Roth vs. traditional IRAs and 401(k)s

Okay, so does everyone know the basic difference between Roth IRAs (Individual Retirement Accounts) and traditional IRAs and 401(k)s? With a traditional IRA and 401(k)s, your contributions are tax-deductible … but you pay income tax on withdrawals from the account when you take the money out (after age of 59 1/2). With Roths, you pay income tax on the money when you put it in but withdrawals (past age 59 1/2) are tax-free.

So when I started saving for retirement awhile ago I was under the impression from various financial literature that Roths made more sense than traditional IRAs, because the money “grew faster.”

However if you think about this it doesn’t really make much sense — at least as far as I can figure it.

Suppose John is in a marginal tax bracket of 33% and puts $300/mo. into a 401k. Because he’s not paying taxes on that money, his actual take-home pay is only reduced by $200. At the end of the year he’s saved $3600. Assuming a 9% average rate of return in 30 years his $3,600 will be worth $47,763.64.

But John still have to pay income taxes on that $47,763.64 … if we assume your marginal tax rate is still 33% it will be worth $31,824.43 after taxes.

Now take Jane who is John’s financial twin. But instead of investing in a tax-deferred account she invests $200 a month in a Roth IRA. Even though she’s investing a smaller sum, her take-home pay remains the same because she’s not saving any money in taxes. In a year she’s saved $2,400. If we assume the same 9% rate of return in 30 years her nest egg will be worth … $31,842.43, just the same as John’s.

Basically if you assume the same tax bracket, it doesn’t matter when the 25% or 33% or what have you is deducted from your savings: now or 30 years from now. It still comes out the same. (Duh?)

Of course, this assumes tax rates won’t change in the next 30 years. I’m sure they will, but have no idea whether they’ll go up or down (Yeah, there’s a big budget deficit, but the political landscape has been slowly drifting rightward for the last few decades). In general I’d guess that most people would be in a lower tax bracket in retirement, so you’d think a 401(k) or traditional IRA makes more sense on that count.

However, there are still some advantages to Roths:

  1. You can take out contributions (not earnings) at any time, without penalty, making it useful for emergency savings. With traditional IRAs there is a 10% penalty, although some 401(k)s let you take out loans from your account.
  2. Both Roths and traditional IRAs have the same maximum contribution of $4,000 in 2007 … as we have seen $4,000 in a Roth is “bigger” than $4,000 in a traditional IRA. However with the contribution limits scheduled to grow to $5,000 in 2008, running up into that limit is going to be an issue for fewer and fewer people.
  3. You don’t have to take “mandatory withdrawals” at age 70 1/2 with a Roth as you do in a traditional IRA. I don’t see why that is an issue but for some people it might be.

Anyway. This is sort of an esoteric subject but savings for retirement is a pretty important topic and the decisions we people in our 30s now will be with us for decades to come! So is there a flaw in my logic, here? Most of my assets are my Daily News 401(k), which I intend to rollover into somewhere new. I was thinking of converting it to a Roth, but if there are no advantages to conversion…

6 comments to Roth vs. traditional IRAs and 401(k)s

  • Tallman

    Yeah, I’ve never really understood the benefit of the Roth because I assume one will be in a lower tax bracket at retirement. Frankly, if you aren’t, you probably are saving too much. Despite financial advisor statements to the contrary, I suspect an income that is half of what you made in your most productive years is probably a good retirement income. Sure more is better. But frankly how much can you spend when you are 80 years old?

  • Well you’re not going to be able to maintain your same standard of living on half… but yeah your contributions to a Roth are always going to come at your marginal rate. In 2006 the tax brackets were $30,650, $74,200, $154,800 and $336,550 — so if you’re just over, especially, a traditional IRA or 401(k) would seem to make more sense.

    (Like in other words if you make $78,000, by putting $4,000 in a traditional IRA you could escape having any of your income taxed at the 28% rate).

  • Tallman

    Yeah, your standard of living might go down a bit on half salary. But keep in mind that you won’t be supporting your kids, you may own your own home or be moving into a smaller place (think less stairs and no need for rooms for the kids), and you won’t be saving for retirement. That could easily reduce your expenses in half right there. Throw in the kids treating you to dinner every now and few cost savings because you don’t have to go comute to work anymore and I think getting by on half your salary wouldn’t be that different a lifestyle change. Medical expenses will probably increase, of course, but they might not.

  • dave

    I believe the theory is that your income and therefore tax bracket is going to be much higher when you’re 65 than when you’re 30, including the tax on the interest.

  • Wellll I am not currently supporting any kids, would shudder to think I will be living in a smaller place (it can’t get much smaller) and am not currently contributing to a mortgage. But yes I won’t have to save for retirement!

    Dave – mmmm maybe. But I am a journalist; I don’t necessarily assume that I’ll be some top editor making a big salary at age 65.

  • RMRose

    today on GMA (http://abcnews.go.com/GMA/TurningPoints/story?id=2925621&page=1)
    Mellody Hobson was saying she recommended that you have nearly the same amount of yearly retirement funds saved up as matches your current yearly income, not the more traditional 60%.

    On the web site she says:
    “Generally, the savings target for retirees should be between 80 to 90 percent of your preretirement income. Statistics show that a healthy retirement savings nest is one which your annual withdrawal is 6 percent or less.”

    I’m in trouble.

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