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What Is The Value Of A Roth IRA Contribution?

J. Patrick Collins Jr., CFP®, EA

Many of our clients still in their working years do not qualify to make Roth IRA contributions (2018 income limits are $135,000 for single filers and $199,000 for married couples).  But from time to time, clients do qualify to make a contribution and we often recommend doing so (maximum contribution for 2018 is $5,500, and $6,500 if you are over 50).  We’ve done some work to quantify the value of being able to make a Roth IRA contribution, versus just leaving those funds in your taxable investment account.  To review the logistics of how Roth IRA accounts work, contributions grow tax-free for your lifetime (and your heirs, if they inherit it).  Another added benefit is there are no required minimum distributions that need to be withdrawn at age 70 ½ like a Traditional IRA.

So, what is the real benefit in dollar terms?  Larger after-tax returns are where you get the biggest bang for your buck.  In a regular brokerage account, every year you have to pay taxes on dividends, interest and capital gains, effectively lowering your after-tax return.  Some studies have pegged this “tax drag” on returns at well over 2% per year.

In our study, we looked at 3 different taxable portfolios of varying tax efficiency, all earning 8% per year PRE-TAX, in order to compare them to a Roth IRA:

Portfolio

Pre-Tax Return

Tax Drag

After-Tax Return

High Tax-Efficiency

8%

1%

7%

Moderate Tax-Efficiency

8%

2%

6%

Low Tax-Efficiency

8%

3%

5%

 

Our study is assumed to take place over 30 years, with the contribution made in the first year.  The results show how powerful Roth IRA contributions can be, if allowed.

Portfolio

After-Tax Return

Growth of $1

% Lost Due to Taxes

Roth IRA

8%

$10.06

n/a

High Tax-Efficiency

7%

$7.61

-24%

Moderate Tax-Efficiency

6%

$5.74

-43%

Low Tax-Efficiency

5%

$4.32

-57%

 

For those that qualify, Roth IRA accounts can be extremely valuable vehicles when compared against investing in a taxable brokerage account.  While there are limits on how much you can contribute, by making those contributions in the years when you are allowed, you can significantly increase your portfolio’s after-tax return, and your overall after-tax wealth.

 

*Always be sure to consult your tax and financial advisor before making any tax and investment decisions.