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Old 03-09-2014, 03:05 PM
 
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In the last couple of months I have had to explain this simple fact to posters that are otherwise very well-informed in retirement savings. Instead of rehashing the information, I thought a dedicated thread would be a more convenient way to settle this issue.

IRA and 401(k) are the same for our purposes, so to make it short I will discuss exclusively the IRA.

As you know, both the Traditional and the Roth allow 5.5k contribution a year. Well, 5.5k is 5.5k, but what makes the limits different is the tax feature of the contribution.

In a Traditional, you contribute pre-tax. So let's say your monthly salary is 5.5k, then you'll be able to contribute this entire amount into a Traditional and be done for the year.

In a Roth, you contribute post-tax. So if your monthly salary is 5.5k, you have to pay income taxes before contributing. Let's just say the tax is 1.5k, so the income available for Roth contribution is 4k. If you dedicate your first month of salary to IRA contributions, you actually have not reached the limit yet. You still have a 1.5k space to fill from next month's salary.

All right, so why does this distinction matter?

As you know, money in a Traditional is taxed when withdrawn. So even though the Traditional contribution looks bigger given the same pre-tax income, it really is the same, as the Roth contribution. Assuming that the tax bracket is the same at contribution time and withdrawal time, the 5.5k Traditional contribution will be worth the same as the 4k Roth contribution. Why? Because, to put it simply, in a Roth tax is collected up front, and in a Traditional tax is collected later, but if the tax rate does not vary, a 5.5k pre-tax income dedicated to IRA contribution is going to take you to the exact same place, regardless of whether you contributed in the Trad style or the Roth style. If you don't understand the logic, hopefully some math will clarify.

To make numbers round, let's say between contribution time and withdrawal time your portfolio has grown 10 times.
To simplify matters, the income tax rate is assumed to be the same at these two points in time. Since 5.5k pre-tax becomes 4k post-tax, the tax rate is 1.5k/5.5k or 3/11.

So if you contributed 5.5k to Trad, you'll have 55k pre-tax at withdrawal. The income tax on the withdrawal is 55k*3/11=15k. So post-tax, you end up with 40k.

If you contributed 4k to Roth, you'll have 40k post-tax.

So 5.5k contribution to Trad means the same as 4k contribution to Roth. This means that any extra contribution you can make to the Roth is going to earn you additional tax advantage. In other words, for the purpose of contributing to tax-advantaged retirement accounts, the Roth gives you a higher contribution limit.

Does this all make sense? Please share your questions/comments/thoughts on this.
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Old 03-09-2014, 03:11 PM
 
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It is easier to get more money into a Roth . But Roth vs 401 k can be made even amounts.

6700 in a 401k would equal 5k in a Roth 25% bracket.

You could put 5k in a traditional and 1700 in a deferred annuity and get similar results.

Last edited by mathjak107; 03-09-2014 at 04:04 PM..
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Old 03-09-2014, 03:14 PM
 
2,409 posts, read 2,490,839 times
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Quote:
Originally Posted by mathjak107 View Post
It is easier to get more money into a Roth . But Roth vs 401 k can be made even amounts.

6700 in a 401k would equal 5k in a Roth.

You could put 5k in a traditional and 1700 in a deferred annuity and get similar results.
Exactly. It is when we get to the limits that things get interesting ...

BTW, I'm sure this is just some sort of typo, but a 401k can be a Roth 401k or a Traditional 401k. But I understand what you're saying anyway. You meant Roth vs Traditional
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Old 03-11-2014, 09:01 AM
 
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On further research, I found out that this is also mentioned on Wikipedia: Roth IRA - Wikipedia, the free encyclopedia and Bogleheads: Traditional versus Roth - Bogleheads

It's surprising how few people know about this.
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Old 03-11-2014, 09:10 AM
 
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but paying the taxes with money from outside the traditional like you do the roth will cut that difference down to almost no difference depending what you do with the tax money over the years.

unlike the roth , with the traditional you are still sitting on that after tax tax money you didn't pay up front.
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Old 03-11-2014, 09:51 AM
 
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Quote:
Originally Posted by mathjak107 View Post
but paying the taxes with money from outside the traditional like you do the roth will cut that difference down to almost no difference depending what you do with the tax money over the years.

unlike the roth , with the traditional you are still sitting on that after tax tax money you didn't pay up front.
Whatever you do with the tax money is not going to be tax-advantaged. This is precisely the reason for the existence of the retirement savings accounts: Roth/Traditional 401k/IRA.

Do you see what Iím talking about?

If not, letís do some math:
Letís assume that income tax is always 25%, and capital gains tax is 15%, and return is 10x.
Letís say, for the sake of round numbers, the contribution limit is 40k for both the Roth and the Traditional. And letís say we have 50k pre-tax, or 40k post-tax to invest.

You contribute everything, 40k post-tax to Roth. You end up with 400k.

I contribute 40k pre-tax to Traditional, and invest the other 10k pre-tax in a brokerage account. Iíll have to pay income tax on the 10k which reduces the investment to 8k. I end up with 400k*0.75+80k*0.85=368k.

The reason for the shortfall is that you pay tax twice on the 10k that I couldnít put in a retirement savings account.
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Old 03-11-2014, 10:33 AM
 
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it would be hard to play even steven with taxes. but then again different investments yield different gains. it is possible the taxable account would do better or worse.

the fairer comparison is roth vs 401k where you can equal amounts up.

Last edited by mathjak107; 03-11-2014 at 10:42 AM..
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Old 03-11-2014, 10:35 AM
 
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Well, if you can get tax advantages that match the IRA and the 401k, then go ahead. You won't even need to contribute to the IRA and the 401k just for the tax advantage.

The point of this discussion is the fact that the Roth allows a higher effective contribution limit than a Traditional. The retirement saving accounts are a tax-advantage saving and investment vehicle. Higher limit means more advantage. If you have other saving and investment vehicles that can make up for the shortfall, great, but that's kind of beside the point.
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Old 03-11-2014, 10:44 AM
 
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you may also pay more in taxes up front on the roth then later on with no pay checks,living in a lower tax state and the tax brackets allowing more through at lower rates on the deferred account.

you have advantages but then you have negatives taking away from that extra dough .
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Old 03-11-2014, 10:52 AM
 
2,409 posts, read 2,490,839 times
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Quote:
Originally Posted by mathjak107 View Post
you may also pay more in taxes up front on the roth then later on with no pay checks,living in a lower tax state and the tax brackets allowing more through at lower rates on the deferred account.

you have advantages but then you have negatives taking away from that extra dough .
What you say has to do with the Roth vs Traditional comparison in general. I'm not going to discuss other advantages or disadvantages of contributing to the Roth or the Traditional now because it will be off topic. There is another thread dedicated to that topic, so let's not beat the dead horse. This is not another "Is the Roth or the Traditional better?" thread. I created this thread for the sole purpose of pointing out one particular obvious advantage of the Roth that people overlook: the higher effective contribution limit.

Going back to the topic, do you agree that the Roth allows a higher effective contribution limit than the Traditional?
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