Since the dawn of retirement accounts, people have been engaged in a great debate. The millennials want to ditch the retirement accounts because of "the oppression, bruh", the retirees complain that they didn't know what they were doing and picked the wrong account, and the legislators fight off the intense allure of more tax income that they could squander if they could only get it from those pesky retirement accounts. Just think of all the sports stadiums and private jets they could buy!
In this article, I want to go into the math of the debate and show you who wins (hint, hint: it depends). First, let's define who the racers are.
A taxable account is your run of the mill investment account that you could open up with any brokerage platform. It is subject to full taxation. For our purposes, the taxable account is subject to both regular income taxes that you have to pay on your earned income and then a capital gains tax.
Capital gains tax is currently 15% for growth in your investments that are held over a year. This could raise in the future, but for our purposes, it will be constant.
This is a retirement account. All retirements have one thing in common: you get some kind of tax benefit in return for restrictions on when you can access the money. A Roth account is the newest kind of retirement account and offers a unique benefit. With a Roth, you contribute your money after you pay your income taxes, but it then grows tax-free and is not taxed when you withdraw it at retirement age.
This type of account has been around a long time. Hence the name "traditional". With this retirement account, you are able to contribute your money pre-tax which means you can technically contribute more money than if you were using Roth since you save on the taxes now. We will see this effect in the calculation. The catch here is that when you withdraw the money at retirement age you have to pay income taxes on the entire amount.
Now that we have the accounts down let's talk about how the math works.
Retirement vs. Taxable
What I want to do in my analysis here is to look at how each account grows over time in three different tax rate environments. There are many different political arguments out there for what tax rates may do over time. Some will say they will increase and some will say they will decrease and some say they will stay the same. The fact of the matter is that we have no idea what is going to happen 30 years in the future with tax rates. For the purposes of this analysis, I will look at all three cases.
Here are some assumptions I am using in the calculation:
- The contribution amount that the person will use is $5500/year pre-tax (~$458/month). This is the current contribution level of an IRA. That means for taxable and Roth the amount will be less after taxes.
- Each person will start with $10,000 at the beginning of the investment period.
- I will assume that the person contributes for 30 years and withdraws at the end of that time bearing all of the taxes.
- I will assume an investment return of 10% per year across the board.
- The beginning income tax rate will be 25%.
- For the increasing tax rate environment, the income tax rate at the end of the period will be 35%.
- For the decreasing tax rate environment, the income tax rate at the end of the period will be 15%.
- For Roth and taxable the income tax rate switches at year 15.
Now let’s take a look at the results!
Above are the results of the calculations. Let’s talk about a couple of conclusions.
Investing in a Roth account is often one of the most common pieces of advice that financial pundits will push. This is mostly because in all the environments (increasing, decreasing, and constant tax rate) the results are relatively the same which means they are fairly reliable. If you are looking for a set it and forget it retirement, then this could be a great option for you.
At the same time, you can see that if tax rates are to decrease over time then the traditional will win out over the Roth. Although this is the only case that this is true in this calculation. At the same time for the constant tax rate environment, the traditional and Roth are fairly consistent.
Lastly, we see that taxable accounts lose in all environments by over $100,000 compared to the Roth.
So what does this mean for you? Do you just go with Roth or risk it with traditional? First, let's talk about some caveats that I haven't considered.
In reality, this question is a bit more complicated than I have made it. The above calculation is to get major trends, but it is not personalized to your situation and goals. There are many things that would make you want to choose a certain account over others.
For example, with traditional contributions when you get to retirement age there are many different ways you can change your tax liability. One simple way is modulating how much you withdraw. You can earn somewhere between $10,000-$12,000 without paying any taxes depending on how you file. So if you were to have some amount of money in other investments and only needed to draw a small amount then you could have no tax burden for quite a while.
Similarly, depending on your current income and how much you want to put into your 401k you could potentially lower your tax burden almost completely by taking advantage of some deductions. This could be a big help to your current tax situation. Here is a great article on how some ordinary people have reduced their tax burden to nearly zero completely legally: https://www.personalcapital.com/blog/financial-planning-2/average-american-pay-no-taxes/.
Another thing is that if you are wanting to draw these funds out for early retirement (that is before the retirement age) there is a way to do this by strategically converting your pre-tax funds to Roth after you quit your job. I will write an article on this later, but for now, you can check out this article which has a great explanation on it: http://jlcollinsnh.com/2013/12/05/stocks-part-xx-early-retirement-withdrawal-strategies-and-roth-conversion-ladders-from-a-mad-fientist/.
The point being that there are many complications that can make your situation different. You need to work with a professional to assess what strategy is best for you.
Let's end off with some conclusions.
Although the calculations are simplified we can learn some important things from them. First, we see that investing in a retirement account, either Roth or Traditional, will get you much farther than using taxable investments even in an increasing tax rate environment. Taking advantage of retirement accounts can have a huge impact on your future financial life.
Secondly, we can see that Roth contributions have the least sensitivity to future tax rate movements. For many this can give them some peace of mind and for general advice to give to someone off the street it is your best bet for success in the retirement game.
Finally, as I had stated before, it is important to get help from a professional to figure out what is best for your situation. Whether you are thinking about retiring early or have a chance to significantly reduce your tax bill currently there are certain strategies that can get you there. It is important to consider those things. Although that will change significantly over your life.
I hope this article helps you out! Stay tuned for additional articles on retirement.