Roth or Traditional is an age-old question. Well, at least since 1997 when Roth accounts were first introduced. I wasn’t planning to prioritize this conversation because it receives significant coverage by the media and financial blogs. I assumed the differences were well understood, but am making this an early post because I recently read a comparison article with flawed logic that made me realize this is still misunderstood by the general public.
A Simplified Approach: There are several details a person could consider when making this decision. From conversations with people, I’ve discovered a simple explanation that seems to resonate with most. I’m a detailed person and this post requires restraint. In the most simplified terms, the question of Roth or Traditional is whether to pay income taxes on this money now or later. Admittedly, this is one of the most common ways of comparing these accounts. What this well-known comparison largely ignores, however, is investment growth. Over a long period of time, the growth should significantly outpace contributions. For this reason, I prefer taking this conversation one step further by incorporating a few simplified numbers.
Imagine a 25-year-old contributing $500/mo. to a retirement account for the next 40 years. Over this time, they will have contributed $240,000. Assuming a 7% average rate of return the future value of this account would grow to about $1,200,000. The same would be true for a traditional and Roth IRA.
The Better Question: The government enforces income limits on these accounts but these don’t affect most people. Excluding these limits, your choices are to opt for $240,000 of tax deductions during your working years and exchange this for a $1,200,000 sum of taxable money in retirement or to pay tax on $240,000 during your working years and have a $1,200,000 sum of non-taxable money in retirement. Explained in this way, most people’s immediate reaction is to opt for the Roth. Explained by the general media, most people opt for the Traditional. The general media doesn’t seem to put investment growth into perspective and encourages people to think only about their current and expected tax bracket. Most people expect to be in a lower tax bracket, but a lower bracket on a larger sum of money doesn’t always translate to less overall tax.
Beyond this simplified comparison, there can be several other considerations such as current and expected income amount and sources, taxation of your overall assets, biases about the financial state of our country, marital status, qualification for social programs, charitable intent, and the financial situation of your beneficiaries. For those who would rather watch paint dry, this simplified approach is this the most effective way I’ve found to help others make a quick comparison.