Fresh Look at Roth Strategies

Roth retirement accounts are almost always considered better than Traditional especially for young people with low incomes.  Recently a friend of mine mentioned in interesting new look on the value of Roth retirement accounts (IRA or 401K).

The potential problem with Roth accounts is that you are taxed at your maximum possible rate today and not your average rate.  As a refresher, if you make $40K in taxable income and find yourself in a 25% tax bracket, that just means your last dollar is taxed at 25% but your entire income is taxed at about 15.5% on average.

The money you commit to a Roth retirement account is considered taxed at your highest tax rate.

Now let’s say you have $4K to put into retirement.  You can choose a Roth type account or Traditional.  If you choose Traditional then you pay no taxes today and your $40K becomes $36K spendable and $4K in retirement savings.  If you choose Roth the $4K is taxed at $1K leaving $3K in your retirement account and again $36K spendable.

Over time the retirement money will hopefully grow.  At a 7.5% rate of return minus 2.5% inflation (to keep everything in today’s dollars), the money will double four times over 28 years.  Thus the Traditional has $64K or the Roth has $48K.

Now if tax brackets do not change and you have $40K in income from some other source the Traditional goes on top and whenever you take it out it is taxed by at least 25%.  The 25% is $16K from the $64K leaving the Traditional account with the same amount of value as the Roth.  But, if the Traditional account is your only source of income then it is taxed in steps – some at 10%, some at 15%, and some at 25% – like income today.  On average, when you take out $40K it is taxed at 15.5% and effectively has $54K in value making it more valuable than the Roth.

Marginal Tax Rates Retirement
If your Traditional retirement account is your only income, then its average tax rate is less than your maximum rate.

This may not be the most likely scenario for everyone, but it is one that should be considered when formulating a tax strategy.  Although Roth makes sense for most people with many sources of future income (Social Security, House, Pension), make sure your retirement advisor considers what sources of income you will have at retirement.  If you have any questions post a comment and I’ll help you out.

If future average taxes are less than current marginal taxes, then a Traditional account may be better.