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All,
I did a bit of analysis on roth vs. traditional, and I’d like you to check my work and see if I missed anything.
Somebody asked me about traditional vs. roth retirement accounts, and I said that the typical advice is to go traditional if you expect a lower tax bracket in retirement, and roth if you expect a higher tax bracket in retirement (for these purposes, assume we’re talking about 401(k)s so we don’t have to worry about eligibility for contributing to a roth IRA and whether the 2010 conversion rules will stick).
He then posed a question that I didn’t immediately have an answer for: For young investors (let’s say those who have forty years before retirement), isn’t a roth automatically better, because the one time tax hit allows tax free access to the compounded proceeds in retirement?
That seems intuitively correct, so I told him I’d have to think about it and get back to him.
Upon reflection, I think he’s wrong, and I used a model: For somebody living in NYC making a six figure salary, it’s reasonable to assume a marginal tax rate of 35-40%. We’ll just take the average and say 37.5%. So, by contributing the $16,500 max to the 401(k), they get a tax break of $6,187.50.
Assuming a forty-year horizon and an 8% rate of return, that $16,500 is worth $331,902.40. Now, assuming a tax rate that has dropped to 20%, the tax on that amount will be $66,380.48, meaning a $6,187.50 tax break cost us nearly ten times its face value. However, had the $6,187.50 been invested and gotten the same 8% returns, it would be worth $124,463.30-- so the tax break was in fact worth about $60,000 (or, put another way, contributing to a roth and paying the tax would have been tantamount to a $60,000 penalty).
I’ve run the numbers for different interest rates and tax assumptions, and the math seems to come out about the same. Am I right, or did I miss something?
I did a bit of analysis on roth vs. traditional, and I’d like you to check my work and see if I missed anything.
Somebody asked me about traditional vs. roth retirement accounts, and I said that the typical advice is to go traditional if you expect a lower tax bracket in retirement, and roth if you expect a higher tax bracket in retirement (for these purposes, assume we’re talking about 401(k)s so we don’t have to worry about eligibility for contributing to a roth IRA and whether the 2010 conversion rules will stick).
He then posed a question that I didn’t immediately have an answer for: For young investors (let’s say those who have forty years before retirement), isn’t a roth automatically better, because the one time tax hit allows tax free access to the compounded proceeds in retirement?
That seems intuitively correct, so I told him I’d have to think about it and get back to him.
Upon reflection, I think he’s wrong, and I used a model: For somebody living in NYC making a six figure salary, it’s reasonable to assume a marginal tax rate of 35-40%. We’ll just take the average and say 37.5%. So, by contributing the $16,500 max to the 401(k), they get a tax break of $6,187.50.
Assuming a forty-year horizon and an 8% rate of return, that $16,500 is worth $331,902.40. Now, assuming a tax rate that has dropped to 20%, the tax on that amount will be $66,380.48, meaning a $6,187.50 tax break cost us nearly ten times its face value. However, had the $6,187.50 been invested and gotten the same 8% returns, it would be worth $124,463.30-- so the tax break was in fact worth about $60,000 (or, put another way, contributing to a roth and paying the tax would have been tantamount to a $60,000 penalty).
I’ve run the numbers for different interest rates and tax assumptions, and the math seems to come out about the same. Am I right, or did I miss something?
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