When planning for retirement, the tax impact of a Roth IRA, traditional IRA, or taxable account can significantly affect your long-term financial performance (tax-adjusted return). While each option has its advantages, the tax implications vary widely and can play a key role in maximizing returns. Let’s dive into a comparison of these accounts, focusing on tax-adjusted returns over time.

1. Roth IRA: Tax-Free Growth and Withdrawals

One of the most appealing features of a Roth IRA is its tax-free growth. Contributions to a Roth are made with after-tax dollars, meaning you pay taxes up front. (Do you call your checking account or save your after-tax accounts?) If you fund your Roth IRA from those accounts, you’ve already paid the taxes. But “qualified” withdrawals during retirement are tax-free, making them an excellent option if you expect to be in a higher tax bracket in the future.

To help crunch the numbers for this article, I used Envestnet’s MoneyGuide Elite software, a financial planning program for financial planners. Based on calculations from the Money Guide Elite IRA Contribution Calculator, Roth IRAs offer significant advantages in tax-free growth, especially when considering long-term gains. With no tax on withdrawals, Roth IRAs provide stability and predictability for retirees who want to minimize their tax burden in retirement.

2. Traditional IRA: Tax-Deferred Growth with Future Tax Liabilities

A traditional IRA allows contributions to grow tax-deferred. Contributions are made with pre-tax dollars, reducing your taxable income today, but withdrawals in retirement are taxed as ordinary income. If you fund your IRA from your checking or savings account, the taxes withheld through your paycheck are adjusted back to you when you file your income taxes. The traditional IRA is a powerful tool for individuals who expect their income (and therefore their tax rate) to be lower in retirement.

The tax-deferred growth of a traditional IRA means contributions can compound more quickly during working years. However, it’s important to remember that all withdrawals will be subject to tax, and depending on your future tax rate, this could reduce the overall value of your retirement savings.

3. Taxable accounts: Flexibility with annual taxation

So-called taxable investment accounts don’t have the same tax advantages as IRAs, but they offer more flexibility. However, these accounts are subject to annual taxes on dividends, interest and capital gains, which can erode returns over time. Unlike Roth and traditional IRAs, contributions can be withdrawn at any time without penalty.

Although taxable accounts may have greater flexibility, they are less tax efficient. Investors must factor in capital gains taxes on appreciated investments and income taxes on distributions, which can significantly reduce the long-term growth of the account compared to tax-advantaged IRAs.

Same investment, different returns. What gives?

You invest in the same fund, except each is placed in different account types: traditional IRA, Roth IRA, and taxable. Let’s say you earn 10% on a $1,000 investment within a year. If your account is taxable, the $100 profit is taxable at your current marginal tax rate. If you’re single earning $150k, that means federal taxes will take $24, giving you a profit of $76 or a 7.6% return. If you saved in a Roth or traditional IRA, there is no tax on the gains unless you withdraw the money or are subject to required minimum distributions. If you withdraw the traditional money and you are over 59 ½, the tax situation is the same as the taxable account. If you withdraw the Roth IRA money, have met the 5-year rule, and are over 59 ½, you keep the 10% return and net $100.

A practical example: Impact over time

Let’s bring these ideas to life with a more complete example. Consider a 35-year-old woman living in Illinois with no previous savings. She saves $7,000, 2.5% inflation adjusted per year until she reaches age 70, and her investments yield an average annual return of 7%. When she turns 70, she begins Social Security, stops saving, and begins taking withdrawals to cover living expenses, starting at $150,110 in her first retirement year and increasing by 2.5% each year. She lives until she is 93 years old. Here’s what we found:

Scenario 1: Roth IRA

With the Roth IRA, she pays taxes on her contributions up front, but her investments grow tax-free. By the time she turns 70, her account has built up a large balance that she can withdraw tax-free during retirement. By the time she reaches 70, her IRA would have grown to approx $1,144,408. Based on the projections from the Money Guide Elite IRA Contribution Calculator, her account would continue to grow even after covering her rising living expenses, and at age 93, her ending balance would be approximately $1,141,856

Scenario 2: Traditional IRA

With the traditional IRA, she avoids paying taxes on contributions today, allowing her to invest money before taxes. By the time she reaches 70, her IRA would have grown to approx $1,144,408, same as Roth. However, withdrawals at retirement are taxed as ordinary income. After accounting for taxes on withdrawals and covering her increasing living expenses, the net balance at age 93 would be approx. $465,905. This is about a million dollars less than the Roth IRA.

Scenario 3: Taxable account

In a taxable account, the woman’s savings would be subject to taxes on distributions and capital gains along the way, slowing the compounding effect compared to IRAs. By the time she turns 70, her taxable account would have grown to approx $839,052. But unlike other accounts, after factoring in ongoing taxes and covering her living expenses, at age 91 she would run out of money. This leaves her with nearly 3 years of unpaid bills or a dramatic reduction in her lifestyle in the last few years of her life.

State Tax Considerations

State taxes can further complicate the comparison between these accounts. For example, Illinois, where our hypothetical investor resides, has a state income tax of 4.95% (However, this would not apply to traditional IRA withdrawals because IL does not perform state tax on IRAs. It is important to note that most states tax traditional IRA withdrawals, but not Roth withdrawals as previously mentioned). This makes the Roth IRA especially appealing to higher-tax residents, as it protects the retiree from future state and federal tax increases.

Conclusion

This practical example highlights how choosing between a Roth IRA, Traditional IRA and a taxable account can affect your long-term retirement savings. For our 35-year-old investor, the Roth IRA provides a balance between tax-free growth and flexibility, while the traditional IRA offers upfront tax savings but carries future tax liabilities. The taxable account, while flexible, is the least tax efficient and provides the lowest closing balance after accounting for taxes and living expenses.

Understanding how these vehicles align with your retirement goals and tax strategy is key to making an informed decision. Each person’s situation is unique, and it is critical to consider your current tax bracket, expected future taxes, and long-term financial goals when choosing the best savings account for your future.

(This part 4 of an ongoing investment-adjusted series – you can read Risk adjusted, Values ​​adjusted and Fee adjusted)