Traditional vs Roth. Does it even matter? Many wonder whether they should invest in a Traditional plan or a Roth plan. Many still wonder what the difference is between the two. By the end of this article you will be able to distinguish between the two forms of retirement plans and have the knowledge to make an educated decision on which one is right for you. Let’s start by defining what they mean.
First, what are we even talking about, Traditional vs Roth? These two represent two ways to invest in retirement plans. Investing done outside of a retirement plan will be taxed before it is put into the investment account and the earnings will be taxed when withdrawn.
Traditional Retirement Plan
As discussed in the article about 401(k) plans, the traditional plan is what most people currently use, probably through their employer. For 401(k) plans, the money is automatically taken out of your paycheck each pay period and put into the investment accounts of your choosing. This is all done before taxes are taken out.
In a perfect world, this money will sit in your investment accounts until you are able to take a withdrawal with no penalty. Uncle Sam will then get his share of the pot! The money you withdraw will be taxed at your ordinary income tax rates, which are set by the IRS each year.
These taxes can hurt. Bad. Lets assume your effective tax rate is 20%. If you have $1 million in your investment account and withdraw it, how much do you really have? Easy math. $1,000,000 * 20% = $200,000. They will take $200,000 in taxes from you. This leaves you with a balance of $800,000. That $800,000 is no paltry sum, but you thought you were a millionaire! Taxes hurt. But that is where a Roth retirement plan comes in!
Roth Retirement Plan
A Roth retirement plan works almost the same way as the traditional, with one huge difference. A Roth Plan is not taxed when money is withdrawn. Instead, money is put into the plan after it has been taxed, instead of pre-tax like a traditional plan. This changes everything!
Every dollar you take out of a Roth Plan, assuming you are over the age of retirement (age 59 1/2 for Roth 401(k)), will be yours to keep! This sounds great, doesn’t it? But does it truly make a difference? Let’s look at an example!
Traditional vs Roth: The Numbers
Let’s assume the following:
- $1,000 to invest each month (Pre-Tax)
- 7% Annual Return
- 30 Year Investment Horizon
- 20% Tax Rate during working years and retirement
Now remember the main difference between Traditional vs Roth investing. It’s all about when the taxes are paid. You don’t pay tax with the Traditional Plan until after you withdraw the money, so that $1,000 goes in tax free. But with the Roth Plan you need to pay tax on that $1,000. With the 20% tax rate above, that $1,000 becomes $800. So you will invest that $800 into the Roth Plan. Now look at how this plays out.
Due to more being invested, the Traditional Plan has the lead in investment balance all the way. Until, that is, it is time for the tax man to take his cut. Then what? Well…its a tie. You will end up with $981,670 in this scenario either way. So what’s the big deal?
Tax Rate Matters
The most important factor to consider when deciding between a Traditional vs Roth plan is your tax rate. Not just your tax rate now, but also your expected tax rate when withdrawing your money.
It is hard to predict the future. Tax rates could change countless times between now and withdrawal time. I find the best way to think about it is do you believe you will take more out during retirement than you are currently making. This will help dictate how you estimate your future tax rate. If you want to withdraw more, your projected tax rate would be higher and vice versa with a lower withdrawal rate.
Once you determine if the tax rate will be higher or lower, the choice becomes easy. If you believe your tax rate will be higher in retirement, the Roth is the way to go.
If you believe it will be lower, then a traditional plan is a winner.
Traditional vs Roth – My Recommendation
As with everything in regards to personal finance, it seems it is a personal choice on which is best. You have to make the decision based on your financial situation.
That being said, there is one thing I would recommend. Tax Diversification.
What is Tax Diversification?
You hear all about diversification when it comes to an investment portfolio. But what is tax diversification?
Simply, it gives you options. Remember, the tax scale is progressive. Sure, the more your taxable income, the more you pay. But that isn’t the whole story. My first $10,000 of taxable income is taxed at the same rate yours is. It doesn’t matter if you have $1 million in taxable income and I only have $50,000.
Where am I going with this? Simple. Once you start making withdrawals, you can use your traditional plan to withdraw money up to a certain point on the tax scale. Any income, including pay via employment or social security plus your withdrawals will determine the tax bracket you fit in. So once your income is bumping up against that next bracket, switch over to your Roth money. Everything from then on will not count towards that taxable income number, keeping you in that lower tax bracket.
That is where the true flexibility comes from. The ability to choose where you want to take your money from. You can take out money from your traditional plan up until you will hit a tax bracket that using money from your Roth plan makes sense.
Traditional vs Roth – The Takeaways
People will argue which one is better. Everyone has their arguments that fit their personal situations. But the flexibility of having both types of plans trumps investing in just one.
Currently, I have both a Traditional 401(k) Plan through my employer as well as a Roth IRA on the side. This will give me great tax diversification when it comes time to start making withdrawals, giving me the greatest savings opportunities. That is what it is all about. Keeping the most amount of money for yourself.
At the end of the day, putting money into a retirement plan is a huge step towards reaching your retirement goals. Making sure you start as early as possible will allow your money to compound over decades and provide you with the life you have always dreamed of!