Choosing whether to invest in a traditional vs. Roth account for retirement can be confusing. Each one comes with it’s own tax advantages and can make a big difference on your bottom line. However, there’s one thing I’ve heard many times that is flat out wrong when making your choice. The big misconception people have is that a traditional account is better because it is pre-tax and thus leaves you with more money to invest. More money invested up front means your nest egg will grow faster than it would with a Roth. That’s not really true and here’s why:
The main difference between traditional vs. Roth accounts
The biggest difference between the two types of accounts are when they get taxed. A traditional account is pre-tax meaning you deduct your contribution and get the tax benefit in the current year. You would then owe taxes on all of it when you begin withdrawing your money (which is required when you turn 70 1/2).
A Roth account is after-tax, meaning you pay the taxes on the contribution and get no tax benefit in the current year. But the benefit is that all capital gains and earnings on your money is tax free whenever you choose to withdraw it. There’s also no required distribution from the account because you’ve already paid taxes on it. These accounts don’t have to be touched and can be passed to heirs, also tax free.
Do the math
It’s important to remember that, all else equal, both accounts will net the same dollar value whether you take the taxes out first or at the end.
Let’s crunch some numbers. The maximum contribution for traditional and Roth IRAs is $5,500 for people under 50 years old. Let’s look at a $5,500 contribution from someone who is in, and will stay in, the 20% tax bracket from now until retirement. Here’s what happens when you plug those values into a future value of money calculator.
Today (pre-tax) – $5,500
Future value of $5,500 in 30 years with average return of 7% – $41,867.40
In 30 years – $41,867.40 x (1 – 20% tax rate) = $33,493.92
Today (after-tax) – $5,500 x (1 – 20% tax rate) = $4,400
Future value of $4,400 in 30 years with average return of 7% – $33,493.32
In 30 years (tax free withdrawal) – $33,493.92
First a quick side note. Look what happens to $5,500 when you invest it for 30 years. It increased over 600%. Thanks compound interest!
But aside from that, look at the final amount when the tax was taken out first or 30 years later. Same number, right down to the penny. So what does this mean?
How to choose between traditional vs. Roth?
So if they come out to the same amount, then does it even matter which one you pick? Absolutely! In the example, I mentioned that the person stayed in the same 20% tax bracket throughout the example. But it real life, most people don’t stay in the same bracket. In theory, they should be making more money as they get older and moving into higher tax brackets.
Of course the idea is to minimize taxes. Ideally you would be paying taxes on your contribution whenever you believe you’d be paying at a lower rate. If you’re young, don’t make much money, had a down year financially or started saving young (and will likely have a large nest egg in retirement), you’re probably better off going for the Roth. Pay the tax now while you’re in a lower bracket.
If you’re in your 40s (peak earning years), had a big financial windfall or were late to begin saving for retirement (and won’t have as much retirement income), the traditional account may be the better way to go. Take the tax break now and pay less tax on a smaller amount of money in retirement.