Comparing a Traditional IRA and a Roth IRA: Theory Versus Practice

Abstract

Financial planners often advise their clients to first take advantage of employersponsored 401(k) plans, especially those with matching employer contributions. They often recommend next that clients consider a traditional or Roth IRA, depending on their current eligibility and tax bracket. Generally, the traditional IRA tends to be preferable to the Roth IRA if one expects to be in a lower tax bracket during the retirement versus the contribution years. This preference could be impacted by the theoretical or the practical assumptions one could make as to the tax bracket effect, minimum distribution requirements, and the impact of withdrawals on the amount of Social Security benefits taxed. This research compares the traditional and the Roth IRA, examining both the theoretical and practical assumptions of client behavior. The results indicate that the best choice between the types of IRAs depends on whether the investor's actual behavior is consistent with theory or practice.

A Savings Plan With Targeted Contributions

“…Our purpose here is to model tax‐free accounts such as the TFSA (Tax‐Free Savings Account) in Canada or the ISA (Individual Savings Account) in the United Kingdom. The performance of the targeted‐contribution savings plan under the traditional and Roth IRAs (Individual Retirement Accounts) in the United States, along the lines of Adelman and Cross (), would be illuminating. Various related issues must be considered in this context, namely, investor behavior during the accumulation and payout phases, reinvestment scenarios, tax rates before and after retirement, and social security.…”

The Effect of the Tax Cuts and Jobs Act on the Choice between Traditional and Roth IRAs

“…To address the financial decision that involves the appropriation of retirement contributions between these two IRAs, it is important that an investor is familiar with the tax bracket effect-the effect of changing tax rates at a point in time (Adelman & Cross, 2010). Rate shifting, which is the process of moving from a higher to a lower tax bracket at retirement, has certain wealth benefits that accompany it.…”

“…Meanwhile, Adelman and Cross (2010), Grossmann and Rose (2012), and Anderson and Hulse (2013) revisited the examination of the Roth IRA and the traditional IRA using an after-tax analysis. Adelman and Cross (2010) noted the importance of analyzing the theoretical and practical assumptions made about the behavior of a client.…”

“…Meanwhile, Adelman and Cross (2010), Grossmann and Rose (2012), and Anderson and Hulse (2013) revisited the examination of the Roth IRA and the traditional IRA using an after-tax analysis. Adelman and Cross (2010) noted the importance of analyzing the theoretical and practical assumptions made about the behavior of a client. They utilized both assumptions in comparing the acquired after-tax wealth at the time of retirement in both the IRA accounts which led them to believe that the choice between one major types of IRA over the other highly depended on the actual behavior of the investor.…”

“…The traditional IRA had already been established to be the preferable IRA of the two, especially if an investor expected to be in a lower tax bracket at retirement than at contribution (Crain & Austin, 1997;Butterfield et al, 2000;Kutner et al, 2001;Adelman & Cross, 2010;and Hull & Hull, 2016). This outcome is in line with the general inference about the preference of the traditional IRA over the Roth IRA and the one that is very popular and most widely accepted.…”