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Contributions: When In Doubt, Go Roth (But Maybe Not for the Reason You Think)

A reader writes in, asking:

“In a recent meeting at work, my team got to talking about retirement accounts and who makes tax-deferred contributions and who makes Roth contributions to our 401k. One person was arguing that Roth is almost always better because Roth accounts grow tax free. What I’ve read, from you and elsewhere, is that the decision comes down to tax rates. Should my coworker’s point not be considered though?”

This is something you’ll see frequently — the argument that a Roth account is better because with a tax-deferred account you have to pay tax on the growth. But that’s incorrect. It’s a fundamental misunderstanding of the math involved.

Both Roth accounts and tax-deferred accounts get to grow tax-free. This is in contrast to taxable brokerage accounts, in which you have to pay tax on interest, dividends, and realized capital gains each year. That is, tax-deferred accounts and Roth accounts grow more quickly because you don’t have to pay tax on the growth. This is the primary advantage of retirement accounts: you literally earn a greater rate of return in them than you do in taxable accounts. And when compounded over many years, that’s a big deal.

This is one of the most critical points to understand about retirement accounts, so I apologize if it feels like I’m belaboring it. When choosing which type of account to contribute to (Roth vs. tax-deferred), they are the same in this regard. If you have the same tax rate now (at the time of contribution) as you have at the time of distribution, both accounts will give you the same after-tax amount available for spending.

Example: Imagine a simplified world in which you have a constant 25% marginal tax rate. And this year you could contribute $4,000 to a traditional IRA or $3,000 to a Roth IRA (because the $4,000 contribution to traditional only “costs” you $3,000 of cash flow given the $1,000 tax savings you’d get from the contribution). After the contribution, both accounts would grow (or shrink) by the same rate of return each year. And regardless of what that rate of return is or how long the period is, at the end, you would have 75% as much in the Roth account as in the tax-deferred account. And after applying a 25% tax to the traditional IRA balance, the amount that’s left is the same.

So again, both Roth accounts and tax-deferred accounts get to grow tax-free. And that’s a big deal. It’s why maxing out your retirement accounts each year (if you have the cash flow to do so) is a good default recommendation before investing at all in a taxable brokerage account.

Of course, our simplified example above is unrealistic. In real life we don’t have a constant marginal tax rate. And so it’s worthwhile to try to judge whether your marginal tax rate at the time of the contribution is more or less than the tax rate you expect to face at the time the money comes out of the account later. (If your current tax rate is higher, tax-deferred contributions are preferable. If your current tax rate is lower, Roth contributions are preferable.)

But when in doubt — and frankly that’s a lot of the time because it’s hard to predict what marginal tax rate you’ll face many years from now — I think it’s prudent to prioritize Roth contributions.

That’s because Roth accounts have a few major advantages over tax-deferred accounts — advantages completely separate from this current-tax-rate-vs-future-tax-rate analysis.

  • Roth accounts do not have required minimum distributions (RMDs) during your lifetime.
  • Contributions to a Roth IRA can be taken back out, tax-free and penalty-free at any age. (Ditto for contributions to a Roth 401(k) or Roth 403(b) that have been rolled over to a Roth IRA.)
  • If you’re maxing out your contributions, Roth accounts have the advantage of effectively letting you shelter more dollars than tax-deferred accounts do. That is, when you contribute to tax-deferred accounts, a portion of that money (specifically, the portion that will ultimately go toward taxes when you take the money out) is effectively the government’s money. So you’re using up a portion of your contribution limit for something that doesn’t benefit you, whereas when you contribute to Roth accounts, the full amount is yours.

So contributing to a tax-deferred account instead of a Roth account only makes sense if your “I have a higher marginal tax rate now than I’ll have when these dollars come of the account later” bet turns out to be right and that difference in tax rate outweighs those three factors above.

To summarize:

  • The idea that with tax-deferred contributions you have to pay tax on the growth — and that you should therefore prioritize Roth contributions instead of tax-deferred contributions — is a fundamental misunderstanding of the math involved.
  • But Roth accounts are often preferable, for a completely separate list of reasons.

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