservative,” or “aggressive” portfolio, and each choice is keyed to a specific rate of return. The web-site provides a detailed explanation of the typical asset allocation for each type of portfolio, but it is not clear whether investors will be able to make an informed decision based on the website information.
A “Yes” in the Asset Allocation column in Exhibit 3 indicates that the calculator allows investors to choose a portfolio type, and a “No” means investors can only pick the rate of return. Are investors sufficiently informed to choose an appropriate rate of return and the risks that accompany their choices? Are they sufficiently aware that compounding at a constant rate of return without incorporating losses may not yield a very accurate future value? In actuality, investors will experience negative rates of return on their portfolios in some years, and these losses may materially reduce the future value they will receive over time.
The calculators in Exhibit 3 can easily determine which type of IRA provides a greater future value based on the inputs and the calculator assumptions, but some investors may not understand the importance of those inputs and assumptions. Most of the calculators also make it easy to compare which IRA type is expected to yield a higher future value, but the decision will be harder with a few of them, such as the T-Rowe Price and TD Ameritrade (ScottTrade) calculators, because they are designed primarily to determine if an investor is saving enough to fund retirement.
The Transparency column in Exhibit 3 refers to whether, in the authors’ opinion, the calculator’s assumptions and results were understandable for a typical investor. The authors tried to replicate the results for the calculators that did not use a Monte Carlo simulation. For some calculators, such as the Voya, John Hancock, and Lincoln calculators, the online results were replicable with an Excel spreadsheet, but for others, such as Vanguard, they were not. Thus, Vanguard is not listed as fully transparent.
The Flexibility column in Exhibit 3 indicates the extent to which investors can choose and change relevant variables such as contributions, years in retirement, inflation, tax rates now and during retirement, and other income during retirement, which could affect future taxes. For example, some calculators performed the calculations as an annuity and some as an annuity due, although this was not always obviously stated. In addition, some calculators automatically calculate the future values in today’s dollars with a given inflation rate, while some make no adjustment for inflation.
In the authors’ opinion, the Lincoln and the John Hancock calculators are the best in Panel A of Exhibit 3 in terms of transparency, flexibility, and ease of comparison of the results of investing in the two types of IRAs. Both calculators are easy to use and provide useful results that assist investors in choosing an IRA. The Lincoln calculator explicitly allows users to compare the after-tax future value of the amount invested in a traditional IRA, with or without the future value of the tax savings, to an equal or equivalent investment in a Roth IRA.
Both of these calculators also allow for different rates of return and tax rates during the accumulation and retirement periods and provide good detail about the before-and after-tax future values and annuities that result from the two types of IRAs. The Lincoln site also has a “break even” calculator that shows which type of IRA is preferable at different time periods; this is useful for investors who may alter their point of retirement or drawdown of their IRA. Both, however, lack the ability to adjust for different inflation expectations, so they may give an incorrect impression about the real value of the retirement accounts and annuities. All of the remaining calculators were easy to use and understand, although some, including Vanguard, Your Roth, and Voya, were limited in providing flexibility of options. As noted above, the authors could not replicate the results of the Vanguard and Schwab calculators, so their outcomes are marked as not transparent. Beyond these differences, there do not appear to be any major advantages or disadvantages to using any of the remaining calculators.
The calculators in Panel B of Exhibit 3 provide investors with the results of a Monte Carlo simulation that incorporates the expected return and risks of their asset allocations. These calculators give different results each time they are run because a different set of simulated future returns is calculated each time. While this is more realistic than simply compounding at a constant return to find the future value of funds invested, it is likely that many investors may not understand both the assumptions and the output from Monte Carlo simulations. Of the three calculators examined, the E-Trade calculator may be the best, because the output from this calculator makes it easier to understand and visualize the difference in results between the two IRA types.
Reproductions of the Lincoln calculator are provided in Exhibits 4, 5, and 6. As shown in Exhibit 4, the inputs the investor must provide are current age, annual contributions, age when withdrawals begin, number of years to receive withdrawals, a pre-tax rate of return on investment during the withdrawal years, and the tax bracket during the withdrawal years. The detailed output provided to investors and the ability for investors to compare the outcomes of IRA choice are two features that recommend this calculator.
Lincoln Financial Calculator Input Screen
Output Screen for Option 1
Output Screen for Option 2
One cannot compare an equal dollar amount invested in a qualified traditional IRA with a dollar amount invested in a Roth IRA because dollars invested in the traditional IRA are tax deductible, and those invested in a Roth are not. There are two approaches to handle this comparison. One can reduce the amount invested in the Roth IRA to reflect the value of the tax deduction; this is Option 1 in Exhibit 5. Alternatively, one can add the future value of the amount saved from the deduction in a traditional IRA, which is normally assumed to be invested in a taxable account, to the future value of the full amount invested in the traditional IRA; this total is then compared to the full amount invested in a Roth IRA. This alternative is presented as Option 2 in Exhibit 6. While this calculator does not allow for the tax deduction to be spent rather than invested, it does help investors understand the difference in the two types of IRA. Most other calculators do not provide the investor with this choice at all. As noted above, this calculator also provides more detail than most about account values at retirement and both annual and monthly income during retirement, as well as a graph for easy comparison.
Exhibit 7 contains some well-known online calculators that, in the authors’ opinion, are not suitable for using to compare a Roth IRA with a traditional IRA. The calculators in Panel A are primarily useful to determine whether an investor is saving enough to fund retirement goals, but are not very useful for choosing an IRA type. There are many calculators designed to show whether an investor is saving enough for retirement; comparing these calculators is beyond the scope of this paper. The interested reader is referred to Dorman et al. for an analysis of calculators for this purpose.
Panel B of Exhibit 7 also lists two software packages, Wealth Trace and J&L Retirement Planning Software, that provide full financial planning software, including budgeting and portfolio management for multiple investments. These two must be downloaded and installed on the user’s computer. Both are designed to manage multiple investments and detailed budgeting. The authors believe that they are probably beyond the expertise of many users and are actually overkill for purposes of comparing IRAs, but have included them for the sake of completeness.
Retirement Is Not One-Size-Fits-All
Given the range of possible considerations, it is not likely that any single online calculator can truly pick the optimal IRA for investors, and most should seek the advice of a financial planner. Most calculators assume that an investor in a traditional IRA will invest the tax savings generated in a taxable account, although many investors do not actually behave this way. Many online calculators use a constant rate of return on investment that significantly undervalues the risk that investors will face in their portfolio, and there are large differences in the future values produced by calculators that employ Monte Carlo simulations and those that do not. The calculators that use Monte Carlo simulations provide more realistic results that incorporate risk, but it is not clear that typical investors will understand the process and be able to interpret the outcomes.
The authors believe that the best use of online IRA calculators is to encourage investors to save more for retirement (see, e.g., Liz Frazier Peck, “3 Reasons Retirement Calculators are Wrong, and Why You Should Use Them Anyway,” Forbes, Dec. 21, 2017, http://bit.ly/35pIlZm). For many, the choice of IRA type requires more considerations than an online calculator can handle, and most investors should consult with a financial planner to find the type of IRA investment best suited to their situations.