2 thoughts on “What are the tax advantages of a retirement savings account: Traditional/Roth 401(k)/IRA

  1. This has several incorrect premises. First, this article assumes the money is taken out one year later without any regards to compound interest. Second, this makes a false comparison between accounts of different amount of contributions.

    The real question is this: with same amount of contribution growing to same amount of final result, how much tax do you pay when you take out the money? Let’s say base income is $50k, income tax bracket for $50k is 20%, contribution is $5k upfront, annual growth rate 7.2%, and taking out 10 years later (for convenience of calculation). $5k grows to $10k in 10 years with 7.2% growth.

    With Roth model, in order to contribute $5k you must have pretax money of $6250, and consequently the total tax you pay is $1250. With Traditional model, you pay 20% of the result as tax which is $2k if tax bracket is the same, and even higher if (base income $50k + income from growth $10k) results in a higher tax bracket.

    1. sakleewp, the compound interest for the one year is the investment return, which I assumed to be 10% to make matters simple.
      In your example, assuming the tax bracket stays the same, investing in the traditional IRA results in 10k pre-tax, which is equivalent to 8k post-tax, as you pointed out. Investing in the Roth IRA, you’d have to pay 20% tax up front, so the 5k pre-tax becomes 4k post-tax. This 4k post-tax grows to become 8k, post-tax. So, if we assume the same tax bracket, both investment schemes take you to the exact same place. It doesn’t matter whether you pay income tax at deposit time or at withdrawal time, you’ll end up with the same amount of money. When you invest in a Roth, don’t forget that the income tax you paid upfront reduces the investment returns you would have gained had you selected to pay the tax later.

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