Many people ask if it is better to contribute to a Roth IRA/401k or a Traditional IRA/401k. Before I get into the breakdown of the numbers, we need to cover some definitions.
Contributions to a traditional IRA or 401k can be taken as tax deductions in the tax year they are made. These deductions reduce your gross income, thus reducing your tax burden for the year. Both contributions and earnings are tax-deferred until the funds are withdrawn. That means that when you withdraw the funds, they are taxed as ordinary income. This type of account is recommended as benefitting individuals whose tax rate will decrease between the time of deposit and when the money is withdrawn.
Contributions to a Roth IRA or Roth 401k are taxed as income in the year they are deposited. You’re contributing with your post-tax dollars so your contributions cannot be taken as tax deductions. However, withdrawals made after age 59 and 1/2, and the earnings on those contributions are not taxed.
So which one is better?
I put this to the test for you by running the numbers.
Let’s say that you have $7,500 free cash flow to contribute to your 401k at work. In reality, you could contribute $10,000 to a regular 401k and it would only “cost” you $7,500, (assuming you are in the 25% marginal tax bracket for federal & state taxes you would get a $2,500 tax deduction).
Or you could contribute $7,500 into your Roth 401k (if you have one at work) with no tax deduction.
What would happen to each of these contributions over 20 years? Here’s what you’d find assuming an 8% rate of return.
Roth 401k Contribution Regular 401k Contribution
I know what you’re thinking. Clearly the regular 401k is the best choice! Not so fast. Let’s see what happens when you actually start withdrawing that money during retirement.
Here is what you’d be able to withdraw in year one assuming you’re still in the 25% marginal tax bracket and can take 4% per year increasing 3% each year for inflation.
Roth Income Non-Roth Income
Well isn’t that interesting? The regular 401k looked so much better but once you withdraw and pay taxes on that money (because you didn’t when you contributed to your 401k), you’re left with the exact same income. This continues year after year and you’d be able to withdraw a total of $398,404 over the next 20 years regardless of whether you went with the Roth 401k or the regular 401k.
So they’re the same?
Well, not exactly. When people put money into a tax advantaged retirement plan through work like a 401k, their payroll department often automatically adjusts their take home pay so their tax liability is relatively accurate.
But here’s the thing, people who put money into these tax advantaged accounts don’t take that additional take home pay that they got from their adjusted tax liability and put into more investments. Instead, most Americans take that increased take home pay and spend it on lifestyle expenses.
This is where the comparison between the Roth and non-Roth falls apart because reality and human behavior changes things. People could probably put just as much into a Roth 401k as they do into a regular 401k, because in both cases, the $10,000 is deducted from their paycheck and they spend the rest of their take home pay, regardless of how much is left.
So, let’s start again with this $10,000 investment example. Because of what we said about human behavior and net take home pay, we’ll show putting $10,000 per year into the example of either the regular 401k or the Roth 401k.
What would happen to your contributions over 20 years? Here’s what you’d find assuming an 8% rate of return.
Roth Contribution Non-Roth Contribution
Depending on which route you took, you would actually end up with nest eggs that are identical. But what happens when you withdraw from the accounts in retirement?
Roth Income Non-Roth Income
You would end up with 33% higher income from the Roth because it isn’t taxed upon withdrawal.
If you’re thinking “But I’ll be in such a lower tax bracket when I retire so it makes sense to pay the tax at that point”, think again.
The assumption that you’re going to be in the same tax bracket as you are right now during retirement is flawed. The tax deductions that people enjoy during their working years (like having kids, a mortgage, etc.) are diminished in your retirement years so your tax liability may very well be higher than it was when you were working.
We are in some of the lowest income tax rates in history. When you look at the unfunded liabilities of Social Security & Medicare and other fiscal responsibilities that taxes have to cover, assuming that tax rates will go down instead of going up is very naive.
If future tax rates do indeed rise, then being able to take tax free income each year from your Roth accounts will mean that much more!
If you need help deciding which retirement vehicles are right for you, click here to schedule a complimentary consultation with me.