Roth vs Traditional Retirement Accounts
Friday, October 3, 2008
The main difference between traditional and Roth accounts is when the money you contribute is taxed. For the traditional, your money is put in pre-tax and then taxed when withdrawn at retirement age. The Roth account is the exact opposite. Your contributions are taxed and then withdrawn tax free. With tax rates remaining constant, the two accounts are esentially the same as seen below.
Contribution: $10,000
Current Tax Bracket: 15%
Retirement Tax Bracket: 15%
Avg Yearly Return: 10%
Years to Retirement: 40
| Traditional | Roth | |
|---|---|---|
| Contribution After Tax | $10,000 | $8,500 |
| Balance At Retirment | $452,592.56 | $384,703.67 |
| Amount Withdrawn after Tax | $384,703.67 | $384,703.67 |
In this example when the current tax bracket is that same as retirement, the accounts have the same benefit.
Now, if we change the tax rate to a higher rate at retirement, we get the following.
Contribution: $10,000
Current Tax Bracket: 15%
Retirement Tax Bracket: 25%
Avg Yearly Return: 10%
Years to Retirement: 40
| Traditional | Roth | |
|---|---|---|
| Contribution After Tax | $10,000 | $8,500 |
| Balance At Retirment | $452,592.56 | $384,703.67 |
| Amount Withdrawn after Tax | $339,444.42 | $384,703.67 |
In this example, the Roth is more beneficial. And, as you would expect, if your current tax bracket is higher than that at retirement, the Traditional would come out ahead.
Contribution: $10,000
Current Tax Bracket: 25%
Retirement Tax Bracket: 15%
Avg Yearly Return: 10%
Years to Retirement: 40
| Traditional | Roth | |
|---|---|---|
| Contribution After Tax | $10,000 | $7,500.00 |
| Balance At Retirment | $452,592.56 | $339,444.42 |
| Amount Withdrawn after Tax | $384,703.67 | $339,444.42 |
So essentially, a lot of the decision making comes down to what your current tax rate is and what type of lifestyle you plan to live at retirement. If your current tax bracket is high, you may want to put a little away pre-tax into a Traditional account to reduce your tax exposure. On the other hand, if you are in a lower tax bracket currently and you plan to live a luxurious lifestyle at retirement(you will need to make large withdraws), you may want favor the Roth account since you will be able to make the large withdraws tax free. The whole point is to reduce your tax exposure. The best way this can be done is by forming a balance between the two that fits your current income level and desired retirment lifestyle.
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