There are many articles on things like roth vs. traditional IRAs. Very few actually walk through an example with numbers, which I find illustrative.
Let’s take an example where I make 8k and can put my in money in a regular investment account, a roth ira, or a traditional ira. Assume that my tax rate is 25% (which is the same now, in the future, on capital gains etc.). Also assume that I have a stock that I can invest in which will double my money. Let’s compare the outcome across these three options:
Regular investment account. I pay taxes now so I invest 8k * 0.75 = 6k. That money doubles to 12k. When I sell the stock I pay 6k * 0.25 = 1.5k in capital gains tax. I end up with 10.5k.
Roth IRA. I pay taxes now so I invest 8k * 0.75 = 6k. That money doubles to 12k. Because I paid taxes ahead of time, I end up with 12k.
Traditional IRA. I don’t pay taxes now but the IRA investment limit is 6k so I put 6k in a traditional IRA. I have an extra 2k which becomes 1.5k after tax which I put in a regular investment account. The 6k in the traditional IRA grows to 12k. I still have to pay taxes on it so I get 12k * 0.75 = 9k. The 1.5k in the regular investment account grows to 3k. I have to pay capital gains on the 1.5k in gains of 1.5k * 0.25 = 0.375k so I get 3k - 0.375k = 2.625k. In total, I end up with 9k + 2.625k = 11.625k.
The regular investment account is the worst because you have to pay taxes on capital gains in addition to income. The real beauty of either a roth IRA, traditional IRA, or even a 401k for that matter is that you don’t have to pay capital gains taxes. The roth IRA is better than the traditional IRA because you can effectively contribute more money to it (the contribution limit is the same but after-tax dollars are worth more than before-tax dollars). Another advantage of the roth IRA not illustrated in this example is that you can take out the principle without a penalty (e.g. to buy a house).
The difference between an IRA and 401k is also often a point of confusion. A 401k has the same tax benefits of an IRA. The difference is that it has higher contributing limits but typically has worse investment options. With an IRA, you can choose whatever index fund you like. With a 401k, you’re often limited to mutual funds with high expense ratios which compounds over time. One hack is to contribute to a 401k and then roll it over to a roth IRA.
In general, the right option for most people is using their money in the following order:
401k matching to get free money from your employer
Pay off any debt you have (unless it’s at a very low-interest rate)
Max out your roth IRA
Contribute to a mix of your 401k (which has tax advantages) and a regular investment account (which you can take out without fees at any time)
Keep an eye on opportunities to rollover your 401k to your IRA (e.g. switching jobs)
I’ve shared this with a variety of friends. Here are a few of the valuable points they’ve made:
Nate: If tax rates increase over time, then the roth IRA would be even a larger winner. One good thing about the traditional IRA is that it is taxed at the effective tax rate (the weighted average from your income bracket) as opposed to the roth IRA which is taxed at the marginal tax rate (which will be higher).
Seth: You can’t rollover a 401k directly to a roth IRA. You have to go 401k -> traditional IRA -> roth IRA which is known as a backdoor roth IRA conversion. Also, what’s best depends on a prediction of future tax rates — in general, tax rates usually go up making the roth IRA even better. Also, some people talk about having both some money in roth IRA and traditional IRA as tax diversification not wanting to bet fully on tax rates being lower or higher in the future.
Ray: You could better highlight how important low fees are. Also, differences between tax rates now and later matters a lot. If you’re like 45 at your peak earnings potential (and therefore peak tax bracket), an traditional IRA will be better. It’s just about whether your taxes are higher when you’re putting money in or when you’re pulling money out.