In a couple of earlier posts, I discussed the basics of traditional IRAs versus Roth IRAs, and explained the sneaky (but legal!) way to make a Backdoor Roth IRA contribution, even if you make too much money to contribute to a Roth IRA the regular way.  In this post, I’m going to show you that no matter how high your current tax bracket is, you’re going to benefit by putting the full $5,500 contribution into a Roth IRA instead of a traditional IRA.  Seriously.  Stick with me, here.

When most financial writers compare the benefits of a Roth IRA versus a traditional IRA, they assume that all you’ve got is $5,500 in pre-tax dollars to contribute.  For nearly all us, that isn’t the case.  But let’s pretend it is for purposes of discussion.

Assume that all of your income is allocated to other expenses, and all you have left is $5,500 over the course of a year.  Assume that you have not yet paid the tax on that $5,500 yet.  Your choices are either (1) contribute the full $5,500 to a traditional IRA, which is tax-deductible, so you won’t owe income tax on that amount, or (2) pay tax on the $5,500 and contribute the balance to a Roth IRA.  Assume that your current tax bracket is 35% (federal and state combined), and that your future tax bracket at retirement will be the same, 35%.  In that scenario, which is better, a Roth or traditional IRA?

They’re exactly the same.  The table below shows one IRA contribution in year one, plus an 8% annual return on that amount.  For the traditional IRA, it shows the full $5,500 contribution, minus 35% for taxes at the time of withdrawal.  For the Roth IRA, it shows the amount of contribution that you could make after tax if you were forced to use part of the $5,500 to pay income tax in year one, and if you contributed the rest.  There is no tax on the Roth IRA withdrawal.

Year Traditional IRA Roth IRA
1 5,500 3,575
2 5,940 3,861
3 6,415 4,170
4 6,928 4,503
5 7,483 4,864
6 8,081 5,253
7 8,728 5,673
8 9,426 6,127
9 10,180 6,617
10 10,995 7,146
11 11,874 7,718
12 12,824 8,336
13 13,850 9,002
14 14,958 9,723
15 16,155 10,500
16 17,447 11,341
17 18,843 12,248
18 20,350 13,228
19 21,978 14,286
20 23,736 15,429
21 25,635 16,663
22 27,686 17,996
23 29,901 19,436
24 32,293 20,990
25 34,876 22,670
26 37,667 24,483
27 40,680 26,442
28 43,934 28,557
29 47,449 30,842
30 51,245 33,309
Tax 35% 0%
33,309 33,309

This is the part where the financial writers will say there are pros and cons to both types of IRAs, and they go into a detailed examination of the details.  But here’s where their premise is flawed: their math problem is based on an apples-to-apples comparison.

This is NOT a scenario that calls for an apples-to-apples comparison.  Let’s get some oranges in here.

The other financial writers are trying to show that the Roth IRA and the traditional IRA work out to be about the same, assuming you only have $5,500 to contribute, period.  They assume that if you have to pay taxes on that initial $5,500, it will reduce your contribution amount.  But is that reality?  NO.

First, let’s get this point out of the way: YOU CAN scrape together enough income from somewhere to pay the tax on that $5,500.  The tax on $5,500 is not all that much, in the grand scheme of things.  If you’re scraping by in the 10% tax bracket, it’s only $550.  Start recycling some cans, sell some old furniture on Craigslist, mow some lawns, give a few music lessons, walk some dogs, babysit some kids.  If you really try, you can earn (or shave expenses by) $550.  If you’re in the 25% tax bracket, the tax will be $1,375.  Your tax bill is getting steeper, but you’re also making between $37,000 and $90,000, so you can get creative and make it happen.  If you’re in a higher tax bracket than that, you’ve got enough income that you should just stop whining and make it happen.

The reason you need to just find a way to pay the tax and contribute your whole $5,500 limit is because contributing the full $5,500 to a Roth IRA could mean a 50% increase in the size of your IRA distributions.  Feel free to check my math below.

Assume that instead of having only $5,500 of unallocated income at the end of the year, you really have enough money to pay tax on your leftover money and contribute the full $5,500 to a Roth IRA.  Here’s the math, assuming again that you’re earning 8% each year.  The far right column is the new scenario, where the full $5,500 after-tax contribution is made.  Again, we are assuming that you will be in the 35% combined federal and state income tax bracket in retirement.

Year Traditional IRA Roth IRA Roth full contribution
1 5,500 3,575 5,500
2 5,940 3,861 5,940
3 6,415 4,170 6,415
4 6,928 4,503 6,928
5 7,483 4,864 7,483
6 8,081 5,253 8,081
7 8,728 5,673 8,728
8 9,426 6,127 9,426
9 10,180 6,617 10,180
10 10,995 7,146 10,995
11 11,874 7,718 11,874
12 12,824 8,336 12,824
13 13,850 9,002 13,850
14 14,958 9,723 14,958
15 16,155 10,500 16,155
16 17,447 11,341 17,447
17 18,843 12,248 18,843
18 20,350 13,228 20,350
19 21,978 14,286 21,978
20 23,736 15,429 23,736
21 25,635 16,663 25,635
22 27,686 17,996 27,686
23 29,901 19,436 29,901
24 32,293 20,990 32,293
25 34,876 22,670 34,876
26 37,667 24,483 37,667
27 40,680 26,442 40,680
28 43,934 28,557 43,934
29 47,449 30,842 47,449
30 51,245 33,309 51,245
Tax 35% 0% 0%
33,309 33,309 51,245

By contributing the full $5,500 to a Roth instead of a traditional IRA, you will end up with $51,245 instead of $33,309!  Because you’ve made your full Roth contribution after paying the tax with other funds, you’ve effectively invested $7,425 in pre-tax dollars into your retirement account, instead of $5,500.  Yes, you pay the income tax of $1,925 up front, but you’re able to invest $5,500 in an account that will never cost you another dime of tax ever again.  In this scenario, at a 35% tax rate, you’re able to save an extra 53% of tax-free income over 30 years.

Also, keep in mind that this scenario involves one single $5,500 contribution in one year.  The numbers increase dramatically if you keep contributing $5,500 over the course of many years.

Here’s the big surprise: this scenario saves you money no matter which tax bracket you’re in now, and no matter which bracket you’re in later.  The lowest federal tax bracket is currently 10%.  In our scenario, we assumed you were in the 35% tax bracket now, which means you’re only paying $1,925 in tax on an account which will grow to be $51,245 after 30 years. The only way you would save more money by putting your funds into a traditional IRA is if your tax bracket ends up being less than 4% at the time of withdrawal ($1,925 divided by $51,245).  Let’s face it: that’s not going to happen.

Take advantage of the Backdoor Roth option, while it is still available.  Scrape together your money to pay the tax on the $5,500 instead of reducing your Roth IRA contributions.  You basically can’t go wrong here.

If you think I’m wrong, or my math is flawed, please feel free to point in out in the comments.