Traditional IRA and 401k versus Roth IRA and Roth 401(k) plan contributions
Many taxpayers puzzle over whether to contribute to traditional versus Roth tax-advantaged retirement plans. For most people, contributions to traditional tax-advantaged plans will probably provide a higher net present value over their lifetimes.
Given our tax-related software modeling capabilities, The Skilled Investor has some observations regarding contributions to traditional versus Roth tax-advantaged retirement accounts.*
1) When all significant personal financial factors are modeled, most individuals would find that contributions to “traditional” IRAs and 401Ks have a higher personal net present value, when compared to the alternative of contributing to a Roth IRA or to the relatively new “designated” Roth 401k plans. This statement is based on an analysis of typical pre-retirement and post retirement income levels, tax rates, asset returns, and a myriad of other factors. As a simplification of an excessively complex issue, traditional wins over Roth for the average taxpayer most of the time. The net present value comparison tends not to be very close.
2) The financial advantage of traditional versus Roth accounts can vary over a lifetime depending upon one’s asset allocation and the assumptions used for the asset class risk premiums that future markets might pay. All of this is unpredictable. However, statement #1 above is based upon 70-year average asset class returns and still holds true with variance modeling above and below these long-term historical returns averages.
3) Statement #1 above also assumes that tax rates and limits will remain constant over time. This is not likely to be true. However, our present tax structure would need to change very significantly to alter the current economic preference for contributions to traditional over Roth accounts for the typical person.
The confounding problem that Americans face is that our government has significantly over-promised Social Security, Medicare, and government employee retirement program benefits. These over-promises will probably hit hardest those who currently are a long way from retirement. Benefits will be reduced and/or taxes with increase. Politics will determine who pays more taxes or receives fewer benefits. Either way, there will be no free money available. More taxes would mean less personal net income from which to save for those are subject to increased taxation. This would make it harder to make retirement contributions. Lower future benefits would mean needing to save more before retirement and/or having to consume less in retirement.
Our government representatives [...]