What does Roth mean?
Roth is actually the name of a former United States Senator from Delaware. But you aren’t wondering whose name it was – you want to know why this word matters to you. Usually you hear this word around investments, or retirement or something, right? Let’s take some of the mystery out of the word “Roth.”
Roth is a word used in conjunction with retirement. So when you hear Roth, think “retirement savings.” In this case, Roth is a tax umbrella. It keeps taxes away from your retirement savings once it has been deposited.
Secondly, your Roth vehicle is an account. It’s a place where you keep and invest money. It can be at a bank. It can be with your employer. It can be with an investment broker. A Roth account will come in 2 flavors that you are likely to encounter. The first is a Roth IRA (Individual Retirement Arrangement). This is an account that is fully under your control with a bank or broker holding the account. The second is likely your employer’s Roth 401(k) option. It’s your money, your employer holds it, and you get to invest in funds that they make available to you.
Now that we’ve established the context of where you will see “Roth” (tax advantaged retirement savings), we can talk about what the advantage is, and why it is important.
You can invest in nearly anything under this tax advantaged umbrella. But we can get into that later. Let’s proceed with the discussion assuming that you want to take reasonable calculated risk. You want to invest in Mutual Funds that contain stocks traded here in the United States. We’ll assume you are not creative and invest in an S&P 500 Index fund that historically returns about 9% on average.
Assumptions for calculation:
- 9% return like the S&P 500
- Starting at age 23
- Starting with no large initial deposit
- Saving 15% of your $50k income, your first job out of college ($625 per month)
- You have extremely low aspirations and you don’t ever get a raise and try to increase contributions
Now let’s look at your results if you used a Traditional 401(k) or a Traditional IRA. In this scenario, you will be paying taxes on all withdrawals from this account (that’s when you are old and using the money). The value of your account at age 65 will be $3,455,127.90. If tax laws stay the same (huge assumption – trust me, I understand), then you will be paying taxes on the withdrawals like regular income – likely about 25%. So the effective value of the money you will actually own is $2,591,345.93.
Now let’s look at your results if you used a Roth 401(k) or Roth IRA. In this scenario, there are no taxes on the money you withdrawal from the account. Why? Because in this vehicle, you get no tax benefit on deposits. You pay taxes on the money you deposit. This is how you manage to get tax free distributions (tax free when you’re old!). Therefore, in fairness, I will presume you still only deposit $625 per month, and your taxes (15%) come out of that amount, for a net deposit of $531.25. I would suggest sucking it up, paying the taxes AND depositing the $625, but our purpose here is to compare apples to apples, not fight about how much to save for retirement. The value of the account at age 65 will be $2,936,858.52.
The difference? Apples to apples – the Roth allows you to own and take home 13% more.
Now what about that scenario where you suck it up and pay the taxes and still sock away the $625 per month? Your value is the same as the traditional account’s gross value – $3,455,127.90 – except you get to take all of it home. That’s an increased value of 18% over the Roth 401(k) that you funded only $531.25. Cool, right?
When you hear that you have an option for Roth, you should get excited. Every time you hear it, your heart rate should increase, and you should get sweaty palms, and you should have a smile on your face. And let’s be real, with the country in massive debt and tax rates more likely to rise than to fall, this tax umbrella shields you from future changes. Additionally, the larger your income (and higher your tax rate), the bigger this Roth advantage becomes! Lastly, the Roth IRA limits your contributions at 5,500 per year, or $6,500 if you’re over 50 (per spouse). However Roth 401(k) contributions are subject to much higher thresholds ($18,000 or $24,000 if over age 50), so there are plenty of Roth vehicles to sock away money.
Both types of investment accounts are good. Traditional and Roth both have tax advantages that are better than investing without any umbrella. So don’t fret if your employer doesn’t offer a Roth, do all the investing you can. Because you won’t have anything for retirement unless you save something.