Which of the below options sounds best to you?
- You invest $750 for 30 years, then pay taxes on the profit
- You invest $750 for 30 years and pay no taxes on the profit
- You invest $1000 for 30 years and pay taxes on the profit
Numbers two and three both sound a lot better than number one, don’t they? If you’ve spent much time on investment matters, you probably know exactly what I’m talking about here: option three is a 401(k), option two is a Roth IRA, and option one is just investing your money outside of any tax-preferred vehicle. We assume that you set aside $1000 to invest, but in the first two cases you first pay $250 of it in taxes. In case three, you’re investing with pre-tax dollars, so at the end you pay taxes both on the profit and on the original $1000.
So how does that work out? Let’s suppose you’re making a modest 6% return on your investment, and just for simplicity we’ll say you’re still in the 25% bracket when you retire. (We’re ignoring the difference between regular income and capital gains, etc, largely because nobody knows what the tax code will say in 30 years, and to make it easier). In the first case, your investment will grow to $4307.62, but then you’ll pay 25% on the profits, which brings this down to $3418.22. With the Roth, you get to keep the whole $4307.62. With the 401(k), it grows to $5,743.49, which drops to $4307.62 after taxes – exactly the same as you got with the Roth!
Does this mean that it doesn’t matter whether you use a Roth IRA or a 401(k) to invest? Of course not. Above we made the assumption that you’ll be in the same tax bracket when you retire as you are now, which most likely won’t be the case. Of course, it’s a great idea to max out both investments, as they’re both far superior to investing outside of a retirement account, or (even worse) not investing at all.