Which IRA Should You Contribute to and When?
Roth IRAs offer better wealth incomes than traditional IRAs do on a dollar-for-dollar basis. Additionally, an investor who makes a lump-sum contribution at the start of a year fares better than an investor who makes a year-end lump contribution, though monthly systematic contributions do offer a compromise. These are the findings of a study about individual retirement accounts conducted by T. Rowe Price.
The study assumed an investor in the 25% tax bracket contributed $1,000 to a Roth IRA or a traditional IRA at various ages. A retirement age of 65 followed by 30 years of withdrawals was used. Returns were 7% annualized during the investor’s working years and 6% during his retirement years. The $250 tax deduction from the traditional IRA was put into a taxable account and taxed annually.
Under this set of assumptions, the Roth IRA created more wealth for most age groups even when the tax rate dropped. Investors who were 50 years old didn’t see any benefit to using the traditional IRA until their tax rate fell by more than 7%. Investors who were 65 benefited from the traditional IRA only after their tax rates fell by 6% or more.
Astute readers may note that the hypothetical investor was not assumed to use his tax savings to increase his traditional IRA contribution, from $1,000 to $1,250. Had the investor chosen to do so, we do think the outcome would have been altered by giving the traditional IRA more money to grow. On the other hand, the lack of mandatory withdrawals allows money invested in a Roth IRA to grow for a longer period of time.
As far as when to contribute, most investors chose to do so from January through April. T. Rowe Price says those who wait to the last moment to contribute for the last year are hurting their wealth. Making lump-sum contributions at the beginning of each year results in greater wealth than end-of-year contributions over rolling three-, five- and 10-year periods. Making contributions in equal amounts over the course of a year is a good compromise, however, and also outperforms end-of-year contributions.
Source: “Roth IRAs: More Effective (and Popular) Than You Thought,” T. Rowe Price.