Thursday, December 28, 2006

Roth Vs Tax-deferred Retirement Savings

Even before blogging became popular, Humberto Cruz has been writing on personal finance in his Savings Game column syndicated in many newspapers. He pointed out in a recent column that if you're in the same tax bracket now as you will be in retirement, there's really no tax advantage between saving in a Roth IRA and a Traditional IRA. For example, someone in a 15% tax bracket would have the same money remaining after paying taxes later-on at a 15% rate on $1000 + compounded earnings as he would paying $150 in taxes on $1000 now and collecting the remaining $850 plus the compounded earnings tax free from a Roth IRA account.

All other things being equal, I agree completely with this. The analysis is absolutely correct. However, the Roth allows you to effectively put more money in tax-advantaged savings. Provided you can come up with the money to pay the taxes this year, then instead of contributing your limit to a Traditional IRA, contributing the same amount to a Roth IRA would let you pull the higher amount plus compounded earnings out tax free in retirement.

However, the tax code is complicated and there are other considerations. So "all other things" are not always equal. While you could be in the same tax bracket in retirement, you might effectively be in a higher tax bracket.

In future posts I will be discussing the possibility of a higher effective tax bracket in retirement and how I am dealing with it.