Finance Myth #2 Traditional Plans are Better than Roths
Depending on your crystal ball for income tax rates, there really is a better choice when it comes to putting your retirement funds in a Roth or traditional IRA, 401(k) or 403(b) account. We’re going to prove this point by crunching the numbers, so you don’t have to go through that exercise yourself.
Before we get into the calculus, let’s first review the difference between a Roth and traditional plan. Like many stories about money, this one starts with income taxes. Whether you agree with policymakers, income taxes fuel the federal government in the United States and when it comes to income, the IRS wants their cut of the action.
Traditional versus Roth Plans
The major difference between a traditional plan and a Roth has to do with the treatment of income for tax purposes. Traditional retirement plans – an IRA, 401(k), or 403(b) – allow individuals to set money aside for retirement on a tax-deferred basis until withdrawn. This means funds are placed in the account on a before tax basis. When the funds are withdrawn, income taxes are due on both the original investment and all earnings.
Funds placed in a Roth account – IRA, 401(k) or 403(b) – are on an after-tax basis. All funds withdrawn from these accounts are tax-free. This includes both the original investment and the earnings on that investment. On the surface, this seems like a great deal. But are Roth’s better than traditional plans? Let’s start crunching some numbers and put a myth to rest.
Scenario 1: One Time Investment, Ten Years Later
In this first scenario, an investor has $20,000 in pre-tax funds they would like to put in either a Roth 401(k) or traditional 401(k). To simplify things (for now), we will assume their incremental tax rate is 24% now and ten years from now. In this case, we will also assume the investor earns 8.0% annually. Let’s start by looking at what happens to the traditional 401(k). We can solve for this ten-year investment using the following compounding equation:
Funds at Retirement = $20,000 x (1 + 0.08)^10
Solving the above, we find the account has a balance of $43,178, which would give us $43,178 – $43,178 x 0.24, or $32,816 after taxes.
Since this investor had $20,000 in pre-tax funds to invest, we need to calculate how much they can put in their Roth 401(k) on an after-tax basis. Doing the math, we find out this investor has $20,000 – $20,000 x 0.24, or $15,200 to fund their Roth 401(k). Using the same compounding equation:
Funds at Retirement = $15,200 x (1 +0.08)^10
Solving the above, we find the account has a balance of $32,816 in tax-free funds. The same amount as the after-tax traditional account. This is no coincidence; we will produce the same result if we vary any of the above factors. Some investors might point out a flaw in this first scenario’s assumptions, let’s address that now.
Scenario 2: Lower Taxes in Retirement
In our first scenario we assume our income tax rate will be the same in retirement. Some investors see this as a flawed assumption, arguing that less earnings in retirement means lower taxes. Specifically, the incremental taxes paid when investing in a Roth are significantly higher than the rate paid on a retirement plan’s withdrawal.
In this scenario, we’re going to keep the tax rate on the Roth plan at 24% and use a 12% rate on the withdrawals from the traditional plan. All other assumptions will be the same as those in Scenario 1. This means our Roth plan will have the same balance at retirement we found previously ($32,816).
We also know from our first scenario the traditional plan has a before-tax balance of $43,178. Using our new tax rate, we’ll have the following on an after-tax basis: $43,178 – $43,178 x 0.12, or $37,997. This is 15.8% higher than the Roth balance, making the traditional a clear winner if you believe income taxes will be lower in retirement.
Are Lower Income Taxes a Reasonable Assumption?
I started my working career back in 1982, which means by 2022 I had been working for forty years. Coincidently, this is about the average career span for many of us. What kind of changes did I see to tax rates over my career?
- In 1982 there were thirteen tax brackets, ranging from 0% to 50%
- In 1987, there were only five tax brackets 11%, 15%, 28%, 35% and 38.5%
- In 1988, there were only two brackets 15% and 28%
- In 1991, there were three brackets 15%, 28%, and 31%
- In 1993, we were back to five brackets 15%, 28%, 31%, 36% and 39.6%
- By 2002, we had six bracket 10%, 15%, 27%, 30%, 35% and 38.6%
- Finally, in 2018 we had seven brackets 10%, 12%, 22%, 24%, 32%, 35% and 37%
That’s a total of seven changes to tax rates over my career. Anyone that says with a high degree of certainty they will be in a lower tax bracket when retired is full of it. The only thing I am certain of is the federal government will collect income taxes. Even if you still believe taxes will be lower in retirement, there is another scenario to consider.
Scenario 3: Maximizing Retirement Contributions
Some investors might be interested in maximizing their total contribution to their plan. In this scenario, we’re going to assume the investor has enough money to contribute $20,000 in after-tax money into their Roth account. This means the funds at retirement would be the same in both accounts (Funds at Retirement = $20,000 x (1 + 0.08)^10, or $43,178).
As determined in Scenario 2, the after-tax funds in the traditional plan would be $43,178 – $43,178 x 0.12, or $37,997. Comparing this value to the Roth, we find there is $43,178 – $37,997, or $5,181 more after-tax funds in the Roth which is 12.0% more than the traditional fund. If you max out your annual contributions, then a Roth is the winner.
Final Words on the Advantages of a Roth Account
For both types of retirement accounts, required minimum distributions (RMD) start at age 72. However, the money in a Roth 401(k) can be rolled into a Roth IRA which can be passed on to the investor’s heirs. This is a critical point, because the recipients of the Roth IRA are entitled to the same tax treatment as the original owner; the money in the account can be withdrawn tax-free. This feature makes Roth accounts attractive to investors that want to pass on some of their retirement funds to their heirs on a tax-free basis