Roth vs. Traditional Retirement Savings Tutorial
Many people have the option of saving for retirement using a Roth or a Traditional retirement savings plan. These plans may be called 401k, 403b, IRA, etc. The primary difference between the two types of plans is when taxes are paid. There are other differences that can be learned about in this article from Investopedia.
Since the arrival of the Roth IRA in 1997, there has been an ongoing debate as to which plan is better. Unfortunately, many people misunderstand taxation and believe they never have to pay taxes on Roth withdrawals. While this is true once the account is funded, it is not a fair comparison to a Traditional retirement savings plan, since taxes are paid before money enters the account. In this tutorial, we will build a model comparing the mathematics of each plan and the effect of taxes.
Begin by downloading the data workbook. Next, we enter tax rates and a starting savings amount. Once that data is entered we can calculate the annual account balances in both Roth and Traditional accounts. Follow the tutorial closely, as we have to account for paying taxes. In the Roth account, taxes are paid at the beginning (time 0), and taxes are paid at the end of 10 years in the Traditional plan.
Once the model is built, we will compare two scenarios:
- Earn a little today, and more in retirement.
- Earn a lot today, and less in retirement.
I used information from the IRS website to show the tax brackets for single and married taxpayers. One assumption in this analysis is that these tax brackets will remain fixed. However, history has told us that taxes can vary, as well as the tax code, which could later change, reduce, or eliminate benefits.
After analyzing both scenarios, you will have a better understanding of the difference between pre-tax savings and post-tax savings.
I hope you enjoy building this model!
