April 10, 2014

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Article

Weighing the Costs

The Superior Retirement Account: Traditional or Roth?

By Lon Jefferies

April 10, 2014


You’re likely familiar with the difference between a traditional IRA/401(k) and a Roth IRA/401(k). While the traditional account enables you to postpone taxes on both the income invested and its growth until the funds are withdrawn, a Roth account does not provide an initial tax benefit but investment growth is tax free. So which is better?

Let’s answer the question with some simple math. Suppose an investor in the 25 percent federal tax bracket invests $1,000 of pre-tax income, obtains an 8 percent annual return over the next 10 years, and is still in the 25 percent tax bracket in the future. Would this investor profit more investing in a traditional or a Roth account?

As the chart below illustrates, the investor in this scenario would end up with the exact same amount in either a traditional or a Roth account.

So does the decision to invest in a traditional or Roth retirement account not matter? Not so fast.

Constant Tax Rate

 

Traditional

Roth

Initial Tax Bill (25%)

$0

$250

Invested Amount (after-tax)

$1,000

$750

Future Investment Value

$2,159

$1,619

Future Tax Bill (25%)

$540

$0

After-Tax Value in 10 Years

$1,619

$1,619

Lower Tax Bracket in Future

Let’s assume our investor will have a reduced income when she retires in 10 years, causing her to be in the 15 percent tax bracket in the future. Perhaps the worker is in her prime earning years and will have less income during retirement. In this scenario, due to the up-front 25 percent tax bill, investing the funds in a Roth would lead to the same after-tax value of $1,619. But investing the funds in a traditional account would allow the full $1,000 to experience growth for 10 years, with a reduced future tax bill of 15 percent, leaving $1,835 of after-tax value in the account. This investor would benefit from delaying taxes into the future when she would be in a lower tax bracket.

Lower Tax Rate in the Future

 

Traditional

Roth

Initial Tax Bill (25%)

$0

$250

Invested Amount (after-tax)

$1,000

$750

Future Investment Value

$2,159

$1,619

Future Tax Bill (15%)

$324

$0

After-Tax Value in 10 Years

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