Before I get into this, let me give a small disclaimer. I am not certified as a retirement planning expert, so my answer comes from a common sense, real-world layman’s perspective. Now, let’s discuss retirement! One day in the future, most people want to celebrate a day when they don’t have to go to work any longer out of necessity and can enjoy the fruits of their labor by way of retirement. The only way to get to that point is to save for retirement (obviously) with a long-term strategy of growing your investments to allow you to live off whatever interest they generate. Most financial counselors agree this means you need to save at least ten times the amount of the number you’d like to live off of when you retire. In other words, if you want $100,000 to live on when you retire, you need to have $1,000,000 in the bank to be able to make that happen. We won’t get into the specifics of that here, but I want to bring it up because it is relevant as we consider the difference between Roth and Traditional retirement plans. Let’s dive in.
Traditional plans, such as a 401k, 403b and Individual Retirement Arrangements (IRAs), are called “tax-advantaged” plans because they allow you to put your money in them and avoid paying taxes on the amount you put in. For this reason they are sometimes called “pre-tax investments.” They are good because they lower your taxes each year since you can deduct the amount you save in these plans (within their given contribution limits) off of your income. Example: You earn $50,000 per year, but put $5,000 in your company’s traditional 401k. You would be taxed at most on $45,000 of that income. These plans save you lots of money in taxes on the front end, but they have a big potential downside – you have to pay taxes on the money you earn in investment growth and interest when you use the money in retirement. Using our original example of having $1,000,000 in the bank that provides you $100,000 of income each year – you’ll have to pay income taxes on the $100,000 of income each year, bringing your actual net (take home) income down to $82,000 per year (based on 2012 rates). In other words, saving those taxes now could cost $28,000 per year later. For many folks, that’s a trade-off they’re okay with. For others, it drives them to the alternative – Roth Plans.
Roth IRAs, 401ks, etc. are named after Senator William Roth of Delaware, who created and helped put them into law. Roth plans are also “tax-advantaged,” but in a dramatically different way. With a Roth, you pay taxes on the money you put in, but never pay taxes on the money you pull out in retirement. Example: You earn $50,000 per year, but put $5,000 in a Roth IRA. You would be taxed at most on all $50,000 of that income. There is no tax savings each year with a Roth – that’s their downside. However, their big upside is that you pay no interest on the earnings when you use that money in retirement. Back to our earlier example of $1,000,000 in the bank generating $100,000 of income – you get to keep all $100,000 because you paid taxes on the income each year rather than taking the deduction as you would with a traditional plan. Make sense?
I believe Roth plans are the absolute best plan for retirement savings for anyone, no matter the age. Especially for younger investors, the math is very much in favor of Roth investing. For older investors, the math may not be as beneficial, but I still recommend Roth because tax rates are always changing and chances are, rates aren’t going down! I would rather know that everything showing in my retirement account balance is mine and I don’t have to share it with the government.
That being said, there are some times when I would recommend a traditional retirement plan. For example, although Roth 401ks are gaining some traction with larger companies, most companies only offer traditional retirement plans to their employees. Usually, the company will match a certain amount invested by employees to encourage them to save and as a benefit of employment. Anytime there is a company match, I encourage you to invest in the company’s traditional plan up to the amount of the match. In other words, if the company will match up to 3% of your salary, put 3% in there because you’ll be getting 100% on your money immediately, and that’s a return you can’t beat. A general rule is to invest in a traditional plan anytime there is a match, but only invest up to the amount of the match. Then do the rest of your investing in Roth.
I’ll tackle more on the topic of Roth vs. Traditional later on, such as discussing rollovers when you leave a job, but for now, I’ll ask you – Roth or Traditional? Which do you prefer and why?