Tuesday, June 16, 2009

Why Traditional 401k wins, assuming same tax rate

One of my friends asked me to explain why the Traditional 401k wins over the Roth 401k in more detail assuming the tax rates are the same as when they retire. Lets assume an individual makes $50,000 today, this means he is taxed at an average tax rate of 11.9% (Federal Income only) but is in the 25% tax bracket. Lets say the same individual puts away $2500 dollars.

This means that his average tax rate dropped to 11.21%, also his take away income only dropped $1875. Now lets say we assume he retires as the financial experts say with 80% of todays income, or 40,000. When he re walks the system his tax rate has dropped even again to 9.45% of his income coming out of the 401k, and he has even dropped to the 15% bracket.

In the case of the Roth 401k you are always at a tax rate of 11.9%. This means when you assume that taxes will go up in the future (comparing the Roth to the Traditional) you must also assume the tax rates will go up enough in the future to cancel out this effect. Since I don't see the marginal tax system in the country going any where I am going to assume that odds are you are going to find that it will probably stay the same or even get better unless you are in the top 2%.

Source for Tax Calculations: http://www.dinkytown.net/java/TaxMargin.html

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