In the world of retirement investing, there are two ways that you can handle your taxes.
ROTH: making after-tax contributions to your investment accounts and then having tax-free growth on your investments.
Traditional: making pre-tax contributions to your investment accounts but then paying tax on the growth later.
In other words, with ROTH accounts you pay tax now and with traditional accounts you pay tax later. Choosing between these two tax designations is a common consideration in personal finance.
Let’s dive into this topic and see what we find.
Mathematically, let’s consider a hypothetical between two people. In this theoretical world, tax rates never change and an investment exists that yields 10% every year.
Person 1: Invests $1,000 pre-tax into a traditional account and buys an investment that grows at 10% for 30 years. After 30 years, that money has grown to: $4,321.94
Person 2: Earns $1,000 and pays a 25% tax on that money. They are left with $750 which they invest. That investment grows at 10% for 30 years. After 30 years, that money has grown to: $3,241.46.
So Traditional is the way to go? Not quite. While person 1 may appear to have more money they are still required to pay tax. Let’s assume they are taxed at the same rate as person 2, 25%. This leaves person 1 with exactly: $3,241.46 after tax. Check that out! The same! Almost like a magic trick.
So what gives? ROTH vs Traditional... it doesn’t matter?!
Not quite.
We made some key assumptions in our previous example that are not quite true for the real world.
TAX
First, we assumed that there is a flat tax on all income. In the United States, we have a progressive tax system. As in the tax rates get progressively larger as income increases. Meaning that, if you are earning more now (and, as a consequence, paying higher taxes) you may be better off paying taxes later (in a lower tax bracket). However, you could also believe that tax rates will change in real dollars between now and your retirement. This would also impact whether ROTH or Traditional accounts would be better suited.
Contribution Limits
In our hypothetical situation, we also assumed that the two investment amounts for both ROTH and Traditional were $1,000. In the real world, there are annual contribution limits on tax-advantaged accounts (in 2025 $7,000 for IRAs and $23,500 for 401ks). This is the limit regardless of whether it is ROTH or Traditional. This means that if you were to add money to the point where you are approaching the annual contribution limit, you would be putting essentially more money into a ROTH account compared to a Traditional account (Because of your tax obligation). Or as I like to put it, with ROTH you put in more dollars per unit dollar.
Withdrawal Strategies
There is one final element to consider here. I mentioned that progressive tax system. That means that even for the richest people in America the first ~$47,000 they earn is taxed at or below 12% (federal income tax rate). This means that in retirement it is good to have the ability to pull from both Traditional and ROTH accounts.
Summary
If you believe that you are at a higher tax rate now than in the future. Go Traditional.
If you believe you are at a lower tax rate now than in the future. Go ROTH.
BUT having a mix of both in retirement could be good to take advantage of lower tax rates at the bottom of the progressive tax buckets.
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