Wednesday, February 08, 2006

Go with ROTH

With your retirement accounts, if you can max them out or come close, you should go with a ROTH account.

The reason for this is simple: $15,000 after tax dollars is more than $15,000 pre-tax dollars (ditto for $4000 after tax dollars vs. $4000 pre-tax dollars).

Assuming the money is going to double & 10% taxes (for simplicity):
Post Taxed: ($15,000 * 2) * .9 = $27,000
Pre Taxed: ($15,000 *.9) * 2 = $27,000

In terms of after tax value put in:
Traditional: $15,000 * .9 = $13,500 after tax contribution
ROTH: ($16,666 * .9) = $15,000 after tax contribution

The more you make, the greater the difference is. Someone maxing out contributions in the 10% bracket only takes a 10% hit by going with a traditional program over a ROTH. Someone in the 38.6% bracket looses more than 1/3 of the potential value by contributing to a traditional IRA vs a Roth.

In the case of an IRA, you can only contribute to a ROTH account up to a certain level of income. In the case of a 401(k), you can only contribute to a ROTH account if your company offers it, but there is no income limit.

High income earners, welcome back to ROTH territory.

Info about:
401(k)s - IRS, Investopedia
ROTH 401(k) - IRS, Roth401k.com, Smartmoney
IRAs - IRS, Investopedia
ROTH IRAs - IRS, Rothira.com, Investopedia

10 comments:

justanotherblogger said...

While I agree that one should go with a Roth IRA. I don't follow your calculations and line of reasoning.

In your calculation where you calculated the 13.5k vs 15k after tax contributions, you claimed that the difference is a 10% hit (equivalent to the imaginary tax rate you used). However, that comparison makes no sense.

Of course there would be a difference between the two after tax contributions, given that you are also contributing an extra $1666 of before tax income towards your Roth IRA. There is no "10% hit", the 10% difference (which you claim to be $1500) is merely the difference in the amount ($1666 x .9) you contributed!

You then go on to say "The more you make, the greater the difference is... Someone in the 38.6% bracket looses more than 1/3 of the potential value by contributing to a traditional IRA vs a Roth."

Again no one is losing any potential value by going with a traditional IRA. If you contribute the same amount of PRE tax money, have the same % return over the same amount of time, and have the same tax rate at withdrawal and contributions, your end result is going to be the same.

tt said...

JAB,

Thanks for a provocative comment, but, I think you need to re-run your numbers.

The whole point of the post is you can put more dollars into a roth than you can into a traditional account regardless of if you measure them pre or post tax.

The difference comes because IRAs/401(k)s have tax-advantaged compounding so an investment yielding 7% in a retirement account will yield some number: 7% - capital gains taxes. The size of the bite depends on a number of factors depending on what you invest in and for how long, but it will always be greater than 0.

The whole advantage comes from having more money compounding tax free.

1) the 10% tax rate is for reasons of illustration. It is further, not imaginary - it is the US federal rate from $0 to $6,000 in earnings. Granted that it is a simplification, but to say that it is imaginary takes it a bit far.

2) the comparison is an apples to apples comparison. $15,000 in after tax dollars is more than $13,500 after tax dollars.

Again assuming the money will double in an unspecified period of time:

Traditional:
$15,000 * 2 = $30,000 *.9 = 27,000

Roth:
$16,666 * .9 = $15,000 * 2 = $30,000

You end up with more in a roth because you put more in to begin with.

3) The "hit" you take is in not contributing as much value as possible to a tax-advantaged account. More value in non-taxed accounts -> More money growing unconstrained by capital gains taxes.

The key word here is "potential"

4) The difference in value put into the account per year is:

at 10% tax: $1666
at 30% tax: $6429

The difference in post-tax value put into the account each year is:

at 10% tax: $1500
at 30% tax: $4500


5) Your final point, that no one is losing money given equal amounts of pre-tax dollars, is true but misleading. When you're contributing the maximums, you can contribute more pre-tax dollars to the ROTH. (I started with "if you can max them out or come close").

Again, the whole point is that you can contribute MORE value to a ROTH than to a traditional regardless of if you measure pre or post tax.

6) If you are not sure if you will be maxing them out, but there is a possibility; then it is rational (given that the end outcome is the same at less than maximum contributions) to go with ROTH in case you do get close to max contributions.

If you know you won't max them out, then they are equal.

This gives the decision matrix:
Maximum Contributions: Roth better
Close to Maximums: Roth better, or both equal
Significantly below Max: Both Equal.
(if you would like the formulas to figure these out, say so and I'll do the more in-depth math in another post)

Since you'll never be worse off and could be better off if you use the ROTH options, it makes sense to contribute to ROTH.

Of course, this analysis assumes that you're elligible for both roth and traditional and elligible for the tax breaks.

Ryan said...

Since my math sucks, let me ask you a simpler question. If you could contribute to a Roth vs a 401k (the company will not match for the first year) and you could only contribute, lets say, $200 monthly to either, but not both. Which would be most beneficial during the first year where the company doesn't match? Thanks.

Wes said...

Wha wha what? What does capital gains tax have to do with any of this? Distributions from a standard IRA type account count as ORDINARY INCOME.

The only deciding point when it comes to ROTH or IRA/401k, in terms of overall wealth, is: do you expect your marginal tax rate in retirement to be lower or higher than it is now?

If it's going to be higher, then go ROTH, because you'll pay taxes now at a lower rate. If it's lower, then go IRA.

Of course, if you can, max out both.

Also, I find it hard to believe that someone with a 38.6% marginal rate can even contribute to a ROTH!

tt said...

Wes,

1) I was unclear in my 1st comment. The 3rd paragraph compares IRAs & 401ks (all kinds ROTH and Traditional) to NON TAX ADVANTAGED ACCOUNTS. So something yielding 7% in an IRA/401(k) will yield some number: 7% - capital gains IN A NON RETIREMENT BROKERAGE ACCOUNT.

That was unclear, and I wish I could just edit it but the blogger comment engine won't allow that. Thanks for pointing that out.

2) There is no income limit on ROTH 401(k)s. So the ROTH is now available to some in the 38.6% bracket.

3) Expected Taxes do play a role, but the whole point of this post is that you can put more value into a ROTH than into a traditional IRA.

Wes said...

My company just got a Roth 401k so I've been thinking about it long and hard.

I think I see your reasoning. I've been looking at it from the standpoint of AmountToInvest = Wage - Taxes. Which, for a working person, "maxing out" his plans, is incorrect. This individual will simply max out the plan. So, in a ROTH type account, even after you subtract the initial tax paid, you make out quite well.


However, imagine two people with 401k's, both put away a max of 15k, one in a ROTH-401k, one in an IRA-401k. The person with the IRA-401k can theoretically put his "extra" money from tax savings away into a long term account, not to be touched until retirement. At retirement pay LT cap gains on that "extra" account.

Wouldn't the person with the IRA-401k + extra account come out ahead over the Roth-401k person?


Thanks for your thoughts...

DCSmooth said...

Great blog, and good point that you're actually contributing more to a Roth than a Traditional IRA when maxing out because it's after-tax dollars.

Also good point by Wes that part of the Traditional/Roth decision should be whether you expect your marginal tax bracket to be higher or lower when you retire.

Now here's something else important that I've been reading a lot about that hasn't been mentioned above where Roth has a clear advantage: Asset Location for stock funds.

Consider the following:

Taxable Account:
LT cap gains grow tax-deferred anyway and when realized are ultimately taxed at a lower rate than your income rate; meanwhile, (depending on the fund) most distributions each year are also taxed at an advantageous rate

Roth IRA/401:
Don't have to worry about tax on distributions or realized capital gains at retirement, you're free and clear

Traditional IRA/401:
Uh oh. Even if I go from the 28% bracket now to 25% bracket at retirement, according to current rules I'll be paying a higher tax on the gains (25%) than if I had just left stock funds in a taxable account (15%). But at least I never pay tax on distributions or when switching funds.

Also, consider that we don't know what the tax situation will look like years from now, so one can cut losses by having both some pre-tax and some post-tax retirement investments.

Thus I say (and I've read it plenty of other places, this is not original) the optimum probably would be:

Traditional IRA/401: best choice for bond funds or (if necessary) equity funds that have lots of distributions (like REIT)

Roth IRA/401: Best choice for your highest expected returning investments

Taxable account: Any equity funds with low expected distributions beyond what you can fit in your Roth

Anonymous said...

The problem with Roths (and IRAs in general) is that you cannot apply leverage to them easily.

Taking your money, borrowing a ton more to match it (at 6.75%), and investing in a diversified index ETF (ie: IVV, VTI, SPY, etc) will accelerate your building of wealth far more quickly than contributing to an IRA.

Further, you may be able to deduct your margin interest against the income from your investments. This will reduce your overall tax burden and allow you to accelerate your rate of contributions.

JoeTaxpayer said...

What I'm not seeing here is that there's a zero bracket (the sum of your standard deduction and exemption) and then a 10% and 15% bracket. You'd need a pretty large pre-tax retirement savings to get back up to 25% marginal rate. My rule of thumb is that anyone currently in the 25% bracket or higher should invest pre-tax, and monitor their portfolio. Someone just starting out, and in the 15% bracket or lower should start with Roth, and move to pre-tax accounts as their income grows. See my article http://www.joetaxpayer.com/toomuch.html for a more detailed explanation.
Joe

JoeTaxpayer said...

tt - in your example, you show a Roth at $16,666, but the traditional starting at only $15,000. Something wrong there.
If I am paid $16,666 gross, I have 2 choices, pay the 10% tax and put the remaining 15K in the Roth (as you show) or put all $16,666 in the Traditional IRA, watch it double to $33,332, and at the end, pay tax and net $30,000 which is the same as the Roth example. Hmmm.
I believe the larger advantage to be had is in the difference in tax rates one enjoys over the years. In the last year I work, I take $6000 and put it in a traditional IRA, saving $1500 (25% bracket). The year after, I pay only $600 in tax to get it out (in the 10% bracket post retirement).
I suggest that one should use Roth when in the 15% or lower bracket, and flip to pretax saving at the 25% bracket if they are on track to get into that bracket. This should help minimize taxes paid over one's lifetime.
Joe