Question: Wouldn't compounding suggest that the Roth is the better choice?
Question: I caught your show while driving to the gym. A listener asked if he should fund a Roth 401(k). He was a 28-year-old making $205,000 income with his wife. You advised him not to invest in a Roth 401(k) because his tax rate (33%) was above the 15% that you recommend if you want to invest in one. I’m confused. Wouldn’t compounding suggest that the Roth is the better choice? Consider this example. A man in his 20s puts $30,000 into such a plan. He pays the taxes on the $30,000 (water under the bridge). He puts no more into this plan but leaves it there for the next 40 years. He achieves a 12% return. The account value at that time is $3.6 million. It kicks out an income of $267,000 per year for who knows how long, and best of all, it’s all tax-free. When he needs a lump sum, he takes it without tax consequence. Seems to me that the $10,000 paid as taxes 40 years earlier sure would represent a GREAT BARGAIN. What am I missing?
Ric: Taxes. You’ve inadvertently (or conveniently, since you called it “water under the bridge”) ignored taxes.
Allow me to offer you a simple illustration that explains why ignoring taxes causes your analysis to fail.
Say you earn $100. You pay 30% in taxes — the “water under the bridge” that you ignored. (By the way, you can change this tax rate to any rate you wish, but you can’t simply choose to ignore taxes altogether.)
This leaves you with $70 to invest. You place the money into a Roth IRA. Now, pick a rate of return and time interval. It doesn’t matter what you pick. Let’s say that, over whatever period of time you select, the account value doubles to $140.
You then withdraw the money; as you know, the withdrawal is tax-free. You therefore get to keep the entire $140. Now consider this: You again earn $100 and you choose a Deductible IRA instead of a Roth IRA. Therefore, you pay no taxes on that $100 (because your contribution is tax-deductible) and thus the full amount gets invested. It then grows at the same rate and for the same period as you selected above. Thus, as it did above, the account again doubles in value.
Therefore, you now have $200. But when you withdraw the money, taxes are due. You pay the same tax rate as you paid above (in this example, 30%). That’s $60 — leaving you with (drum roll please) $140.
As you can see, you end up with the same amount of money regardless of whether you choose the Roth IRA or the Deductible IRA. And yes, you’ll reach the same result even if you use $30,000 instead of $100, a 12% return instead of a mere doubling and a 40-year time frame instead of my unspecified one. Go ahead, try it and see.
So, the issue here is not the principle of compound interest. It’s the reality of taxes.
Sure, you can say that you’d rather pay a small tax now instead of a larger tax later — but doing so does not create greater wealth. And as a financial advisor, my job is to help you create wealth — not merely to help you pay less in taxes.
And sure, you can speculate that future tax rates will be higher — giving you justification for choosing the Roth today. But please realize that such a stance is pure speculation, for one can just as easily predict that future rates will be lower rather than higher.
Here’s the final point. If neither the Roth IRA nor the Deductible IRA is superior to the other, why did I tell the caller that the latter is, well, superior? The reason is this: I don’t trust Congress. Although the Roth offers the promise of a future tax benefit, I can’t be sure that this promise will be delivered. But the Deductible IRA offers a tax break right now. Bird in hand, so to speak. If you feel differently about Congress, you can go the other way. Just make sure you’re doing so for the right reason.
By the way, the reason we said to choose the Roth only if your current tax bracket is low is because the savings offered by the Deductible IRA in that case are so small that it’s worth the bet that the future promise will be fulfilled.