Last week, I was researching for a Roth 401(k) article and came across a Roth IRA study from T. Rowe Price. Basically, the study concludes that the Roth account is the better choice for most investors. You’ll have more money unless your tax rate is much lower in retirement. If you’re 55, then your tax rate will have to drop by 7% for the Traditional IRA to beat than the Roth IRA. If you’re 25, the Traditional IRA basically can’t beat Roth IRA. Your age makes a difference because the younger you are, the more time your Roth account has to compound. They didn’t publish any numbers, so I thought I’d sit down and try to figure it out.

First, we’d have to make some assumptions. These are from another Roth 401(k) article from Fidelity that gave more details.

  • Marginal tax rate stays the same at 28% throughout the working years and retirement.
  • ROI is 7% in the tax advantaged retirement accounts.
  • We’ll invest all the tax refund from the Traditional 401k in a taxable account.
  • ROI is 6% in the taxable account. This is due to tax.
  • Invest $5,000 in 2014 and let it compound for 30 years.

Here is my spreadsheet.

Year Roth Traditional tax refund
2014 $5,000 $5,000
2015 $5,350 $5,350 $1,400*
2016 $5,725 $5,725 $1,484
2017 $6,125 $6,125 $1,573
2018 $6,554 $6,554 $1,667
2019 $7,013 $7,013 $1,767
2020 $7,504 $7,504 $1,874
2021 $8,029 $8,029 $1,986
2022 $8,591 $8,591 $2,105
2023 $9,192 $9,192 $2,231
2024 $9,836 $9,836 $2,365
2025 $10,524 $10,524 $2,507
2026 $11,261 $11,261 $2,658
2027 $12,049 $12,049 $2,817
2028 $12,893 $12,893 $2,986
2029 $13,795 $13,795 $3,165
2030 $14,761 $14,761 $3,355
2031 $15,794 $15,794 $3,556
2032 $16,900 $16,900 $3,770
2033 $18,083 $18,083 $3,996
2034 $19,348 $19,348 $4,236
2035 $20,703 $20,703 $4,490
2036 $22,152 $22,152 $4,759
2037 $23,703 $23,703 $5,045
2038 $25,362 $25,362 $5,348
2039 $27,137 $27,137 $5,669
2040 $29,037 $29,037 $6,009
2041 $31,069 $31,069 $6,369
2042 $33,244 $33,244 $6,751
2043 $35,571 $35,571 $7,156
2044 $38,061 $38,061 $7,586
after tax
$38,061 $27,404.12 $7,586

*We won’t get the tax refund until 2015 so the taxable account loses one year of compounding.

If we go with Roth, then we’ll have $38,061 in 2044. If we go with Traditional IRA, then we’d have $27,404 after cashing out the account (28% tax) plus $7,586 in the taxable account. That’s a total of $34,990 for the Traditional route. The Roth option will give us an additional $3,071, about 9% more.

Now that I’ve done the spreadsheet, I see how the Roth accounts beat the Traditional accounts. The last column, the tax refund account, is the key. We lose one year of compounding right off the bat. That makes a difference in the long term. The ROI of the taxable account is also a little lower than the retirement account. This is understandable because investors can’t stop trading. Selling will lower your overall ROI because you’ll pay capital gain tax when you make a profit. These two things give the Roth account an edge over the Traditional account.

Additionally, most people do NOT invest their tax refund. They usually spend it. The Roth account is meant for retirement and it’s more difficult to take the money out so it’s a little safer. If you’re not diligent about investing your tax refund, then the Roth option is the clear winner.

Max contribution

Of course, $5,000 isn’t going to make a big difference in your retirement account so let’s see what happens with $17,500/year contribution. I’m assuming this is Roth 401(k) now so we have a higher contribution limit. With that much additional investment every year, we’ll end up with $1,786,278 in the Roth account. By going with Roth, we’d have $112,773 more. Now that’s a significant sum.

Roth is best

Personally, I really like the Roth accounts and we max out our Roth IRA every year. We went back and forth on the 401(k), though. I was a bit undecided, but now I can see that the Roth is probably the way to go for 401(k). Here are the highlights of the Roth accounts.

  • Tax diversity – You should have assets in tax-free, pretax, and low tax (capital gain and dividend) accounts. This way you’ll be able to optimize your tax strategy in retirement.
  • Required Minimal Distribution – You need to take RMD from the Traditional IRA and 401(k) when you reach 70 ½. The rule also applies to Roth 401(k), but you can roll it over to a Roth IRA and avoid the RMD.
  • Estate planning– If your spouse is the beneficiary of your Roth IRA, then she can treat the Roth IRA as her own. If the beneficiary isn’t a spouse, then they’d have to take distribution in 5 years or over their life expectancy. The income from the Roth will be tax free if the Roth IRA was established 5 years before the distribution. The Roth IRA is still counted when calculating the estate tax, though. The inheritance tax is quite complicated and you’ll probably have to talk to a professional.
  • Employer matching goes into the Traditional 401(k) – As mentioned above, it’s nice to have your investments in different tax buckets. Since your employer is putting the matching in the pretax bucket, you should put some in the tax-free bucket.
  • Early withdrawal – You can roll over the Roth 401(k) into a Roth IRA and then you’ll be able to withdraw the contribution without penalty after 5 years. It’s not a good idea to withdraw early because you’re depleting your retirement fund too early, but it’s there if you need it for an emergency.

The Roth option is a great tax advantaged retirement account. However, only 11% of all eligible workers are taking advantage of the Roth 401(k). That’s probably due to automation. Most workers set up their retirement with Traditional 401(k) and never change it. Younger workers will benefit the most from the Roth accounts so if you’re young, read up on the Roth 401(k) and see if it’s right for you. Older workers won’t benefit as much, but the Roth is still a better way to go for most people according to T. Rowe Price.

Are you taking advantage of the Roth 401(k) and Roth IRA? What’s your opinion on Roth VS Traditional?

Here is how to start contributing to a Roth IRA. Check it out if you don’t already have one.

Photo credit: PT Money


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