It has been declared by the Harvard Business School that Roth IRAs are the clear winner over traditional IRAs, but it’s probably not for the reasons you might guess. For some time now, I have also believed that Roth IRAs are better — but for a different reason altogether.
Before we jump into the study, let’s look at how these two powerful retirement tools work. With a Roth IRA, your money is taxed when you make your contribution, allowing you to withdraw your money tax-free. With a traditional IRA, taxes are deferred until you withdraw your money. So, looking strictly at the numbers, which is better?
Mathematically, they are identical.
If we were to compare a $10,000 one-time contribution in a Roth vs. a traditional IRA, with both invested at 10% interest for 30 years, looking strictly at the numbers, they would each be worth $148,000. (The Roth would be taxed at 25% at the time of contribution, and the traditional would be taxed at 25% at the time of withdrawal.)
Yet, I would argue that this is not realistically how it works. Many people who opt for the Roth IRA invest the full $10,000, paying the $2,500 in taxes out of pocket instead of taking the taxes out of the contribution. This means that the full $10,000 (instead of $7,500) grows tax-free. That single action would increase the Roth’s final cumulative total to $198,000, making a Roth IRA the clear winner with 33% more accumulated wealth.
Remember, this is a one-time investment example. If you were to multiply the investment by 30 or 40 years-worth of contributions, the difference would be enormous.
As it so happens, this is essentially what the Harvard Business School study concluded as well. (The study was based on 10,000 employees across a variety of industries who invested in either a Roth or a traditional 401(k), but the results translate just as well to IRAs.)
They first realized that people generally use rules of thumb when dealing with the complex tax system and when investing. Some rules of thumb for retirement saving include contributing the amount necessary to maximize employer matching, making the maximum contribution allowed, or saving 10% of pre-tax income.
The Harvard Business School study found that people who invest in Roth 401(k)s use the same rules of thumb as those who invest in traditional 401(k)s. Since the same amount would be going into both the Roth and the traditional IRA, but since the Roth is tax-free at the end, individuals who kept their rules of thumb in a Roth saved even more and had greater purchasing power in retirement than traditional 401(k) savers. Click here to read the Wall Street Journal article online.
Those are the numbers and facts as to why Roth is the clear winner, but I still believe there is one even more important reason to go with a Roth. Since we are human beings, not calculators, our emotional well-being trumps all else. Not one of us invests without being emotionally involved. Despite the fact that I am a self-proclaimed “spreadsheet king,” in order to move forward with any of my investments, I have to feel good about them.
This is where the Roth is the clear winner for the greatest reason of all: peace of mind. You can sleep better at night knowing that, in the end, your money can be withdrawn tax-free. End of story.
No one knows what the future holds, especially since all our elected officials seem to have swallowed a crazy pill. But at least the Roth gives you some measure of certainty in this ever-changing world.