Choosing between Tax-Advantaged Savings Accounts: A Reconciliation of Standardized Pretax and After-Tax Frameworks

Abstract

Abstract Previous research models the choice between a traditional IRA and Roth IRA by standardizing either the pretax investment or the after-tax investment. This paper synthesizes these two approaches and develops a unified model that accommodates changing tax rates and different types of tax structures during the accumulation phase. Simulations indicate that the investor's withdrawal tax rate is important in making the optimal choice. We also argue that uncertainty about future tax rates increases the value of the traditional IRA, but that in any case investors benefit from having a portfolio of both traditional IRAs and Roth IRAs when withdrawals are made. © 2003 Academy of Financial Services. all rights reserved. JEL classification: D91; G11; G21; G23 Keywords: IRA; 401(k); Retirement planning; Saving; Tax planning 1. Introduction Since the introduction of the Roth IRA, researchers have analyzed the optimal choice between a traditional (i.e., tax-deductible) IRA and Roth IRA. Some authors have compared these investment options by equalizing the pretax investment in both accounts. Under this framework one assumes that pretax investments are less than the after-tax contribution limit [e.g., Crain and Austin (1997)]. Otherwise, one makes an assumption about how a portion of the pretax investment in excess of the after-tax contribution limit for the traditional IRA is to be invested [e.g., Stout and Barker (1998)]. Other researchers have standardized the after-tax investment, which requires an assumption about how tax savings from the deductible IRA strategy are to be invested. Some authors have assumed that the tax savings are invested in a fully taxable investment [e.g., Krishnan and Lawrence (2001)], while others have assumed that tax savings are invested in a typical mutual fund (e.g., Horan and Peterson (2001)]. Not surprisingly, authors arrive at different conclusions regarding the relative attractiveness of these investment accounts because they make different assumptions. As a result, investors and financial planners can be left confused. An after-tax approach is appropriate in the sense that investors make consumption and investment choices with after-tax dollars. A pretax approach may be appropriate, however, if investors or financial planners seek to maximize the amount of pretax income invested in tax-sheltered investment vehicles. The first purpose of this paper is to reconcile the two approaches of standardizing either the pretax or the after-tax investment by developing a unified framework. The second goal of this study is to analyze the choice between a traditional IRA and a Roth IRA using a generalized model that is nominally predicated on a pretax framework and can be applied in a broad array of situations. The model developed in this paper allows for tax rates to change over time from the initial contribution, through the accumulation phase, and upon withdrawal. Allowing for temporal tax rate changes is important because evidence suggests that investors are likely to fall into lower tax brackets upon retirement [e.g., Bernheim, Skinner, and Wienberg (1997)]. In addition, the analysis incorporates different tax rates on ordinary income and capital gains during the accumulation phase, allowing a portion of the return to be taxed as either. The analysis is placed in the context of the recent Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) of 2003 recently passed by Congress in May of 2003. Finally, this paper considers other issues pertaining to the IRA decision, such as the effect of withdrawal patterns, the uncertainty of future tax rates, and the benefit of having a portfolio of both traditional IRAs and Roth IRAs at retirement. This paper is organized as follows. Section 2 reviews the literature most closely related to the choice between traditional IRAs and Roth IRAs. section 3 illustrates the relationship between the standardized pretax and after-tax investment frameworks. …

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