Joe and Suzy make $56,000 per year household income ($4,667 per month)
Following Dave Ramsey’s baby steps, once Joe and Suzy are debt free other than their home mortgage and have 3-6 months emergency fund saved, they are ready to invest 15% towards retirement. They will invest $8,400 per year. Over 30 years, their total contribution to the retirement account is $252,000.
Using a Traditional IRA or by making pre-tax contributions to their company-sponsored 401K, Joe and Suzy can defer paying taxes on the $8,400 per year IRA contributions. At a tax rate of 20%, the total taxes they would defer over 30 years are $50,400. At 8% growth rate, their retirement account would grow to $951,549 which would all be subject to taxes when the money is withdrawn. At 20%, their taxes would be: $190,316.
In a Roth IRA or Roth 401K, Joe and Suzy would pay 20% taxes on $8,400 more income per year for a total of $50,400 over 30 years. At 8%, their retirement account would grow to $951,549, of which None is subject to taxes.
The Roth option provides more and more advantage to Joe and Suzy as the rate of growth on their investments increases. Further, if their tax rate increases over time, the Roth option provides more benefit when compared to the Traditional IRA.
Alternatively, as the rate of return on Joe and Suzy’s investments decreases, it lessens the advantage of the Roth IRA/Roth 401Kover the Traditional IRA/401K. This is also true if Joe and Suzy’s tax rate goes down over time, as the favor would beshifted toward the Traditional IRA option which defers tax payments on both contributions and earnings.
Keep in mind in the above example, Joe and Susy would pay almost 4 times as much in taxes using a Traditional IRA/401K than they would if they saved using a Roth IRA/Roth 401K.
