Roth vs Traditional IRA
Table of Contents
Roth vs Traditional IRA
One of the most asked, and controversial, questions we get as advisors is whether you should do a Roth IRA/401(k) or Traditional. Needless to say, it is a very specific and nuanced question for individuals to ask. I could write an entire book on the topic, to be honest, but I think I’ll keep a very high level so it remains topical while still being generic enough.
Quick Difference
My momma always told me when you assume you make an ass out of you and me. That said what is the difference between a Roth vs. Traditional IRA/401k? Traditional, your dollars go in pre-tax, grow tax-sheltered, and when you retire are finally taxed at your (then) ordinary income tax rate.
A Roth account works in reverse. You are taxed now, at your ordinary income tax rate, the dollars grow tax-free, and when the funds come out you are not taxed at all.
The Bet
I’ve never shied away from a good bet, and here is the general bet most people are making when deciding to Roth or not. The bet is where you think your income and tax rates will be when you retire. If you are not working and high earner today, you likely have a lower tax rate. If you have other incomes and/or expect rates to change for the worse, you will likely be at a lower rate today than in the future.
At the end of the day, this is virtually the “bet” you are making when deciding. Sadly, no one knows where rates will be and other things come into the decision-making process. For instance, are you concerned about the required minimum distributions? How much will you need to pull out in retirement to subsidize your lifestyle?
The Math
Here is where the math gets fun. This may sound counterintuitive, but I’ll make the math super easy. Let’s assume the following, recognizing this is not reality but the taxes are:
- Name: Dr. Jablowski.
- Tax Rate 50% flat.
- You make $100/yr.
- You put all the money into a Roth or Traditional account.
- Tax Rate does not change when you retire.
- Invest for 10 years and the account doubles.
- No penalties for taking funds out.
Example 1: Dr. Jablowski makes $100 and puts it all in his work Traditional 401(k). $100 gets invested and in ten years doubles. Now his account is $200 and he wants to pull it all out to go to the racetrack. He pulls out all his funds and at a 50% tax rate has how much left after tax? Assuming your math came out to $100 left after tax, if not smh 😊!
Example 2: Dr. Jablowski makes $100 and puts in all in his work Roth 401(k) plan. At a 50% tax rate after-tax that means he has invested $50 into a Roth IRA. Dr. Jablowski lets it sit there for 10 years invested in the same funds that his Traditional 401k is invested in. These dollars double to $100 in 10 years. Following me thus far? Seeing the writing on the wall? Ok, I’ll continue. Now Dr. Jablowski takes out these funds to go to the track. Since no taxes are owed on his Roth 401(k) he gets the full amount of $100 to go bet with.
Identical
As you can see above, assuming the same tax rate and the same investments there is literally no difference as to which option you see. Literally, the way the math works out the net amount received is, you guessed it IDENTICAL!
I know it doesn’t sound intuitive, but I promise you it is that simple from a math perspective. The real trick is all the other assumptions you want to plug in and/or personalization you think may happen in your life to tip the scale more towards one direction than the other.
I generally tell people exactly this and candidly I am a big fan many times of splitting the proverbial baby and doing a little in each. If you are a high earner, I even love maxing the pre-tax and then doing advanced strategies like a back door or mega back door Roths that can allow you to work smarter, not harder.
In any event, it is a very personal decision and one we pride ourselves on discussing with our clients. It is also one that can be very complex and/or often be over-analyzed when the math may not justify it.
Stay wealthy, healthy, and happy.
