As a financial planner, a common query I encounter is whether to opt for traditional (pre-tax) or Roth (post-tax) retirement accounts. It may seem like an easy question that any entry level financial advisor could answer, but there is a surprising amount of nuance. It often bothers me that I cannot give a blanket answer to the friend or perspective client that asks. This quick blog post hopefully helps illustrates the dials turning in my head when I work to answer in an individual’s situation.
Illustrating the Basics with a Simple Scenario:
Imagine you have $100,000 to invest. We'll assume this amount triples over the investment period and that the tax rate stands at 25%.
- In a Pre-Tax Account: Your $100,000 grows to $300,000. Post-tax (at 25%), this leaves you with $225,000.
- In a Roth Account: Here, your initial $100,000, taxed at 25%, leaves $75,000 for investment. This amount, when tripled, also results in $225,000 — tax-free.
Surprisingly, both scenarios yield the same after-tax amount of $225,000. This is certainly an oversimplification and unlikely scenario; more on that below.
The Real Determinant: Timing vs. Tax Rates:
The crux of the decision is not about when you pay the taxes; it's about the variation in tax rates at the time of contribution and withdrawal. The optimal strategy is to pay taxes at the lowest possible rate. This might mean deferring income to the future or, in some cases, accelerating income to the present. For example, an individual at 50 may be in their prime earning years and it their highest tax brackets of their lives, therefore taxes in retirement may be lower, hence deferring tax may be preferable. Conversely, an individual just starting out in a lucrative field may be at the lowest income bracket of their lives, hence paying taxes now may be the way to go.
It's essential to understand that there's no universal answer to the Roth vs. Traditional dilemma. Your decision should be a part of a broader financial plan, considering future projections and personal financial goals. By carefully analyzing your unique financial situation and potential tax rate fluctuations, you can make an informed decision between Roth and traditional retirement accounts.