Conventional wisdom says that Roth IRA and Roth 401(k) accounts make the most sense for younger investors, because they have the greatest likelihood of facing higher tax rates in retirement. As a result, they’re thought to be better off paying taxes now (since contributions to Roth accounts are made with after-tax dollars, but withdrawals are tax-free) than in the future. This is in contrast to a traditional IRA or 401(k), where they would receive an upfront tax deduction for their contribution, but pay income tax on future withdrawals.
At first glance, contributing the same amount to a Roth or a regular 401(k) will get the same result. For example, if you contribute $5,000 of pre-tax income to a regular 401(k) that earns a 7% annual return, you will have $38,061 before tax in 30 years. After paying tax at a 28% rate, you will net $27,404. This is the same amount you would accumulate in a Roth after paying a 28% upfront tax on $5,000 of pre-tax income and investing the remaining $3,600 at 7% for 30 years.
But research completed earlier this year by mutual fund company T. Rowe Price shows that the Roth accounts may benefit older workers, too.
First, While the IRS’s rules allow you to put $23,000 before taxes into a regular 401(k), you can put as much as $23,000 after taxes into a Roth 401(k). As a result, while for someone in the 28% tax bracket the IRS effectively has a claim on 28% of a $23,000 contribution to a regular 401(k), it has no claim on any of the $23,000 of after-tax money that goes into a Roth. Roth money grows tax-free, provided the account owner has the account for at least five years and is 59 1/2 or older when he starts withdrawals. This allows someone in the 28% bracket to effectively put 28% more in a Roth.
Roth accounts also offer greater tax flexibility, since taking withdrawals for expected or unexpected expenses – like new cars, weddings or home repairs – don’t have the effect of increasing your taxable income and potentially subjecting you to a higher tax bracket or higher Medicare premiums.
The Wall Street Journal published an article on the T. Rowe Price research on June 22, 2014. You can read the entire article here.