Traditional vs Roth: Social Media Saturday

This week, I mentioned on a Facebook post that Traditional retirements accounts are often a great choice even though most people recommend Roth. The person I was speaking to asked me to follow up with why Traditional could be better. Today’s Social Media Saturday is my answer to that question.

With Social Media Saturday posts, I basically copy everything exactly as I originally wrote it other than formatting. Because of that, you may be left wondering about something not covered in the post that may have been covered in the original discussion. If that’s the case, leave a comment or ask me for more details on social media! I’m on Facebook and Twitter.

Please note that on this particular question, I was talking to another officer whose income I have a general idea of. For a different person, I would have used different numbers and examples. If you read this post and think “that’s not what my situation is like at all!” that’s why. But if you’d like, I’m happy to talk to you about your specific situation.

Okay, so, Traditional vs Roth. Everything I’m about to write is about Traditional vs Roth TSP and does not translate directly to Traditional vs Roth IRA. That’s because both types of TSP accounts are identical except for the tax treatment, whereas with IRAs the Roth IRA has a few features that are not available at all on a Traditional IRA. This isn’t answering whether you should prioritize TSP over IRA, which is a different topic.

Roth vs Traditional

Very, very basically speaking, Roth is recommended the most frequently because it’s incredibly simple. You put in money after you’ve paid taxes, then it grows tax free and can be withdrawn tax free. If your account balance says $1000, you can withdraw $1000 and have $1000 to spend. That’s easy for people to understand because they don’t have to think about tax implications. This is a pro in favor of Roth TSP.

If nothing else, it’s never wrong to use a Roth account. It might not be the most perfectly optimized choice, but it’s simple and easy to understand and gets you some tax benefit. So if you don’t want to think about it too hard, you can go with Roth and be fine.

Additionally, lots of people recommend Roth because there is an assumption that taxes will be higher in the future. This is a FALSE PRO about Roths. Nobody actually knows. Do I think taxes will be higher in the future? I think *tax brackets* will go up in the future. Probably not much, at least within our lifetimes and for our income levels. And (this is super important) I recognize there is a difference between tax rates/brackets going up, and MY taxes going up. I can’t control tax brackets but I do have some level of control over the taxes I pay. So while most people say this is a pro for Roth TSP, I say “you can’t actually know that until the future arrives.”

What I do know for sure is that

1. most people have a lower income once they retire than when they are working (duh)
2. I am currently near the peak of my income years

So even if *tax rates* rise, I will be dropping into a lower bracket once I retire…as will most people.

Tax Talk

Speaking of taxes, when you use a Roth account you are locking in your tax rate right now. It comes off the top of your income, so whatever bracket you are in, that’s how much you are paying on your Roth contributions.

As an example (to make this simple, these are fake numbers) let’s say you have a taxable income of $100,000 and are in the 25% bracket. If you put $7500 into a Roth TSP, it actually cost you $10,000 to do that. That’s because you had to pay 25% taxes on the money before you had it leftover to add to TSP ($10,000 – 25% = $7500).

That in and of itself is not inherently a pro or con, because you don’t know what your future tax rate will be. But what you do know for sure is that by using a Roth, you are locking in taxes at whatever your highest tax rate is. Specifically, you are paying your MARGINAL TAX RATE (25% or $2500 in this example).

If you instead used a Traditional account, you could put the whole $10,000 in. Then when it came time to withdraw, you would pay the EFFECTIVE TAX RATE. With effective tax rates, you might be in the 25% bracket but your actual cost to withdraw that money might be, say, 20% because effective tax rates are a blend of all the brackets you are in, not just the top one. Effective tax rates are at the very most equal to your marginal tax rate but in reality are always lower (I’ve yet to see an exception).

Comparing Roth and Traditional

So let’s do a super simple comparison. Both start with $10,000.

Roth: taxes reduce the contribution to $7500. The money doubles every 10 years, and you leave the money in the account for 30 years. At the end you have $60,000 ($7500 x 2 x 2 x 2 = $60,000). You can withdraw $60,000 tax free. Simple, right? You only paid $2500 in taxes.

This is where people who don’t like to do math usually stop. Paying only $2500 on $60,000 of income sounds dope, right?

Traditional: no taxes so you contribute the entire $10,000. The money doubles every 10 years, and you leave the money in the account for 30 years. At the end you have $80,000 ($10,000 x 2 x 2 x 2 = $80,000). But you have to pay taxes. Specifically, in our example, 20% effective taxes. $80,000 – 20% taxes = $64,000, the IRS gets $16,000 in paid taxes.

OH NOES, YOU PAID SO MUCH IN TAXES!! But wait.

Roth walking away money: $60,000
Traditional walking away money: $64,000

THIS IS THE THING

You know how people are always raving about Roths because “you pay less in taxes!” Well, they are forgetting that by putting more in up front, you end up with more in the account. So yeah, with the Roth you “paid less taxes.” You paid $2500 in taxes using a Roth instead of $16,000 using Traditional.

But that’s because they aren’t thinking about how that extra $2500 would’ve grown in the account and then only been charged effective tax rates instead of marginal tax rates.

Me? I’d rather have more money in my pocket at the end of the 30 years and not care that on paper it appears I’ve paid more to the IRS. I care about how *MY* pockets look when it comes time to actually withdraw my money and Traditional accounts mathematically usually beat Roths. WHO KNEW??

Other Considerations

Another thing – people especially love to tell military members that their taxes are stupid low and therefore Roths are best. That may be true early in a career or when deployed. But this myth that military members typically pay no taxes needs to die. I’m in the 24% bracket, for crying out loud! And yeah that’s because I’m an O-5, but it’s not like I’m the only one. Most officers are at least in the 22% bracket unless they have a stay-at-home spouse and a few kids. Enlisted members are likely firmly ensconced in the 12% bracket, which is nice but not 0%.

And again, compare to retirement tax brackets. If you are in the 22% bracket now, you are likely to be in the 12% bracket in retirement unless you build up incredible income streams (which maybe is your goal, I don’t know). So why not lock in 22% savings now and pay 12% (at worst) later? Or lock in 12% savings now and pay (at worst) 10% later? Instead people are paying 22% now with the Roth so they can save 12% later. It gets a little goofy when you think about it.

Here’s another Roth con – you don’t know what will happen in the future. Maybe they’ll keep Roth laws as they currently are (I suspect they will). But maybe they’ll say “nope, you need to pay taxes on that amount.” So you are risking that tax laws won’t change before it comes time to withdraw. And here’s the irony – people who always recommend Roth tend to do it because they are convinced taxes will go up, but they never consider that the tax laws for Roth withdrawals could go up. Weird, right? You are betting that taxes will go up while…also betting that taxes won’t go up.

WHAT??

With Traditional accounts, you are locking in the tax benefit now. So even if tax laws do change, you’ve already captured a known benefit. They aren’t going to come back and retroactively have you pay those taxes. But taxing Roth withdrawals 30 years in the future? That’s an awfully juicy looking target to a politician needing to fund their pet projects. This isn’t me being irrational – this has been brought up in Congress a few times already.

So, yeah. Roth is great, but Traditional is the secret powerhouse nobody really bothers to do the math about.

Additional Thoughts

Note: my feelings about Roth vs Traditional totally change when deployed to a combat zone, so that’s a whole ‘nother discussion.

Second note: nothing I’ve said above should be construed as definitive advice on what’s right for anybody else. The whole thing is, it totally depends on your individual income, tax filing status, tax brackets, and goals for the year. And it should be reassessed every year! It changes!! That’s why Roth is the simple answer and a good answer, but not necessarily the optimized answer.

Third note: there’s also some advanced strategies to save even more on taxes by funding Traditional accounts while working, then converting them into Roth accounts later. But that’s again a whole ‘nother discussion.

Final Notes

I’m not a financial advisor or financial professional and I’m definitely not your financial advisor. Do your due diligence. I’m happy to answer questions but each of you is responsible for making your own decisions about how you will invest.

To see what I’ve previously written on this topic, check out this post which was one of my very first!