I have read countless times online (mainly through other blogs) that I should be maxing my Roth IRA out every year. When I was first introduced to the idea of a Roth IRA I thought it was an amazing deal, but I soon wised up.

Suppose you have $5,000 and can choose to make a contribution of $5,000 to your Roth IRA (after-tax) or your traditional 401k (pre-tax), which is better? It might the exact same. Roth IRA’s benefit can be calculated off of two factors:

1) What your current tax rate is for the contribution, and
2) What your expected marginal tax bracket will be when you retire

If you think about it, it really is basic math. Let’s assume the following tax brackets (fictional):

$0 – $35,000 = 15% Tax
$35,000 – $85,000 = 25% Tax
$85,000+ = 33% Tax

Again these are not real tax brackets, just to illustrate a point.

Back to the $5,000 you had to put into your Roth or traditional 401k. For this example we will assume that you receive an annual rate of return of 5% for 30 years. We will also assume you make $80,000 a year today and that when you retire you will have social society, a traditional 401k that you pull from, capital gains, interest earned, and/or pension, that equal to at least $35,000 but less than $85,000 annually, that are use for living expenses. Assume no inflation and the tax brackets above are constant.

Roth: $5,000 * 75% [Taxed on the Front End] = $3750 * 1.05^30 [Rate of Return of 5% for 30 years] = $16,207
401k: $5,000 * 1.05^30 [ROR of 5% for 30 years] = $21609.71 * 75% [Taxed on the Back End] = $16,207.

It’s the same thing folks.   So when do you benefit from a Roth? (Go to the next page)

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