Further Nerdy Thoughts About That Tax Deduction

Okay, so you read the previous section and you see how a tax-deductible retirement account can give you tax-free growth, just like a Roth. In fact, if your tax bracket is lower in retirement, a tax-deductible retirement account can let you come out ahead at the taxman’s expense. Meanwhile, if your tax bracket in retirement is higher, you’ll be happy you funded a Roth.

But what if your tax bracket stays the same? All even? It depends. Go back and look at the previous section, where we assumed you were in the 25% tax bracket both when you funded the account and when you’re retired. Instead of putting $8,000 in your employer’s traditional 401(k), suppose you put $6,000 in the Roth 401(k). Your initial out-of-pocket cost would be the same in both instances and you would have the same after-tax sum in retirement. So, yes, it would be all even.

Now, imagine instead that you plan to max out your IRA. You have a choice: Put $5,500 in a tax-deductible IRA or $5,500 in a Roth. Either way, the account doubles in value between now and retirement, growing to $11,000. With the Roth, that will mean $11,000 in spending money.

With the tax-deductible IRA, you will owe taxes when you tap the account. If you’re in the 25% tax bracket, you would be looking at a $2,750 tax bill. Fortunately, you also had the initial tax deduction, which would have been worth $1,375 if you had been in the 25% tax bracket when you funded the account. In an effort to cover the eventual tax bill on your IRA, you decide to invest the $1,375 tax savings in the same investments that you own in your IRA, so the $1,375 also doubles in value. That way, it would grow to $2,750 and cover the final tax bill, right?

Wrong. The problem: The $1,375 would have to be invested in a regular taxable account, where its growth would be taxed and hence it wouldn’t grow to $2,750. That’s why, if you suspect your tax bracket will be the same in retirement as it is now, you should favor Roth accounts over traditional retirement accounts.

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