Tax-Favored Savings Accounts: Who Gains? Who Loses?

Policy Reports | Taxes

No. 249
Thursday, January 31, 2002
by Jagadeesh Gokhale and Laurence J. Kotlikoff

Contributing to Regular IRAs and Roth IRAs

Table IV - Change in Lifetime Taxes from Participating in Regular and Roth IRA Plans with Constant Annual Contributions

Not all companies offer tax-deferred saving plans. For workers in such firms, access to tax-sheltered saving plans is limited to regular IRAs or Roth IRAs. Table IV compares the lifetime tax and spending effects under the new law of investing either $2,000 or $5,000 annually in real 2001 dollars in either a regular or Roth IRA. The table assumes a 6 percent real return. It also assumes, for the purpose of comparison, that high-income workers are also able to contribute these same amounts. Finally, it assumes that the contribution credit is permanent and indexed for inflation.

The first two columns of the table deal with contributions to regular IRAs and reinforce the lesson learned above: Too much tax-deferred saving should be avoided by low-income households. For example:

  • If a couple earning $25,000 makes an inflation-adjusted $2,000 annual contribution each to a regular IRA, it will lower its lifetime taxes by $754.
  • But if the contribution is $5,000, rather than $2,000, lifetime taxes will rise by 38 percent, increasing the couple's lifetime tax bill by more than $23,000!

"Roth IRA participation generates tax savings for all income groups."

In contrast, contributing the same amounts to a Roth IRA generates lifetime tax savings in both cases. Under this option, deposits to the account are made with after-tax dollars and withdrawals during the retirement years are tax-free. The pattern here is repeated for all income groups earning $50,000 or less. [See Figure I.] For example:

Figure I - Change in the Present Value of Lifetime Taxes with Annual Contributions
  • The $50,000 a year couple lowers its lifetime taxes by more than $6,000 when its IRA contributions are $2,000 each per year.
  • But this gain is converted into a loss in excess of $5,000 when the IRA contributions climb to $5,000 a year.
  • By contrast, the couple will enjoy a $6,000 lifetime tax reduction if the contributions are made to a Roth IRA.

"With smaller contribtutions, tax deferral can be profitable."

In general, the tax saving from Roth IRA participation is higher, the higher one's income. This is because higher-income taxpayers are escaping higher progressive tax rates. However, in percentage terms the tax reductions enjoyed by low-income households are larger than those enjoyed by higher-income households if they, too, contributed similarly to a Roth IRA, but did not contribute to any other retirement account. This reflects the fact that a fixed annual Roth contribution represents a smaller share of earnings as the household's income level rises.

For households with initial earnings of less than $50,000 per year, tax savings are smaller when Roth IRA contributions are $5,000 per year than when they are at $2,000 per year. As Table V shows, a similar result is obtained for the same households if Roth contributions grow annually 1 percent faster than inflation rather than remaining fixed in real terms. The explanation for this surprising result is that the couple accumulates very little in the way of regular assets prior to retirement when it makes the $2,000 Roth contribution.2 Its regular asset accumulation is roughly the same when it makes the $5,000 contribution. That means that the $2,000 contribution pretty much eliminates taxable capital income and pretty much exhausts the ability of this household to save on capital income taxes.

Table V - Change in Lifetime Taxes from Participating in Regular and Roth IRA Plans with Growing Annual Contributions

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