Financial Perspectives: Traditional vs. Roth IRA accounts

To Roth or not to Roth?

As part of the process, I get to see how people are preparing for the eventual retirements. When it comes to retirement savings, many people are still saving exclusively on a pre-tax basis. This may not be the most advisable strategy, especially if you are in your 20s or 30s.

Contributing to retirement accounts on a pre-tax basis has become the most common approach to saving for retirement, whereby you get a current year tax break on the income you are saving in your 401k, 403b or traditional IRA. Then down the road – 20, 30 or 40 years from now – you will pay taxes when you begin withdrawing the money during retirement. This money would grow tax deferred over all these years. The only trouble is that you could be paying taxes at a much higher rate when the money is withdrawn.

If instead you were to make your retirement plan contributions with after-tax dollars, you could be helping yourself immensely. You would forfeit a current year tax benefit but your eventual withdrawals would be completely tax- free. This means that all the growth you could experience would be tax-free.

Let’s review a quick example of how this could work for you. We will assume that you will contribute $10,000 per year into your 401k on a pre-tax basis and earn 5 percent over 25 years. You would accumulate $501,135 over this period. If you took 5 percent distributions per year over the next 20 years, you would withdraw $513,242 (gross) and pay total federal income taxes of $128,311 assuming a 25 percent tax rate and would net $384,931.

This sounds pretty good, but let’s look at what would happen if you made the contributions to a Roth 401k. The same $10,000 contribution would grow to $501,135 over 25 years. The taxes paid on these contributions would amount to $62,500 over the period. If you took the same 5 percent distribution per year over the next 20 years you would withdraw the same $513,242, but the difference is that this would all be tax free. This would represent an additional $65,811 in your pocket ($128,311-$62,500). The longer you live and take withdrawals, the more dramatic the difference. Similarly, the higher return you earn the more beneficial the Roth would be.

In our assumption, we assumed a 5 percent return. If you actually earned 7 percent the total withdrawals would amount to $622,799 and the taxes owed would be $155,700 – which would be $93,200 greater than the $62,500 you would have paid under the Roth scenario.

Finally, if you died after receiving distributions for 20 years under our original scenario, your family would receive $475,472 (on a pre-tax basis), or $356,604 net, assuming a 25 percent tax rate, which would amount to an additional $118,868 in income taxes. Total income taxes paid for the pre-tax scenario would amount to $247,179 ($118,868 + $128,311) versus $62,500 if you made the contributions to a Roth.

As you can see, making full use of the Roth can beneficial not only to you, but to your heirs.

Good luck with your retirement planning!

Jim Heisler is a Certified Financial Planner with Family Wealth Services in Holmesburg. You can read all his Financial Perspective columns here.

Registered Representative, Securities offered through Cambridge Investment Research, Inc., A Broker/Dealer, Member FINRA/SIPC and Investment Advisor Representative, Cambridge Investment Research Advisors, Inc. a Registered Investment Advisor.  Family Wealth Services, LLC and Cambridge are not affiliated.

Jim Heisler, CFP®, CDFA™, CASL™ Family Wealth Services, LLC is located at 8275 Frankford Ave. (215-332-4968)

The views expressed are not necessarily those of Cambridge and should not be construed as an offer to buy or sell any security. These situations are hypothetical in nature and do not represent a specific client.

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