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 invested |
| 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 |
| total 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.
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It’s really an “it depends” issue
The problem is that it works best if you are in a low tax bracket at the time of contribution. If that is the case, chances are you may have cash flow issues which prevent you from contributing. That is one of the factors that lead to low Roth IRA contributions.
If you are making more money and, hence, you have disposable income, you are also likely to be in a higher tax bracket. In that case, you may feel that you need the tax break from a Traditional IRA. In addition, you will be likely to be in a lower tax bracket at retirement. In that case, the Roth IRA just won’t cut it.
It’s worth remembering that the Roth IRA is not tax free, it is just taxed differently.
Quick question: Aren’t there limits on a Roth IRA if you company offers a 401K plan? I’ve done some searches and see two tables but it’s still unclear. Income limits maybe??
I’m going the 401K route myself. My employer contributes $7K a year to my $17.5K. During my career that employer match is now worth $100K+. I didn’t see company match as an advantage to 401K plan?
For me once I do the 401K max I don’t really have much left to do an IRA (if I’m eligable).
I’m pretty sure there are no limits on the Roth IRA if you participate in company’s 401k plan. There is an income limit. If you make too much money, you can’t contribute to the Roth IRA.
Great job with your 401k!
There is a $17,500 limit for people under 50 up to your earned income
Wow! So – I just saw an article, I think in Money magazine, that was talking about this same study… which got me thinking. I had never done out the calculations myself before, but lets just say, a few days after reading that article and running some numbers, I had switched my traditional 401k contributions to Roth!
Great read, thanks. What are your thoughts about converting 401k investments into Roth during a very small income year? I’m considering it for this tax year vs. putting new money into Roth. Thanks!
I had a Roth while I was younger, and still unmarried. Once I was married, our combined incomes were too high to contribute to a Roth any longer. At the time, I had no Roth 401(k) option, so I just went with the traditional IRA. Now, not sheltering our income in the traditional 401(k) would cost us almost 12k in taxes per year (or two of us).
We’re expecting to have a much lower tax rate in retirement – just because we can live on half of our income, so we’re sticking with the traditional IRAs.
The Roth is still there growing, just not getting anything added to it.
One other thing to think about – many people can’t contribute the max to a roth ira, because of income limits. In that case, assuming you have a company 401K available, it makes sense to max that out.
RB40,
Great points and you did the math/calculations out to show why the Roth vs traditional is better. Luckily, back when I was 20 I began my investment into a Roth IRA. With my employer I am a Roth 401k kinda guy. I actually did an analysis where you can max out your Roth IRA for a certain amount of years and you can essentially stop at some point, to which you’ll still have a HEFTY nest egg at 59.5 years of age. Reason being – you can take those funds elsewhere – into an individual taxed account, or further rental properties or XYZ. It’s pretty interesting, but it all comes down to compounding growth and dividends, I love it. Great post and great way to show the differences for those that are considering to invest into a retirement account, trying to understand more or are debating/on the fence of switching one to the other. Hope you’re having a great week, talk soon!
-Lanny
I did this calculation years ago but with differing assumptions. My assumption was that I was unable to max the Roth out. Suppose say you have only $3K you can save. You could put it in a Roth at $3K or a Traditional ($3k + money saved from taxes). Also you continue adding in this manner over the years.
And here’s one other key. Don’t withdraw the money immediately all at once in retirement. Do it over time. I withdrew at a consistent rate over a period of years, adjusted for inflation, withdrawing the same amount from the Traditional and the Roth (of course the Traditional had taxes withdrawn in retirement, the Roth didn’t, so as to produce the same withdrawal amount).
The conclusion reached from that analysis changed things. I tweaked the tax rates while working and in retirement to evaluate at what point the Roth starts to make sense. What I found is that if the working tax rate is 20% you have to get all the way up to 48% before a Roth starts to make sense. Below that the funds from the Traditional last longer.
test
x(0.72) = $5,000
x = $6,994 of pretax dollars to make a $5,000 Roth contribution
So Traditional starting balance is $6,994, Roth starting balance is $5,000 to make this a fair comparison
Assume both have the same market returns
If taxes are lower at distribution Traditional wins
If taxes are higher at distribution Roth wins
I like the 50/50 approach so you are tax diversified and have options when you take a distributions.
This simple example was shown in Fidelity’s literature when they introduced our Roth 401k at work.
This is a tough one. I’m currently doing a Roth 401K because I think I’m young enough that it makes sense over the traditional 401K, and my employer match still applies.
I’ve heard great arguments both ways.
Great job with your Roth 401k. If you’re young, there is no doubt about it. Once you’re in the higher tax bracket, then you can always change it to Traditional.
Hi Mr. RB40. While I love many of your articles I have to disagree with you on this one. Almost every way you look at it a traditional retirement account is ALWAYS better than a ROTH. The reasoning comes from the fact that you always end up with more money in your pocket when using a traditional. For someone earing 60,000 they end up at the end of the year with$ 3,900 more if they invest in a tradional account vs. roth. This extra money really adds up over the years and, if invested every year, would equal roughly $540,000 after 30 years.
They way I look at it is this: If, in retirement, I were to withdraw to the current 15% max (36900) I would have to pay 5081.25 in taxes on it. My $540,000 fund could easily supply that amount and more in dividends ($16000) which means that I get a net $47,818 a year in retirement which is certainly liveable. Plus I alwyas have that extra half million set aside for emergencies which will also continue to grow in total amount with the market.
You lose that boost when investing in Roth acounts.
Thanks for your comment.
Actually, we accounted for the tax refund in the third column above. The problem with the taxable account is that it has lower ROI due to tax. If you’re a great investor, then go for it.
In retirement, you’ll have other income including social security, pension, and other investment income. I’m pretty sure we’ll already be over 15% without any withdrawal.
I’m just saying it’s good to have some Roth and some Traditional.
Roth is better. I will NEVER pay tax on the decades of earnings (dividends, shares of stock sold for gain, etc.) that has taken place inside my Roth. Folks who believe they will be in a lower tax bracket when they retire may be in for a surprise, between what they find out is included in income for tax purposes; and how many FEWER tax deductions are generally available to them. I disagree with your comment on Roth IRA of $5000 not making a big difference to retirement accounts. First of all, many people save nothing or almost nothing, so $5000 is plenty (as a target for folks to shoot for to save). We opened our IRAs when the limit was $2000/year (and converted to Roth IRAs during the Net stock froth of 2000). The issue is TIME IN THE MARKET. The Roth IRAs are our largest (of several) retirement accounts, primarily because of all of the years and years of bull markets to which they’ve been exposed. Thanks for your work; I enjoy reading it.
Thanks for your comment. I don’t know about the lower tax bracket either. We’ll have income from various sources and probably won’t go down much.
Wow, great job with your Roth IRA. My 401k is the biggest of our retirement account because of time in the market and the larger contribution.
Thanks for breaking it down for us. Roth is a much better deal if you’re not getting a company match on your 401k through your employer. I do the max to get the match on my 401k and then max out my Roth. If I have extra money then I go back to either the 401k or a taxable account.
Roth IRA is the way to go.
My only nitpick: the “total after tax” applies a 28% effective rate when 28% is the marginal rate in their working years. Shouldn’t the effective tax rate play in at some point?
For this article, we’re just assuming the same tax rate in retirement. That’s probably not the case, but I don’t think it will be much lower. I should estimate our retirement tax bracket for a future article. thanks.
RB40: You didn’t actually address Amy’s comment. Yes, you are assuming the same *marginal* rate of 28%. That means that the last dollar earned is taxed at 28% during your contribution years. During retirement, the last dollar withdrawn is taxed at 28%. But the TOTAL sum is not taxed at 28%.
Let’s assume your retirement income is solely from this account. The first few thousand dollars you withdraw aren’t taxed at all. The next 10’s of thousand dollars are taxed at 10%, the next few 10’s at 15%, and finally the last dollars withdrawn are taxed at 28%. This means that effectively you paid much less than 28% when you withdrew it.
Most of my retirement money is in tax deferred accounts because I fully expected to be in a lower tax bracket once fully retired. That said I do have what is now 13% of total retirement holdings in Roth accounts that my plan has invested for the longer term. Who knows what future tax changes may come. I do like the idea of being able to get to my Roth contribution if I absolutely had to without Government intrusion and penalty. I have recommended to my daughters to first contribute to get the max from their 401K company match and then 2nd contribute to their Roth. If they can swing saving more after fully funding their Roth then 3rd increase their 401K contributions beyond just the match percentage. I think the reason of low participation in Roth IRAs is its not as automatic as investing in a 401k through work and most 401Ks don’t offer Roth 401Ks, or at least nowhere that I have ever worked. Good article. These comparisons help to see the benefits.
13% is not bad at all. I think we’re around 10% as well. I’d like to get it up to around 25%, but it’s probably too late now.
Thanks for the very helpful table!
What about having both traditional and Roth accounts to fully maximize the tax benefits? For example, when you retire, you’ll pull out $35,000 out of your traditional accounts to keep the marginal tax rate at 15% and then whatever else you need live, you’ll pull from your Roth accounts, which is tax free.
I think it’s best to have money in both Roth and Traditional accounts. You’ll have a lot more options when you’re retired. Maybe 50/50? Our Roth is much smaller than our Traditional account because we’ve been saving much longer in the Traditional account.
Unless I run into some big windfall, I fully expect our marginal tax bracket to be lower during retirement. That being said we first fill up our $17,500 each in our 401k and then put $11k into our Roth.
The limit on Roth makes it ok, but if you only save Roth dollars (assuming you don’t put money into a Roth 401k), you just aren’t saving enough.
We do not plan any Roth 401k contributions. Any additional savings after Traditional 401k and Roth IRA will go to taxable investments to fund our “early retirement”.
Thanks for the post.
You’re right. For early retirement, you’d need money in your taxable account. Good call.
We’ve been kicking this issue around back and forth, trying to figure out which is the best option for us. We currently contribute to both a Roth and a Traditional IRA. we feel like we should be doing one over the other. Just trying to do the math to figure out which one.
I think contributing to both is the way to go. You’ll have more choices in retirement.
If you expect to be in the same tax bracket when you retire as when you are working and accumulating capital, then I think the Roth makes a lot of sense.
When I was younger and making a much lower salary I used both a Roth IRA and Roth 401k for that very reason.
But for us, we’re going to be in a dramatically lower tax bracket in retirement. Currently between state and federal income taxes we pay about 40%. Shielding that income from taxes now to withdraw it later in a much lower tax environment is very valuable.
Being able to shield $35,000 year from 40% taxes is pretty spectacular, and definitely allows us to invest more now. That’s the key I think. We’re able to invest more because we’re paying less in taxes.
You’re right 40% is significant. It’d be really nice if you can move to a state with lower income tax in retirement. Hopefully, the tax rate won’t increase too much in the next 20-30 years.
Hi. Máx contribution in Iras is 5500…no 5000
You’re right. Did I say $5,000 is the max somewhere? I couldn’t find it.
I personally prefer the ROTHs to the tax deferred accounts but I do think it depends on your tax bracket. If you are in a high tax bracket now then it would make no sense to pay the tax on the money now when you can pay a much lower tax when withdrawing a conservative 4% during retirement. Also, deferring taxes has always been one of the tools the wealthy use to build their wealth and continue to expand it. Recently I did a rollover from a traditional IRA to my ROTH IRA with Vanguard (who I use as my brokerage) and the retirement specialist told me that Congress is looking to do away with the rollover. They don’t want high income earners to get the benefit of a ROTH. I really hope this doesn’t happy because like you illustrated Joe, it is more beneficial financially in the long run to invest in the ROTH.
I hope we keep the Roth rollover around. I want to do it in years where we don’t have much income. Even 4% could be significant in retirement especially if you’re diligent about saving. You’ll also have social security benefit, investment income from stocks, and possibly other sources. That could push you up the tax bracket. It’s hard to calculate when you’re 20 years out.
I dislike this analysis. You have essentially shown that tax free space is better than taxable. A Roth simply allows you to add more money into the account because it is already taxed. Whether or not a Roth is a good idea depends on your marginal tax rate. Due to a progressive tax structure, traditional accounts are often a better deal for those with significant tax advantaged space. If I contribute money in a 28% bracket, I’ve lost 28% due to taxes in a Roth. If that money is taxed at 10% in retirement from a traditional ira, I see a significant win with the traditional account. Most people would be better off using a Roth early in their career when their marginal rate is low compared to later in their career when their rate would be high. Of course if you do not have much tax advantaged space, Roths could win simply because tax advantaged is better than not. Most people do not take full advantaged of their tax advantaged space though.
I’m just trying to show what Fidelity and T Rowe Price did in their study. Of course, if your marginal tax rate will be much lower in retirement, then it’s probably better to go with Traditional. I’m pretty sure it won’t be 10% for us.
You’re right about the tax advantaged space. I think most readers of this blog contribute the max, though.
Actually traditional 401 (k) works best for me. If I received a 30% tax deduction on the $17,500 I put to use in a regular 401 (k), I now have $5,250 more to invest. I can then put those money to work in a Roth IRA.
Then, when I retire early, I will be in a very low tax rate. So I will be able to convert the money from my traditional 401K plan into a Roth IRA slowly over time, while being mindful of tax brackets.
So to summarize, I will get to put more towards my retirement, defer a lot of taxes, and then end up with money that is essentially tax-free. I would always go for the traditional 401K first.
What people forget is that if you have more money, you have more options. Do not forget that.
I agree along a similar vein and unless you begin in the 15%, I doubt many people will live above their means when they retire. The one thing that bothers me however about this comparison, along with many others, is that it assume an inital (and continued) contribution of the same amount, which actually is a misrepresentation. What is always left out is that if an individual has a limited amount to invest, say 5,000, if they choose the Roth IRA route, their starting principle and thus the impact of compounding interest will be lessened as they will be likely contributing in the range of 3500-4250 vs a traditional starting at 5,000 (the starting points for the comparison above should not be 5000 vs 5000, it would be more like (6250-5750 less 25% -15%) vs 5000), and yes that is a huge difference after years of compounding. The future is unknown and a Roth may very well pan out as the best option, especially considering everyone’s situation is different, but for me max 401k then remaining to Roth seems the best.