Dollars and Jens
Wednesday, July 11, 2018
Roth vs. traditional retirement plans
I have a lot of work I should be doing, but someone is wrong on the internet:
The chart makes a lot of assumptions, including that each investor contributes $1,000 to either the Roth or traditional IRA, that they are in the 25 percent tax bracket and that there is a seven percent annualized return. And in almost every case, the Roth does better than the traditional, even for older workers.Okay, this is correct: if you give up $1,000 per year now to put into a retirement account that won't be taxed in the future, you will have more retirement savings than if you give up $750 per year now to put $1,000 into a retirement account that will be taxed in the future, at least if you assume the growth rate of the money exceeds the rate at which you discount your marginal consumption spending. (And boy do they seem to assume that, but that's a harder quibble than the apples-to-oranges comparison they're making here.)
They would be on somewhat firmer ground if, instead of supposing each investor contributed $1,000, they supposed that each investor contributed $5,500: because the dollar amounts of the contribution caps are the same, the effective cap on the Roth is higher than the traditional IRA: you can forego up to $5,500 to a Roth, versus (using the 25% rate) $4,125 for a traditional IRA. Similarly, if you're going to max out a 401(k), even if you think your tax rate in retirement will be somewhat lower than it is now, it may be worth paying the extra taxes now to avoid not just taxes in retirement but compounding taxes along the way. Furthermore, if you are likely to save more money using one kind of account than the other (perhaps because of the salience of taxes), there may be behavioral reasons to use the one that will incline you toward better behavior. If you aren't hitting the caps, though, and you think your tax rate in retirement will be lower than today's, and you compare apples to apples, the Roth is your better bet.