Traditional vs Roth Accounts: Which is Better?
The question arises within both social and academic circles. The definitive answer, taking all possible factors into account, is arguably incalculable. Asset allocation, savings rate, accumulation period, retirement window: all of these can influence one's decision whether to invest in traditional or Roth-based retirement accounts.
A brief primer on retirement for lay persons
Within the retirement universe, there are defined benefit plans and defined contribution plans. While it is a bit more complex than this, think of pensions plans on one side and the rest of retirement plans on the other. Within that "other" category lie employer-sponsored plans and individual retirement accounts. Each of those types of plans (401k, 457, 403b, and so on) can be either traditional or Roth. Note that often, employer-sponsored plans will contain a Roth option so that participants can direct which money is placed within the traditional side and which are placed within the Roth. Here is an (overly simplistic) visual representation of the retirement taxonomy within the United States tax code:
It is important to segregate these funds because they receive different tax treatments. Typically, contributing to a traditional account allows for a tax deduction for the contribution (up to certain limits). Contributions to Roth accounts are "after-tax" meaning there is no deduction, and the money you place within those accounts has already been taxed. While the money compounds within any retirement account, there is no tax generated and no 1099 tax form issued to the participant because the taxes are deferred until retirement. Withdrawing money from either plan incurs a 10% penalty before age 59 1/2 (there are exceptions). For traditional accounts, withdrawals are taxed at ordinary income rates as though you received that money as a salary. Withdrawals from Roth accounts, however, are not taxed (currently).
It should also be noted that there are fully taxable accounts as well, often called "brokerage" accounts. There are no special tax treatment of these accounts other than long-term capital gains for positions that are held for one year or longer. Capital gains rates are often lower than ordinary income rates. For instance, with the passage of the Tax Cuts and Jobs Act, in 2019, there are three capital gains tax brackets: 0%; 15%; and 20%. By contrast, there are more (and higher) ordinary income brackets: 10%; 12%; 22%; 24%; 32%; 35%; and 37%.
Below is a quick reference table as to the normal tax treatment of the three different types of retirement accounts:
Retirement accounts & ordinary income tax rates
So, in which type of account should you invest: brokerage (taxable); traditional (tax-deferred); or Roth (tax-free)? That depends. Assuming that ordinary tax rates (as well as the bracket within which you fall) are the same throughout your working and retirement years, both traditional and Roth plans will produce the same cash flows. Traditional wisdom says that if tax rates are higher during your working years, it is better to use a traditional account. Conversely, if tax rates are higher in retirement, a Roth is preferable. Traditional wisdom usually ignores taxable accounts for retirement purposes. Moreover, such wisdom rarely specifies at which tax rate one should switch between traditional and Roth. Cramer, however, says 25% and under should go with the Roth; Higher rate taxpayers should use a regular (traditional) account. In short, "the less you make, the more likely a Roth is for you."
Using Excel, I test this theory in an attempt to identify not only the point of indifference between a traditional and Roth account but also between a traditional, Roth, and fully taxable or brokerage account. The assumptions I used in my analysis include working for 40 years, a 30-year retirement, 6% average annual compounded rate of return, $100,000 per year salary with an 80% replacement ratio (meaning $80,000 deducted from the account each year once retirement begins) and annual contributions to the account totaling 15% of salary. Inflation was not factored into the calculations.
Below is the Excel output for comparing the tax consequences of taxable, tax-deferred, and tax free vehicles for retirement. Numbers in green represent tax savings while numbers in red indicate taxes paid. The participant electing a traditional account enjoys $600,000 in tax deductions throughout his or her working years.
Once retirement begins, both the taxable and tax-deferred accounts begin paying taxes while the tax free account (aka the Roth) does not. The values listed in the table reflect total taxes paid during the retirement window (30 years). Because the taxable account only pays capital gains rates, there is no value under the "0.1" column because that effective rate for capital gains is 0%. Beginning with the 0.25 column, the color for the brokerage account turns green. This represents the tax savings that long-term capital gains enjoys over ordinary income rates within that column (meaning at those respective rates). For example, the brokerage account pays $120,000 less over the 30-year retirement than the traditional account at the 25% marginal rate.
The 25% ordinary income bracket is the point of indifference between the traditional and Roth accounts (shaded yellow). This is consistent with Cramer's advice. Any tax rate above 45% tax (shaded orange) is more favorable for fully taxable accounts versus the traditional. This is because these respective points--25% and 45%--represent the points where the $600,000 of tax deductions enjoyed by the traditional, the Roth, and the brokerage taxpayers are equal ($600,000).
Many aspects of one's financial situation determine which account one should choose for retirement. Both scholars and practitioners advise placing money in all three buckets. That way, no matter where tax rates lead in the future, one will have the luxury to pick and choose from which account to draw (and how much). For instance, if tax rates rise in retirement, one might withdraw less from the traditional (paying roughly the same amount in taxes as before the hike) and withdraw the rest from either the Roth or brokerage accounts (or both).
This is sound advice, but it warrants further consideration such as expected future inheritance, required minimum distributions from the traditional account, whether one owns a business, other assets earmarked for retirement, the respective ages of the spouses in the case of marriage, and more. Unfortunately, accounting for all those factors, if possible at all, would move beyond the scope of this post.