Is Tax-Free Always Better Than Tax-Deferred? 

There is an old saying that a bird in the hand is better than two in the bush.  I think about that when talking about Roth strategies because the old adage still applies, in many instances.  To put it in similar context, paying taxes today is better than paying taxes in the future – under the right circumstances.

The Roth account is a fairly new one - it was established by law on January 1, 1998 and remains a mystery to many people.  Nonetheless, the premise is quite simple.  You contribute money to the account and it grows tax-free until you take distributions. As long as you take distributions for a qualified reason - mainly retirement - you pay no income taxes upon distribution.  

Obviously that sounds too good to be true right.  In reality, tax-free growth is only good in certain circumstances.  Let's think about this a different way.  What would happen if I offered you $10,000 or $8,500 and that amount doubles in value at some point in the future - which one would you take?  In other words, the $10,000 now becomes $20,000 and the $8,500 now becomes $17,000.   You probably still want the $20,000 don't you?  

What if the $20,000 was in a 401(k) and your tax rate was 30% (meaning you get to keep 70% of the value after paying taxes)?  Now your $20,000 is only worth $14,000.  If the $17,000 is in a Roth account - meaning distributions are income tax free - then it is still worth $17,000 after taking the distribution.  In other words, in this instance taking $8,500 was better than taking $10,000 even after both doubled in value.  

Obviously, if your tax rate was only 10% then the $20,000 is still $18,000 after taxes (you get to keep 90%) and you would rather have $18,000 than $17,000, right?  If so, then taking the $10,000 was better than taking the $8,500 even after paying taxes in the future.

How do I know which is better?

With that bit of information, you can start to put together the picture of what makes a Roth account more successful than a traditional IRA or 401k.  Understanding your future tax rate can help you make an informed decision.  But that is only half of the picture because you need to know your current tax rate too.  

In essence, you are given $10,000 (though most of us earn it) every so often through work and you have decisions to make with that money. You can spend it (the popular American choice) or you can save it.  If you save it, the money can go into a savings account, a pre-tax account (IRA or 401k), or a Roth account.  There are valid reasons to save to a savings account but we are going to disregard that today and just focus on the decision to save it into a pre-tax account or a Roth account.  

If you choose to save $10,000 into a pre-tax 401k then the full $10,000 goes into the account – remember you pay taxes when it is distributed, not when it is contributed.  If you choose to save it into a Roth 401k then you have to pay taxes first – I know the persistent them of taxes is a real downer.  

If you are in the 15% tax bracket, then you can only contribute $8,500, not the full $10,000 (this is simplified for our discussion today).  The money grows over time and eventually you start taking distributions to support expenses in retirement.  The tax rate at which it goes into and comes out of the account determines the optimum way to save the money.  Ideally, you would contribute to a Roth account if your marginal tax rate is low today and expected to be high when taking distributions.  Alternatively, you would contribute to a traditional pre-tax account today if your marginal tax rate is high today and expected to be lower when you start taking distributions.  

Assume that you earn $10,000 and can contribute it to either a Roth account or a traditional account, your current tax rate is 25%, and you take a distribution when the account doubles in value.  This would mean that you can contribute $10,000 to a pre-tax account or $7,500 to a Roth account.  Which is better?

Future Tax Rate	15%	25%	39%
Roth Account Value	$15,000	$15,000	$15,000
Pre-Tax Account Value	$17,000	$15,000	$12,200

So the general principle is pay taxes when you know they are going to be the lowest. 

In other words, the bird in the hand is paying taxes today rather than in the future.  You know what you get today but the future is an unknown to all of us.  With that being said, Roth contributions still don’t make sense for everyone and should be used only in the right situations.