For this post, I’m going to assume you understand what an IRA is and how a Traditional IRA differs from a Roth IRA, otherwise this will get too long. If that doesn’t describe you, take a look at my previous two posts: How much does an ira really save? and Isn’t a Roth (vs. Traditional) IRA usually a bad idea?.

We’ll save the explanations for later. To start, play around with these knobs and get a feel for how it affects the value of $1 and the value of a “maximumum pre-tax roth contribution” (more on that later) after being invested for 40 years in one of three methods: not using and IRA, using a Roth IRA, and using a Traditional IRA.

Current Tax Rate: %
Average Return Rate on Investment
(/yr for 40 yrs):
Long-term Capital Gains Tax Rate: %

What are we looking at?

The first graph shows what 1 pre-tax dollar will become in 40 years if it’s invested using each of the three methods in question (not using an IRA, using a Roth IRA, and using a Traditional IRA) as you vary your retirement tax rate.

The second graph shows what an investment of the maximum pre-tax Roth IRA contribution would become in 40 years, invested using the same methods, also as you vary your retirement tax rate. The second graph is not just a multiplied version of the first.

Here’s why. Let’s say the maximum pre-tax roth contribution is ~$8,500. You can’t invest $8,500 in a Traditional IRA. You can only invest a maximum of $5,500 pre-tax dollars in a Traditional IRA. So the additional ~$3,000 pre-tax dollars has to be invested “normally”, i.e. without the assistance of an IRA. Which means it’s taxed twice (income tax and capital gains).

So what is the maximum pre-tax Roth IRA contribution? Well it depends on your current tax rate. If you can contribute $5,500 to a Roth IRA using post-tax dollars, and your tax rate is 50%, then you’re effectively contributing $11,000 pre-tax dollars. If your tax rate is 10%, then you’re only contributing ~6,100 dollars. Notice how the labels of the second graph change as you slide around the current tax rate input.

Understanding the differences

Now that we understand what we’re looking at, let’s highlight a few things:

  • The investment methods not using an IRA and using a Roth IRA do not depend on the retirement tax rate at all. That makes sense since the only way in which you end up paying income tax in retirement (on your investment) is if you use a Traditional IRA. Consequently, using a Traditional IRA becomes a worse value as your expected retirement income tax increases.

  • In the first graph, using a Roth IRA = using a Traditional IRA when your current tax rate = your expected retirement tax rate. This also makes sense since, for a fixed pre-tax contribution, the only difference between the two is whether you pay income tax now or later. However, that is not true in the second graph. Here’s why.

  • using a Roth IRA = not using an IRA if you take your expected average return rate to 0% or if you take long-term capital gains tax to 0%. In both using a Roth IRA and not using an IRA case, you pay income tax up-front. The difference is that, in a Roth IRA you don’t have to pay capital gains tax, whereas you do if you’re not using an IRA. If you expect to make 0% on your investment, then you expect to have no gains, and therefore they become the same thing. Likewise, if there is no capital gains tax, they’re also the same thing.

  • And finally to round things off, if current tax rate = your expected retirement tax rate AND long term cap gains tax = 0% (or expected average return rate = 0%), all these methods are equivalent.

  • Oh, and one more thing: compound interest is crazy. This isn’t really about IRAs at all, but notice how if you take your average return rate from 4% to 8%1, your $1 goes from tripling to being multiplied by about 14x!

Information overload!? Just tell me what to do!

Here’s what I think you should do (with all the normal caveats about how I’m not a tax professional):

  1. Contribute the maximum amount in an IRA (probably a Traditional IRA, but more on that later). Which means you should focus on the second graph.

  2. Invest your IRA in something diversified - something like SPY. Adjust the expected average return rate slider (above) to something realistic given your choice. For SPY, it’s probably something between 3% and 8% (although that’s a huge range).

  3. Adjust the current tax rate slider (above) to the correct value for you.

  4. Keep the long-term cap gains slider at 15%.

  5. Estimate your retirement tax rate. As I described in an earlier post, I think it’s highly likely that your retirement tax rate will be considerably less than your current tax rate.

  6. Look at the second graph, specifically the point on the x-axis that you estimated for your retirement tax rate, and pick whichever type of IRA has a higher value! Q.E.D.

If I do all that, here’s what I come up with:

  • Expected average rate of return: 5%
  • Current tax rate: 35%
  • Expected retirement tax rate: 25%
  • Value of $8462 pre-tax contribution in Roth IRA = ~$39,000
  • Value of $8462 pre-tax contribution in Traditional IRA = ~$41,000

Traditional IRA it is!

  1. That was assuming current tax = 35% and long-term cap gains tax = 15%.