As someone who loves discussing finances, a misunderstanding about retirement accounts that I hear over and over is that, when deciding between a Roth or a Traditional retirement account, you should always choose the Roth account because (here it comes) “traditional accounts tax your gains and Roth’s don’t.”
Although the surface-level comment is technically true, the spirit of the advice is misleading at best. This common misconception stems from the way the accounts are income taxed.
How are Roth and Traditional accounts taxed?
Traditional retirement accounts are tax-deferred. This means that you are electing to defer (put off) the income taxes on that money until later. You will pay no income tax on that money now, it will grow without capital gains taxes in a retirement account, and then any money that you withdraw upon retirement will be subject to income tax when you remove it from the account.
Roth retirement accounts are funded with post-tax dollars. This is money that you already possess from your regular income, and therefore money that has been income taxed for the year in which you earned it. The money will be put in the Roth account, and no money in the Roth account is ever taxed again.
After hearing about how the two accounts are taxed, you may be inclined to believe the title statement and say: “The Roth never taxes my capital gains, while everything that comes out of the traditional is taxed, even the capital gains! The Roth is definitely better!”
There’s only one problem with that statement: Math
Let’s just break it down with numbers. For a simplistic hypothetical situation, we’ll take a one-time $100,000 investment that will grow at 8% annually for 40 years. We’ll assume an effective income tax rate of 10% on both accounts — of course, the Roth will be income taxed before investment, and the Traditional will be income taxed, along with all gains, upon distribution.
And there you have it. Both accounts have exactly the same amount of money after the income tax has been applied, regardless of if it happened before or after the growth.
How can this be true? It’s simple math, really. Percentages are found by multiplying. As I hope you remember from your math career, multiplication is commutative. This means you can do it in whatever order you want, and it doesn’t change the answer. So take a 10% tax first, or last; it doesn’t matter.
Well what if tax rates go up?? See some considerations in this post.
So then how do you decide which one to use?? That’s a topic for the next post: Should I Choose a Roth or Traditional Retirement Account?
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