One of the most important decisions you need to make is whether to put your retirement money into a Roth or a Traditional 401k. The decision is a personal one depending on your view on taxes. On the traditional 401k, you get a tax break now, but pay regular in tax rates when you withdrawal. On the Roth 401k, you don’t get a tax break now, but pay no tax when you withdrawal. Take a look at the comparison table below.
I’d personally rather pay the $25 now per $100 invested (Roth) than pay $400 later per $100 invested (Traditional).
The Roth has another advantage, no Required Minimum Distributions (RMD) in your lifetime. On the traditional 401k, you have to start taking RMD’s at 70 1/2. The government wants that tax revenue. In english, this means under the Roth, I never have to take any distributions in my lifetime. I can pass all of the money in the Roth to my kids tax free to them and they don’t pay taxes when they pull from my Roth. It is a huge consideration if you want to keep wealth in your family and not give it to the government. I know I do.
I have been putting money into the Roth since my company starting matching on the Roth in 2016 and will continue to do so. I stopped putting money into the traditional 401k altogether.
What is the ‘Rule Of 72’
The rule of 72 is a shortcut to estimate the number of years required to double your money at a given annual rate of return. The rule states that you divide the rate, expressed as a percentage, into 72:
Formula: Years required to double investment = 72 ÷ compound annual interest rate
Thanks for stopping by and hope the post has been helpful.
Think about the scenario like this, you start with $133.33. With traditional IRA you get the immediate tax break of current rate 25% so what would otherwise be $100 is $133.33 (100/.75). Meanwhile with the Roth the $133 is taxed at 25%, so it turns into $100 (133.33*.75). Now the rule of 72 applies the same to the Roth. But the traditional doubles over and over to total $2133 over the same period. Now hit it with the same 25% tax, and viola, total back down to $1600.
Basic logic of traditional vs Roth IRA is to use traditional if your current tax nracket is higher than uour expected btacket at withdraw. And roth now if you think your withdraw rate will be higher. No telling what the tax code will be when you retire is the tricky part.
Jade, Great point and I completely agree. What would happen if if used $18,000 for the example. I want to put $18,000 in the Roth. Agree with you on taxes being unknown in the future too.
I believe it would work like this:
Roth requires 24K earned to fund at 18K for the year at 25% tax rate (24*.75). That 18K doubles 4 times over 40 years to total 288K tax free withdraw.
IRA takes that same 24K earned, 18K goes into IRA and doubles
four times over the 40 year period to also equal 288K. That is now taxed at 25% resulting in 216K. The remaining 6K (24K earned – 18K into IRA) is taxed at 25% and invested into a non-tax sheltered account. That 4.5K (6K*.75) doubles 4 times over the period totaling 72K. The 216K from IRA and 72K from traditional account total 288K. BUT the 72K will be taxed at long term investing rate, which is currently 15% if you are in the 25% tax bracket. So total now becomes 277.2K instead of 288K.
I hadn’t needed to consider the maximum 18K annual investment yet in my life. Thanks for enlightening me!
You’re welcome. Thanks for the detailed response. Love it! The math makes total sense to me. Great example.