Roth or Traditional?
Which makes more money? Which is better for you?
Should you chose roth or traditional? Exactly how does the math work out and which will make you more money? This article applies for any retirement account to include; Roth and Traditional IRA, 401k, TSP, 403b, and 457b.
Roth means you contribute “After Tax” dollars. Such as for a Roth IRA or Roth 401k you pay the taxes on the front end and when you withdraw the money it’s completely tax free. Traditional means you contribute “Before Tax” dollars. You don’t pay any taxes now on a Traditional IRA or Traditional 401k but instead you pay the taxes on the back end when you withdraw the money.
Which makes more money?
Let’s look at Roth Randy and Traditional Tom. Both make the same amount of money therefore they are both a 22% income tax bracket. Both invest 15% of their salary into their 401k:
In the end both Roth Randy and Traditional Tom finish with the exact same amount! Dollar per dollar the math comes out the same every time. I’ve heard people that support the Roth use the argument: Would you rather pay taxes on $1k dollars this year or $1million in retirement? But that’s not a logical argument. Dollar per dollar Roth and Traditional are the exact same.
Whether you have a high income or low income it doesn’t change anything. And whether you plan on living longer in retirement or dying sooner it still doesn’t change the math.
2 Ways Roth or Traditional Could Beat One Another
#1 Tax Bracket Changes
If you think you’ll be in a higher tax bracket when you retire then during your working life, Roth is better. In other words, if your investments are going to make you more money during retirement than you currently make in salary, Roth is better. Some people call that “Retiring better off”. This will typically be the person who starts investing early and often.
On the other side if you think you’ll be in a lower tax bracket when you retire, Traditional is better. In other words, if your retirement investments will make you less money than you make in salary right now, do Traditional. This is typically the person who started saving for retirement later in life.
Estimating this right could earn you hundreds of thousands of dollars more. The table below has my general guidelines, based off the math I’ve done, for the breaking points for Roth or Traditional. The table does not factor in social security or any other retirement benefit you may receive such as a pension, real estate income, etc. If you do plan on having other sources of income during retirement, I would favor Roth if you are close to the numbers below.
How to analyze this table? Find the percentage of your salary you invest into retirement. Look at the corresponding “Years Until Retirement” column. If you plan on retiring in less than that amount of years, do Traditional. If it will be more years until you retire, do Roth.
#2 The Inheritance Left Behind
On average this could lead to a $2.2million dollar difference between Roth and Traditional!
Let’s look at average Joe. According to the US Census Bureau’s last study done in 2018, the average household income is $63,179. Average Joe gets raises over the years just enough to keep up with 2.5% inflation. Average Joe does 15% of his pre-tax income into a TRADITIONAL account- he’s putting away $789.74/month into retirement and it that slowly increases as he gets small raises. Joe does this from age 25 to age 60 and retires with $3,799,151. If Joe withdraws 6%/year being taxed at 12% (2020 Married filing jointly with the $24,400 tax deduction) Joe would take home a total of $8,172,781 by the time he dies at 85 and there would be an inheritance left of $5,709,014.06 (after 37% tax).
Compare that to if average Joe does 15% of his post tax income into a ROTH: $63,179 taxed at 12% (Married filing jointly), Joe’s take home pay is $55,597.52. 15% of that is $694.97/month. Investing that money from age 25 to 60 while Joe gets small raises, he would retire with $3,343,253. Withdrawing 6% a year, remember no taxes on anything, Joe would take home a total of $8,172,781 (exact same amount to the dollar as the Traditional account) by the time he dies at age 85. But there would be $7,974,496.11 left as an inheritance ($2,265,482 more than the Traditional!).
Assuming your tax bracket stays the same Roth and Traditional both produce the exact same amount of income for you. But the Roth comes out on top because it leaves behind a tax-free inheritance which will produce a lot more “take home” money for your beneficiaries.