To Roth or Not?

Among the most popular options for retirement planning are tax-deferred plans like 401k's and traditional IRAs, and tax-exempt plans like Roth-IRAs and Roth-401ks. With tax-deferred plans, you get to put pre-tax money into retirement, let it grow tax free, then pay income taxes on it when you withdrawal at the end. With tax-exempt plans, you place after tax money in, it grows tax-free, but you pay no taxes when withdrawing later on. In both cases, "later on" means after you are about 60 years old. And in both cases, you get the awesome benefit of the money growing tax free until it is withdrawn, instead of paying capital gains taxes every year on your investment income.

Even after having been schooled in these two options from my Dad, who's obsessed about saving for retirement, until recently I was confused about the differences between the two. I thought Roth-IRAs would actually yield more money in the long run since you weren't paying taxes on the much larger sum of money that would accumulate. That's bunk, however, due to basic commutativity of multiplication: whether the tax bill comes now are later, it is still being multiplied by the same stuff. With the same tax rate and return on investment, the same pre-tax income placed into a Roth-IRA and a traditional IRA will yield the exact same amount at then end!

Let's say you take 10,000 dollars in pre-tax income, and want to save for retirement, and you expect to make 8 percent a year on investments over 30 years. And let's say the tax rate is 20 percent. With a 401k, you have:

$10,000 * (1.08)^30 * 0.8 = $80,501.25

The 10,000 dollars is multiplied by the compound interest you make over 30 years, after which you take away twenty percent (multiply by 0.8) for taxes. In the case of a roth-IRA, the math is:

10,000 * 0.8 * (1.08)^30 = $80,501.25

You take out the 20 percent first, but you still have the same growth; in both cases the money grows tax free.

After understanding that fundamental point, there are still a couple subtle things to consider when choosing. First, your tax burden might be different later on. Some recommend the tax-exempt Roth style approach because they figure by the time they retire they won't be making as much money, and will be in a lower income tax bracket. Others think they will still be working, and perhaps be making more money. Still others thing there is no way to know what the tax laws will be decades from now, and feel better paying taxes now when they know exactly what it is.

A second very important thing to consider is the contribution limits. If the contribution limits are "the same", for example if your company gives you the choice between a 401K and a roth-401K, then you can actually save more money with the Roth. Let's say the limit is ten thousand dollars. Ten thousand dollars after tax money is more than ten thousand pre-tax dollars, so you will in effect be saving more money. For example, if your tax rate is twenty percent, you could contribute (1 / (0.8)) = 1.25 times more money into an account where it can grow tax free with the Roth style account. It of course requires placing more of your income into retirement, but at least it is an option.

Personally, I'm torn. I like the idea of being able to save more with Roth, due to the limits issue I just mentioned, but I suspect I'll be paying lower taxes later on given that I'm a software engineer and by the time I'm sixty years old I will likely have long since trained my fresh twenty year old replacement :)

What I decided to do is split it up fifty fifty. In the end, when one turns out to be the best option due to the tax bracket I end up in, I will have only blown it half way.