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The Knockout Punch in the IRA Grudge Match

There’s an ongoing battle in the financial realm pitting the Roth IRA against its older cousin, the Traditional IRA.  Most of the debate, however, is rendered irrelevant because it doesn’t consider the Traditional IRA’s fatal flaw.

Tale of the Tape:

The IRA debate is almost entirely about taxes.  As long as you meet certain income requirements, Traditional IRAs offer you the opportunity to claim a tax deduction up to the maximum contribution limits in the tax year for which the contribution is made, but every dollar that is ever distributed from the IRA will be taxed as ordinary income in the year of distribution.

The Roth IRA offers an inverse tax privilege.  While there is no deduction for the contribution, qualified distributions of both principal and growth are tax-free.

As the predominant logic goes, then, if you expect to be in a higher tax bracket in retirement than you are today, contribute to a Roth IRA. If, instead, you are likely to be in a lower tax bracket in retirement, contribute to a Traditional IRA.

By this logic alone, if your tax bracket would never change, there’s virtually no difference between the two investment options. But, like many personal finance one-liners and rules-of-thumb, this one falls woefully short of giving you the whole story.

The Knockout Punch:

Please consider this:  Which is more valuable—a dollar in a Roth IRA or a dollar in a Traditional IRA?

As long as you’re expected to pay taxes the answer to this question is always—100% of the time—the dollar in the Roth. This is because the Roth allows you (and your heirs) to extract qualified distributions free of taxes. The dollar in the Traditional IRA, on the other hand, is subject to taxation whenever you (or your heirs) remove it. So, if you’re in a 25% tax bracket, your Traditional IRA dollar is actually only worth 75 cents.  The higher your tax bracket, the less your Traditional dollar is worth.

In order for the Traditional-is-better logic to succeed, we must assume you take the extra cash on hand, born from your tax deduction specifically associated with your Traditional IRA contribution, and invest it for your future retirement.  Practically speaking, if you make a $5,000 contribution to a Traditional IRA and you’re in a 25% tax bracket, your deduction should be worth $1,250. In order for the Traditional to have a chance at beating the Roth, you must not only be in a lower tax bracket in retirement, but you also must save that additional $1,250 for retirement.

But what do most people do with their tax refund? SPEND IT!

What if you use your refund as a down payment on a car or for a vacation? The Traditional edge is eliminated. What if you didn’t receive a refund at all? Unless you write a check to invest the amount you should have received as a consequence of the deduction for your Traditional IRA contribution after you write Uncle Sam a check, the Roth wins.

One of the great frustrations in financial planning is that most of the planning is based on assumptions of things we can’t actually control or change—annual income, inflation, market returns and, of course, taxes. So, you can contribute to a Traditional IRA, calculate the proportionate amount of tax deduction and invest it in an taxable account dedicated to retirement—every year—OR you can take control of one of those factors and pre-pay your taxes using a Roth IRA.

Like so much of personal finance,  the Roth/Traditional debate appears on the surface to be about numbers, but it’s more about our behavior.

If you enjoyed this post, please let me know on Twitter @TimMaurer.

This commentary originally appeared May 30 on Forbes.com

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© 2014, The BAM ALLIANCE

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As director of advisor development at The BAM ALLIANCE, Tim designs and implements focused educational programs for our advisors around the country. His goal is to prepare them to provide an outstanding experience to each and every client through skillful investment advising and financial life planning.

A central theme drives Tim’s work: Personal finance is more personal than it is finance. Regardless of our income or net worth, Tim believes it is our underlying values and goals that drive our behavior with money, which ultimately determines our satisfaction in work and life. With a passion for relational communication, Tim has been featured on the Today show on NBC, CNBC and ABC’s Nightline, on NPR programs The Diane Rehm Show and Marketplace as well as in The Wall Street Journal, The Washington Post, The New York Times, The Baltimore Sun, Kiplinger’s Personal Finance, U.S. News & World Report and Money magazine, among others.

You can follow Tim on Twitter at @TimMaurer.

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