April 17, 2012

The Massive Advantage of the Roth IRA Over the 401k

Flight attendants.
As many of you know, there was a movement a few weeks ago started by Jeff Rose from Good Financial Cents where nearly 150 bloggers took part in The Roth IRA Movement.  Nearly all of them wrote posts for their own respective blogs on the benefits and advantages of investing within a Roth IRA.  One post really stood out to me though, because this particular blogger actually opposes the Roth IRA.  Sam’s post over at Financial Samurai discusses what he believes are the Disadvantages of the Roth IRA.  To my surprise, many of the comments on his post even agree with him.  Many of those commenters are all over the map with their complicated calculations and future income and tax presumptions.  The purpose of this post will be to lay out some simple math to show you exactly why the Roth IRA absolutely makes sense.


To illustrate my point, I will make up a hypothetical situation.  (Haven’t done one of these in awhile)  As with all hypotheticals, assumptions will have to be made.  In order to keep it as simple as possible, we are going to ignore inflation.  Pretend that inflation simply no longer exists.  (Wouldn’t that be nice?)  Also, we will assume that the people in my example are American and are taxed at ordinary U.S. tax rates.  Furthermore, we have to assume that tax laws and rates will stay the same for the duration of time as laid out in this hypothetical example.  Also, (for simple sake) we are going to ignore any other tax deductions that could have an affect on adjusted gross income.  Here goes...


The Story
Samantha and Madison both become flight attendants for the same major airline.  At age 25 they have very similar life situations.  Both are married and plan to work until retirement.  Both are aware of the state of Social Security in the U.S. and know the importance of saving their own funds for retirement.


They both understand mutual fund investing and the power of compound interest.  They are good friends and they talk about this stuff on occasion.  They decide to invest in the exact same funds.  Their only difference in opinion is in which investment vehicle to invest through.  Samantha refuses to pay the government taxes up front in order to invest in a Roth IRA, so she sticks with the company 401k plan.  Madison prefers to take advantage of the tax free growth within a Roth IRA, so she pays her taxes up front and does just that.  Here is a basic look at their numbers on a yearly basis:


Samantha
Madison
Annual Income
$50,000
$50,000
401k Contribution
$5,000
0
Adjusted Gross Income
$45,000
$50,000
Annual Taxes Paid
$6,750
$7,500
Roth IRA Contribution
0
$5,000


Some Numbers
This example assumes a current and future tax rate of 15%.  As you can see on the yearly numbers, Samantha pays $750 less in taxes each year than does Madison.  They both put exactly $5,000 into their investment accounts.  Madison simply has $750 less to put into her household budget.  This works out to $62.50 per month or $14.42 per week.

The Story Continues
Samantha and Madison continued to work together for the same airline for their entire careers.  They monitored and compared their retirement savings from time to time over the years.  Just as planned, their balances were pretty much dead even.  Samantha loved to brag about the wonderful tax savings she was taking advantage of by investing through her 401k.  Madison would just smile and think to herself how she would be bragging later.

By age 65, 40 years later, Samantha and Madison are quite pleased with their results.  They were able to yield average annual investment returns of 10%!  They decide to retire.  Their life situations are still very similar.  Both have their home mortgages paid off and both of their kids have already completed college.  $50,000 per year is more than enough for them to live off, but they want to live it up during retirement.  They both agree that $50,000 per year is what they will need to cover their planned living and travel expenses.

Samantha understands that she now has to pay taxes on the money she withdraws.  But, who cares!  Look at her balance!  Samantha needs to withdraw $58,823 to come out with $50,000 after paying 15% in taxes.  Madison already paid her taxes before the money was put into investments.  Her entire balance, including all of the growth, is sitting there tax free!  She only needs to withdraw $50,000 per year.  Here is a look at their numbers after 40 years:

Samantha
Madison
Total Taxes Paid
$270,000
$300,000
401k Balance
$2,657,000
0
Roth IRA Balance
0
$2,657,000
Annual Withdrawal
$58,823
$50,000
Annual Taxes Paid
$8,823
0


Commentary
Over their 40 year working lifetime, Madison paid $30,000 more in upfront taxes.  Divide that by the $8,823 that Samantha now needs to pay in taxes annually, and you get approximately 3.4 years that it will take for Madison to break even with her friend.  From that point forward, Madison will come out ahead.  She will be making tax free withdrawals while her friend Samantha will be paying taxes for the rest of her life.


The Famous 'Singapore Girl'

The End of The Story
20 years into retirement, at the ripe old age of 85, a twist of irony takes the life of both Samantha and Madison as they die together in a plane crash.  Before takeoff, they were sitting in first class reminiscing about their days as flight attendants.  They couldn’t help but make fun of, while at the same time admire, the costumes that the Singapore Airlines flight attendants were wearing.  More importantly, they got to talking about their retirement funding.  They got out a calculator and did some simple calculations.


Samantha multiplied her yearly withdrawal amount, $58,823 by 20, to find out that she has taken out $1,176,460.  After she paid her 15% tax bill, she has spent a cool $1 million in retirement.  Madison has spent the same cool $1 million, but she hasn’t paid any taxes on her retirement income.

Suddenly a light bulb goes on in Samantha’s head.  Looking at the numbers, she finally sees the light.  She has now paid more than $176,000 in taxes during retirement, when she saved only $30,000 up front by taking the tax deferred savings.  She decides to do another quick calculation.  Recalling that her total retirement contributions were $200,000 and they grew to $2,657,000, she now takes 15% of the total amount just out of curiosity.  If she were to withdraw her entire retirement savings in one lump sum, she would have to pay nearly $400,000 in taxes.  Meanwhile, Madison get to keep her entire balance completely tax free.

Samantha never thought that the power of compound interest would have such a great affect on her 401k balance.  After seeing for herself that the bulk of her balance was from growth over time, she finally understood the tax advantages of a Roth IRA.  All of the growth is completely tax free within a Roth IRA.  Madison sits next to her friend on the plane and quietly thinks to herself, I told ya so!  Samantha flicks herself on the forehead, curses, then vows to start a blog as soon as they get home from this trip.  She plans to blog about the power of compound interest combined with the tax advantages of the Roth IRA.  She wants as few people as possible to make the same mistake that she did.  Too bad she is about to die in a fiery plane crash.

Fortunately, I was able to get inside Samantha’s head before she died (because I made her up).  I was able to tell her story for her, because I have the foresight.

I would like to add that investment rate of return doesn’t really matter that much in this example, as far as taxes are concerned.  Even if they only earned 7% on their investments, they still would have ended up with balances over $1 million.  Their withdrawal amounts would be the same and the tax implications would be the same.  There would just be less growth.

Conclusion
There are three situations that I can think of where it may not make sense to pay taxes up front in order to invest in a Roth IRA.
  1. You are going to die early and not be able to take advantage of the tax-free growth.
  2. Your investments suck and you earn crappy returns that don’t even keep up with inflation.
  3. Tax laws change

None of these three reasons can be accurately predicted.  The one you have the most control over is your investments.  Do your due diligence, learn about investments and choose wisely.  Tax laws are what they are.  Nobody knows how or if they are going to change in the future.  The only way we can plan is to go by what current laws are.  And death.  Everybody knows that they are going to die, but nobody knows when.  For this reason, we can only plan according to life expectancy averages.  Most people, on average, are going to live well into their 80’s.

My advice is obvious.  Invest in a Roth IRA.  Try to choose the best possible investments within your Roth IRA in order to maximize the power of compound interest.  Make healthy lifestyle choices that will help to ensure that you live long enough to enjoy your savings.  Vote for politicians who aren’t going to screw up this wonderful tax advantage.

For those of you who aren’t going to invest in a Roth IRA, my advice is exactly the opposite.  Choose crappy investments in order to minimize what would have been massive tax savings.  Vote for politicians who will screw up the tax advantages of the Roth IRA.  And lastly, make unhealthy lifestyle choices such as smoking cigarettes, to help ensure that you won’t live long into your golden years.

Did this story help shed some light for you on the tax advantages of the Roth IRA?  Do you agree or disagree with my assumptions or calculations?
 

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