Comparing the Deductible And Roth IRAs

Beginning in 1998, millions of Americans will be able to choose between two individual retirement accounts--the deductible IRA and Roth IRA--that provide important tax savings in very different ways.

Those who have earned income and fall below certain income limits may contribute to a Roth IRA, a deductible IRA, or both, so long as total contributions do not exceed $2,000. But it takes a bit of analysis to make the choice that is right for you. This article presents some issues you should consider.

How the Accounts Differ

As its name implies, the deductible IRA allows eligible taxpayers to invest in retirement accounts and to receive an up-front tax deduction for the amount contributed. The deduction reduces the amount of income subject to federal income tax. (Some states also allow an income tax deduction for IRA contributions; others do not.) Interest, dividends, and capital gains on investments are not taxed while inside the IRA. But when money is taken out of a deductible IRA, the withdrawals count as taxable income and are subject to income tax.

Eligibility for Deductible IRA

If you have earned income and are not covered by a retirement plan at work, you are eligible to contribute up to $2,000 in 1998 to a deductible IRA no matter how high your income. The amount of your contribution is subtracted from your taxable income. If you are covered by a retirement plan, you may make the full $2,000 deductible contribution only if your adjusted gross income (AGI) falls below certain thresholds, which will rise in 1998 to $30,000 for single taxpayers and $50,000 for couples filing joint returns. Contribution limits in 1998 are scaled down for single taxpayers with AGI between $30,001 and $40,000 and for couples filing joint returns with AGI between $50,001 and $60,000. A spouse who has no earned income may contribute the full $2,000 to a deductible IRA if the couple’s AGI is $150,000 or less, and may make a partial contribution if the couple’s AGI is $150,001 to $160,000.

Eligibility for Roth IRA

Eligibility for a Roth IRA is not dependent on whether a taxpayer is covered by a retirement plan at work. However, eligibility does depend on income limits. To make the full $2,000 contribution to a Roth IRA in 1998, single taxpayers must have earned income and an AGI that is $95,000 or less, and couples filing joint returns must have AGI of $150,000 or less. Reduced contributions are allowed for single taxpayers with AGI between $95,001 and $110,000 and for couples with AGI between $150,001 and $160,000. (Those with incomes above the Roth limits may contribute to a nondeductible IRA. Earnings on the account grow on a tax-deferred basis but are taxed upon withdrawal from the IRA.)

The Comparison

If the investor contributes $2,000 to the deductible IRA, only $778 of the $2,778 will be subject to income tax ($218 at a 28% tax rate--see chart above). The investor who intends to contribute to the Roth IRA will owe tax on the full $2,778 ($778 in taxes at a 28% rate). Thus, the investor could have $2,000 in the deductible IRA and $560 available to put in a regular account outside the IRA. Or the investor could have $2,000 to invest in the Roth IRA. At this point, of course, the deductible IRA has the big advantage. But we’ve told only part of the story. For the sake of simplicity, assume that the investor earns an annual return of 8% on the investments. IRA earnings are not subject to tax year to year, but assume that the earnings outside the IRA are taxed annually at a 28% rate. Let’s see what happens to the investments after 20 years.

The above analysis shows that the Roth IRA is the better choice, so long as the tax rate in effect when the deduction is taken is not considerably higher than the tax rate in effect when withdrawals are taken from the IRA. The Roth IRA results in greater after-tax wealth because all of its investment earnings are tax-free, so long as the money is withdrawn after five years and the investor is at least age 59½, or meets an exception (death, disability, or first-time home purchase). But with the deductible IRA, at least part of the investment earnings on the up-front tax savings is subject to tax each year. Or, considered another way, the Roth IRA effectively allows you to defer taxes on a larger sum than the deductible IRA. This is why the Roth IRA beats the deductible IRA no matter how long the comparison period, provided the tax rates when withdrawals are taken are the same as or higher than when the IRA contributions are made.

The Roth IRA is particularly attractive for investors who fear that tax rates during retirement may actually be higher than the tax rates they pay now. In effect, the Roth IRA allows you to ‘lock in’ your tax-rate today so that you’re protected against future tax-rate increases. For it to be the wrong choice, the tax rate in effect when you take IRA distributions will have to be substantially lower than your tax rate at the time you contribute to the IRA.

However, the deductible IRA is the better choice if the investor’s tax rate is substantially lower when the withdrawals are taken—and this may be the case during retirement . For example, if the investor’s up-front deduction came when the tax rate was 28% but future withdrawals are taxed at a 15% rate, the result is very different (see chart below).

In this case, the tax rate at the time the IRAs are tapped would have to be about 18% or lower for the deductible IRA to yield a higher after-tax sum than the Roth IRA. This "break-even tax rate" varies, depending on how much of the investment earnings of the deductible IRA are subject to tax each year. Thus, the deductible IRA looks somewhat better if most of the investment return on the money held outside the IRA is in the form of long-term capital gains, which are subject to lower tax rates than ordinary income.

Finally, if your contribution to the Roth IRA is equivalent to $2,000 or less of pre-tax income and your tax rate is the same when you withdraw money from the account as when you contributed it, there is no difference in the amount you’ll ultimately receive from the Roth IRA versus a deductible IRA. The following example shows why. It employs the same assumptions about tax rates and investment returns as our previous example. But this time, the investor in the 28% tax bracket has $1,389 available, before taxes. That amount can be contributed to a deductible IRA, while the investor would have $1,000 remaining, after taxes, to contribute to a Roth IRA (see chart below).

After 20 years at an annual average total return of 8%, the deductible IRA would be worth $6,474, while the Roth IRA would hold $4,661. However, there is a 28% tax on the withdrawal from the deductible IRA while no tax is levied on withdrawals from the Roth IRA. As you can see below, the after-tax result of the two accounts is identical.

All information provided is general in nature and intended to create awareness, not to address the specific circumstances or concerns of any individual or entity. Although we try to provide correct and timely information, we cannot guarantee the accuracy of any information or that such information will continue to be accurate in the future due to the changing nature of the tax laws. Before acting on any of the information provided here, you should consult with a professional advisor who knows all of the unique facts and circumstances pertinent to your particular situation.