Traditional vs. Roth: The Longer Version
This page applies to both 401Ks and IRAs.
The Question
Why is it better to do a Roth early in your career (when you pay less in taxes) and a Traditional later in your career (when you pay more in taxes)?
Here are a couple examples explaining why. Set aside ten minutes to work through each one.
Also, there are a lot of numbers in the following paragraphs. You'll have to read them slowly, and it can get overwhelming to keep track. It's easier to reference a spreadsheet with some structure as you go.
So here's the spreadsheet with the numbers. You'll have to make a copy of it if you want to change the numbers.
Example 1: The Todd's Traditional 401K
Meet Todd. Todd makes $10,000 a month before taxes or anything else. Todd normally pays 30% in taxes.
Pause here, make sure you have it right. If Todd doesn't save or anything, Todd would pay __ (how much per month?) in taxes.
$3000. Todd would pay $3000 in taxes. $10,000 * 30%. That's right.
Todd has a Traditional 401K. Todd saves $2,000 towards retirement with his Traditional 401K this month. How much does Todd pay in taxes this month?
Todd gets to take that full $2000 out of his $10,000. Leaving him with $8,000 to get taxed on. So Todd would pay $2400 in taxes. That's $8,000 * 30%.
Todd wants a high-five for saving money. And for letting you crunch his numbers. But hang on...
Todd needs to pay taxes when he eventually takes money out of his 401K. Flash to thirty years later. Todd's money grew by 10x. Todd's $2,000 turned into $20,000. Older Todd is also, separately, making bank as a top surgeon at the hopital, and his tax rate ballooned to 40%.
Older Todd now pulls out his $20,000. How much does Older Todd pay in taxes?
...
$8,000 ($20,000 * 40%). So Older Todd ends up with $12,000 left. ($20,000 - $8,000)
How much did Todd end up paying in taxes, overall? We need to think in terms of today's dollars. To simplify, we'll assume that his present value factor is 1/10, because his money grew by 10x.
Taxes Todd pays now: $2400
Taxes Older Todd pays, in today's dollars: $800 ($8000 / 10)
Total taxes Todd pays: $3200
So Todd pays $3200 in taxes.
How much money does Todd end up with himself?
Leftover money for young Todd: $5600 (10K - 2K savings - 2.4K in taxes)
Money from older Todd, in today's dollars: $1200 (12K / 10)
Total money for Todd: $6800
So Todd gets to keep $6800 of the original $10,000. Notice that taxes ($3200) and leftover ($6800) still add up to his original $10,000 today. It's a nice check on your math.
Example 2: Roger's Roth 401K
Meet Roger. Roger is Todd's twin. Roger makes $10,000 a month before taxes or anything else. Roger normally pays 30% in taxes. Just like Todd.
Roger has a Roth 401K. Roger saves $2,000 towards retirement with his Roth 401K this month. How much does Roger pay in taxes this month?
Roger gets taxed on his full $10,000. So Roger would pay $3000 in taxes. That's $10,000 * 30%.
Roger doesn't do high fives. Because Roger is too busy saving money.
Flash to thirty years later. Roger's money also grew by 10x. Roger's $2,000 turned into $20,000. Older Roger is also, separately, making bank as a top surgeon at the hopital, and his tax rate ballooned to 40%.
Older Roger now pulls out his $20,000. How much does Older Roger pay in taxes?
...
$0 ($0 * 40%). So Older Roger keeps the full $20,000.
How much did Roger end up paying in taxes, overall?
Taxes Roger pays now: $3000
Taxes Older Roger pays, in today's dollars: $0
Total taxes Todd pays: $3000
So Roger pays $3000 in taxes.
How much money does Roger end up with himself?
Leftover money for young Roger: $5000 (10K - 2K savings - 3K in taxes)
Money from older Roger, in today's dollars: $2000 (20K / 10)
Total money for Roger: $7000
So Roger gets to keep $7000 of the original $10,000. $200 more than Todd. This happened because tax rates went up, and Roger had a Roth IRA.
Play around with it and change the tax rate in the future down to 20%. See how Todd wins? Now change today's tax rate down to 5%. See how Roger wins?
Summary
You can see that choosing a Roth vs. a Traditional depends--along with a bunch of other things--on the tax rate you're paying in the future. Generally, you'd expect your tax rate to go up as your income goes up and you advance in your career, which is why I recommend doing a Roth if you're younger and a Traditional when you're older.
Some people recommend putting 50% of your money in a Traditional and 50% in a Roth to hedge your bets. Imagine that a very conservative congress takes over and cuts tax rates to 10%. Roger would be screwed (you can check this by plugging 10% into the excel sheet as the tax rate).
Exercises
- Find the tax rate, today, that would cause Todd and Roger to have the same outcome (Total money left over). Does it make sense why?
- How much would Todd have to save today, to have $50,000 in the future?
- How much would Roger have to save today, to have $50,000 in the future?