Planning Your Retirement: Roth vs. Traditional

I’ve given a careful analysis of the various retirement vehicles. Read on to find the outcome of my crunching, but the key is to not get hung up on making the decision. Make your own analysis and jump in, and fully fund. Whether you choose one or another or a combination, they all are very good decisions to make when compared to no retirement fund.

I can see there’s a lot of confusion over what kind of retirement account is best, and what is what. The good news for people agonizing over these choices is that even choosing a lesser retirement vehicle puts you ahed of the curve. It’s the choice between Roth 401k (or Roth IRA) and Traditional 401k (or Traditional IRA) that seems the most daunting. (Choosing betwixt Roth IRA and Traditional IRA has the same ramifications.

Just to brief: a 401k is an employer sponsored deal with an annual contribution limit of $15,500, and IRA mean Individual Retirement Account, is set up by the *individual* and has an anual cap of $5000. Within both types you have two choices, Roth with taxes up from and tax-free withdrawal upon retirement (after the age of 59 1/2), and Traditional with tax deductions up front but income tax when withdrawing at retirement. 

The choice is between up-front taxes of a Roth or tail-end taxes of a Traditional. So which way to go?

Maybe the best question to start with is What would you do with the money you saved upfront by going the pre-tax route, i.e. a ‘Traditional’ 401k? If that money is just going to blow into the wind, then this whole analysis is moot.

Assuming the money is reinvested, we have 30 years to retirement, and all investments get a 10% return, a fully funded 401k ($15,500, Roth or Traditional) would give you $1.92 million. If it was Traditional, you’d be paying 25% taxes on the other end, when you pulled your money out (assuming, perhaps brashly, no increase in taxes).

So what would you make by reinvesting the taxes save by going Traditional? I came up with $3875 taxes lost annually to the Roth, at 25% on the $15,500. It’s still nothing to sneeze at. If you saved that by going Traditional and reinvested you’d end up with $727,877 to add to your $1.92 million, taxed at 25% for a grand total of $1.98 million.

If you went Roth, you’d have the $1.92 million tax free, but no money from investing the taxes you saved.

So to recap, after 30 years, fully funded at 10% return, you get:

• $1.92 million with the Roth
• $1.98 million with the Traditional

The Traditional account wins! But I’m assuming you can invest your tax savings and not be taxed until you withdraw…over on Wikipedia they say the Roth wins (this is for IRA) because the tax savings go into a “naked” (i.e. taxable) account. Can’t you just put it into an index and let it be? You’d be taxed coming and going, but not annually.

I think some calculations may put the Roth far ahead, only because they don’t take into account what you could do with the tax savings of a Traditional. Then again, the more the tax rate rises, the better a Roth is going to look. Going Roth is hedging against rising tax rates.