While introduced only in 1997, the Roth IRA has become a major retirement vehicle for millions of Americans. While everyone knows that the Roth IRA provides tax benefits, most people have difficulty quantifying precisely how valuable the Roth IRA is compared to other accounts.

So in this article, let’s try to quantify how valuable a contribution to a Roth IRA is compared with a taxable account. The results may surprise you.

Introduction to Roth IRAs

Roth IRAs were created into the tax law in 1997 by Senator William Roth of Delaware, and by 2007, more than 50 million taxpayers held a Roth IRA.

Roth IRAs have always had an income phaseout for direct contributions, which is $120,000 for single taxpayers and $189,000 for married filing jointly taxpayers in 2018.

This means that most high-income professionals such as physicians are not permitted to directly contribute to a Roth IRA because of income limitations. However, Congress recently stated in a footnote of the tax bill that contributing to a so-called backdoor Roth IRA is legal.

The backdoor Roth IRA involves making a non-deductible contribution to a traditional IRA, followed by a conversion to a Roth IRA.

Benefits of a Roth IRA

While you cannot deduct contributions to a Roth IRA or backdoor Roth IRA like you can in a traditional retirement account, there are still multiple benefits to investing in a Roth IRA:

  1. Tax-Free Growth: As your investments grow, you do not have to pay taxes on your profits from dividends or capital gains. You would have to pay taxes each time you receive a dividend or sell an investment for a profit in a taxable account.
  2. Tax-Free Withdrawals: Withdrawals after the age of 59 1/2 are tax-free. In a traditional retirement account such as a 401(k), withdrawals are taxed as ordinary income.
  3. No Required Minimum Distributions: Unlike in many other retirement accounts, you are not required to withdraw money from a Roth IRA after a certain age.

Calculating The Value Of A Roth IRA

So how valuable is a Roth IRA? I’ve previously calculated the benefits of a traditional 401(k). The benefits of a Roth IRA are more straightforward.

The money you save with a Roth IRA compared to a taxable account is approximately the tax savings of a Roth IRA compared to a taxable account. If you never sell your stock in your taxable account until retirement, the approximate benefit is simply your investment gains multiplied by the long-term capital gains tax rate.

We assumed that the taxable account was managed in the most tax-efficient way (i.e. buy an index fund once and never sell until retirement). If you invest in a less tax-efficient manner, i.e. you do short-term or long-term trading, the tax benefits of the Roth IRA are even greater, since trading incurs tax consequences in a taxable account but not in a Roth IRA.

An Example

Consider a 35-year old who contributes the maximum $5,500 to a Roth IRA (either directly or indirectly through the backdoor Roth IRA). Here are our assumptions:

  • Comparator arm is a taxable account.
  • Long-term capital gains tax rate – 15%
  • Investment returns – 5% real (after-inflation) returns
  • Time horizon – 30 years (retire at age 65)
  • Trading frequency: never – she would invest her money in a low-cost index fund either way and never sell until retirement
  • Withdrawal strategy: she will immediately withdraw money at age 65 (for simplicity)

In this case, the $5,500 initial contribution will grow to $23,771 in 30 years, which if liquidated, would save you 15% * ($23,771 – $5,500) = $2,741 in taxes, or almost 50% of the original contribution.

What Affects The Tax Benefits Of A Roth IRA?

Long-term capital gains rate

The amount of benefit you get from contributing to a Roth IRA instead of a taxable account depends on the long-term capital gains rate. If Congress were to raise the capital gains rate in the future, your Roth IRA becomes more valuable.

Investment returns

Higher investment returns means more money that is protected from taxes when compared to a taxable account.

Trading frequency

While I certainly do not recommend it, if you must trade, you should trade in a Roth IRA instead of a taxable account. All the trades in a taxable account are taxable events. On the other hand, you could theoretically day-trade in your Roth IRA without worrying about short-term capital gains.

Time horizon

The longer your investing time horizon, the larger your Roth IRA (and its tax benefits) will grow. If you pass your Roth IRA to your child or grandchild after you die (the so-called Stretch Roth IRA, described below), you can even lengthen the time horizon of the Roth IRA to beyond your own lifetime.

Stretch Roth IRA

One of the benefits of a Roth IRA is that you can pass it down to a beneficiary tax-free. This is a so-called stretch Roth IRA. Once the Roth IRA is passed to a beneficiary, the Roth IRA becomes subject to required minimum distributions, but these distributions are tax-free.

This means that if you were to invest in a Roth IRA when you are 30, die at age 95 and pass it on to your 25-year-old grandchild, the Roth IRA could have over a century of tax-free growth. The benefits of a Roth IRA are in proportion to how much tax-free investment gains it creates, and the longer you (and your heirs) hold the money in the Roth IRA, the more tax-free benefits it will provide.

Conclusion

The tax benefits of a Roth IRA are quite significant, especially early in your career. The value of a Roth IRA is based primarily on the expected total return of the Roth IRA. For young investors with a long investment time horizon, a Roth IRA can be very valuable.

And if you end up not using your Roth IRA during your lifetime and pass it on to your children or grandchildren in the form of a stretch Roth IRA, the Roth IRA’s value becomes even greater.

Because of the account’s tax benefits, physicians and other high-income professionals should strongly consider contributing to a backdoor Roth IRA in addition to their other tax-advantaged accounts.

What do you think? How valuable do you think a Roth IRA is? Are you planning to never withdraw from your Roth IRA and leave it to a child or grandchild (stretch Roth IRA)?

Poll: Do you contribute to a Roth IRA?

4 COMMENTS

  1. I plan on using some of my Roth IRA, but plan to leave most of it to my kids as a stretch IRA. They will have to pay RMDs on it, even though I get to avoid them during my life. That said… The RMS is tax free money they can invest or spend and the rest continues to grow tax free.

    I actually put $29500 into Roth accounts each year and the rest of my retirement contributions go in viw pre tax contributions (totaling about $50k).

    Once my debt is paid off from med school I’ll open a taxable account. Plan to draw down taxable first, then pre tax, then Roth if I have to.

  2. I was very exited when I learned about the opportunity to do a backdoor Roth, as I think the tax-free earnings will be great whether I withdraw in retirement or pass this account on to my children. I just completed my backdoor Roth this past week and I am now looking to go ahead and invest next years IRA contribution of ~5.5k into this retirement account to let it start compounding. Aside from the bond fund I already own within this Roth (BND), I want to max out this account and was wondering would you recommend going with Vanguard Total Stock Mkt Idx Inv (VTSMX) since I do not have the 10k minimum for admiral shares? Or would the Vanguard Total Stock Market ETF (VTI) be better due to the lower ER?

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