When do you benefit from a Roth then?
1) You are in a lower tax bracket at the time of making the contribution than at the time of withdrawal during retirement (pay smaller taxes today to avoid larger taxes at retirement)
You make $35,000 a year and put $5,000 into your Roth at a rate of only 15%. You career gets better through out your life and you end up making more and contributing towards retirement. Upon retirement your yearly retirement benefits (all forms) are greater than $35,000 and less than $85,000. If you would have put that $5,000 into a traditional 401k and taken the money now at retirement – it would have been taxed at 25% (your current margin tax rate), but luckily you avoided that 25% tax rate by paying 15% upfront. You saved 10%.
2) You are able to use Roth later to keep your other retirement income from social society, traditional 401k withdrawals, capital gains, interest earned, and/or pension from “spilling-over” into the higher tax brackets.
During your time in the workforce you contributed to your Roth at 25% tax. Your annual retirement benefit is $85,000 a year. If you would have done a traditional 401k, it now would have been taxed at 33% (new tax bracket). You saved 8%.
3) You make the assumption that tax rates are going up and tax rates increase by the time you retire.
Taxes at time of retirement:
$0 – $35,000 = 18% (+3%) Tax
$35,000 – $85,000 = 28% (+3%) Tax
$85,000+ = 35% (+2%) Tax
You would have been taxed at 28% today, but you prepaid it at 25%. You benefited from a Roth. You saved 3%.
When are you harmed from a Roth then?
1) You assume tax rates are going up, but they go down.
Taxes at time of retirement:
$0 – $35,000 = 12% (-3%) Tax
$35,000 – $85,000 = 22% (-3%) Tax
$85,000+ = 30% (-3%) Tax=
You prepaid 25%, but now they are 22%. You lost because of your Roth. You lost 3%.
2) You make a Roth Contribution at a higher rate, but during retirement you fall into lower brackets.
You contributed to your Roth at 33% Tax rate (because your income was $85,000+) but upon retirement you are only getting roughly $60,000 worth of yearly income? Well you would have been taxed only 25% if you would have just put into a traditional 401(k). You lost because of your Roth. You lost 8%.
It’s hard to predict the future, but it is good to have a basic understanding of this concept. People who claim Roth IRA’s are free money only “because the returns are not taxed upon withdrawal”, need to go back to school for some basic math lessons. If I give you $10 and say I want half of the $10 and whatever you earn on it at a later point versus give you $5 and let you keep the returns, it will result in the same thing.
10 * 2 [You double your money] = 20 * 50% = $10
5 * 2 [You double your money] = $10.
Just something to consider.
Disclaimer: Always consult a financial professional for advise about retirement. This example is to show how the math can work for or against you ONLY. This site does not offer any specific retirement advice or planning.