Investing

Roth Often Delivers Greater Ending Wealth

By John Manganaro editors@plansponsor.com | March 15, 2017
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O’Shea adds that “lower down on the contribution scale below the maximum, things get a little muddier, certainly. But we think it is important to highlight this as a goal for people—to represent what the ideal might be so that people can work towards that. If you are maxing out contributions, most likely it will make sense to go with Roth.”

The analysis offers some additional examples: For someone with a current effective tax rate of 20%, the cost of making a $5,000 contribution to the Roth would be $6,250. Another way to think about this is to say that the individual has saved $5,000 and at the same time pre-payed some of the tax he would otherwise owe in retirement. So the trick is that this after tax account is allowing the individual to save more on net than he could in a traditional IRA, through which you aren’t able to pre-pay taxes.”

Even in cases where an investor isn’t very eager to change their investing approach, this is important stuff to consider—how significant the impact of taxes will be on net wealth in retirement. It can be hugely significant.

“One other aspect that impacts the analysis is whether or not you invest the tax savings you see in the short term when using a traditional IRA,” O’Shea adds. “Say, if you take the equivalent of the $1,250 that you would have had to pay in taxes to make a $5,500 Roth contribution and put that into an after-tax brokerage account.”

This can go a long way to making up the performance gap and matching the performance of the Roth approach. But, of course, this requires an annual commitment to fund and manage the brokerage account, which is far from a given over a 30-year time horizon.

“In a way it feels less painful to make the $5,500 Roth contribution, even though it is costing you more because you are not getting a tax deduction—but you aren’t actually physically putting that extra money into a separate account,” O’Shea concludes. “Instead, it is just absorbed into your taxes and you don’t really have to feel that loss as much. We have seen a lot of evidence that the behavior element is very important.”

The full analysis is available for download, along with a helpful Roth-versus-traditional calculator, at www.NerdWallet.com

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