Roth vs Traditional

The difference between a Roth and a Traditional financial instrument lies in the tax treatment. The Roth and Traditional designations apply to a few investment vehicles (i.e. accounts such as 401k, and IRA), but the concept extends much more broadly to any type of investment activity.

In the context of 401K’s, IRA’s and other retirement accounts, Roth accounts pay taxes up front and then pay no additional taxes on earnings from the already taxed money, while taxes are levied on traditional accounts upon future withdrawals. The timing of the tax payment in theory should not matter if tax rates are the same when the money is deposited vs when the money is withdrawn because if you pay taxes now (Roth), you will have less money to earn returns. Conversely, if you defer the tax (traditional), you will have more money now to earn returns, but you will pay more taxes later, leaving you with the same as the Roth approach. A simple example:

Tax 20%, Income $1,000
Roth: Invest $800 (20% income was taxed already). 25% return = $1000 total (no more taxes owed)
Traditional: Invest $1000 (defer taxes). 25% return = $1250, but 20% taxes ($250) = $1000 after taxes.

If both situations are the same, then why bother picking one over the other? They key lies in the tax rate and your expectations of whether your future tax rate will be higher or lower than taxes now. I’m not a tax professional and everyone comes from different financial backgrounds with potentially vastly complex tax structures, but I follow a few basic rules, which should apply to most people:

– Pick the Roth when you’re young and starting out because your income will be low, so you will pay at lower tax rates, and thus less in taxes.
– Start putting into traditional type accounts as your marginal tax rate starts to hit higher levels because you will save on the high taxes. Later in retirement, you can withdraw a combination of Roth and Traditional money, but because the Roth money won’t be taxed, it also doesn’t count as income, thus the Traditional withdrawals apply to lower marginal tax rates.

This two step strategy is effectively a tax arbitrage, which should help increase your assets and income 30-50 years from now in retirement, hopefully as you remember this fp tip.

-fp

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~ by fp on June 28, 2014.

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