Roth IRA

Why Pick a Roth IRA?

In the real world, all else is rarely equal. Two wrinkles can give a Roth the edge. The first stems from the fact that Congress set the same contribution limits for Roths as for regular 401(k)s and IRAs, and that nuance means you can effectively shelter a larger sum from taxes in a Roth.

Think of it this way. If you’re in the 28% bracket, contributing $15,500 in after-tax dollars to a Roth is the equivalent of socking away $21,528 in pretax dollars in a regular 401(k) because you’ll have to pay taxes eventually on the regular plan’s withdrawals. But you can’t put that much in a 401(k). To match the Roth, you’d have to put $15,500 in a your regular 401(k) and then invest the remaining $6,028 outside the plan. You’d owe income taxes on that $6,028, which leaves you with $4,340 in a taxable account (where taxes will drag down your returns).

The combined after-tax value of your 401(k) and taxable account would be smaller than the Roth’s tax-free balance.

One warning: If you switch your $15,500 from a regular 401(k) to a Roth 401(k), every other week your paycheck will be $167 smaller (at a 28% tax rate) because of lost tax savings.

The second wrinkle is changing tax rates. This example assumes that you’ll be in the same tax bracket when you retire as you are today. But if your rate is higher in retirement, a Roth becomes an even better deal because you paid taxes at today’s relatively low rate. If you fall into a lower tax bracket, paying taxes later would likely win out.

How is a Roth IRA Different?

Think of a Roth as the mirror image of a regular IRA or 401(k): Instead of collecting a tax benefit up front, you get your break at the back end. When you fund a traditional IRA, you can take an immediate tax deduction on your contributions, but you then pay income taxes when you pull your money out. When you open a Roth IRA you’re not entitled to a deduction, but you can withdraw all your money, including earnings, tax-free. The Roth 401(k) works the same way.

Mathematically, there’s no difference between getting a tax break at the beginning or end. All else being equal, you end up in the same place whether you pay taxes at the outset or in retirement.