To Roth Or Not

When Margot and I finished the asset allocation I thought we were done.  Set up the accounts, do the automatic contribution twice a month and take out a bunch of money in 35 to 40 years.  Nothing to it.

But it seems I missed the part about the Roth 401k.  Missed it mainly because I didn't know it existed.  Actually I have never spent much time on Roth's because when I first started contributing to 401k's, Roth didn't exist.  Well, maybe he existed but Roth accounts did not.  Then when they did they only applied to IRAs and there was an income limitation which I exceeded so never paid much attention. 

Actually let's go back in time when even 401k's didn't exist.  Prior to that you had the pension system where you stayed and they paid.  The bad thing was that most pension plans only applied if you stayed with the company at least TEN years.  Leave one day (or get fired one day) before ten years of penal service and you got nothing.  NOTHING.  These plans were  called cliff plans because if you didn't stick around ten years your pension plan went off the cliff.  Most of the dreary news reports lately about the demise of the traditional pension plan conveniently leave this little factoid out of the story. 

So along came 401k's and they were a better deal.  Put in a dollar and the company usually matches something.  The second company I worked for had no pension plan but if you put in a dollar, they put in $2.12.  That added up in a hurry.  You always had your money and the company's money vested on a schedule so usually after five years you had all their money as well.  But don't contribute and you don't have any kind of retirement plan.

The good news is tax deferral until you take it out.  The bad news is when you take it out you pay ordinary income tax rates on the withdrawal. 

Which leads us to the Roth which is, of course, the opposite--pay tax now on the contribution but the earnings are forever tax free.  Unless Congress changes the tax law.  Don't think that will happen.  Even the Dems aren't stupid enough to try that I think...  Well, I guess it is a risk but life is a risk. 

Like I said, Roth's used to apply only to IRAs.  They were not available if you had a traditional 401k or if you made too much money. 

But then Congress changed the tax law to allow companies to offer Roth's in their retirement package.  I missed it but Margot didn't. 

Margot asked, "What should I do?"  My response, "You tell me."  "No, you tell me."  And so on. 

Time for some quick thinking.  Grasping for the rule of 72 I figured at 11% (the traditional return on US stocks) Margot would double her money every 6.5 years.  Assuming a working life of 40 years she would have at the end...a lot.  The exact number doesn't matter because I realized she would have a lot whether she put the money in a traditional IRA or a Roth.  THAT IS THE KEY.  EITHER WAY SHE WOULD HAVE A LOT BECAUSE SHE INVESTED. 

The only difference is the tax treatment.  I was always taught that tax deferral was gain and to be sought after since tax rates were always assumed to be higher in the future.  So I went for the traditional 401k.  Tax deferral plus it was the only game in town.

But now with the Roth 401k there was a choice and I had to go against my instincts because a lot of free cash building up over 40 years is pretty attractive. 

So back to the Rule of 72.  If Margot put in an after tax dollar and doubled her money every 6.5 years she would have  $6.15 dollars for her one dollar after forty years.  (Actually I think this analysis is all screwed up but I was on the phone and had to think fast so let's just go with it for the time being.)  Anyway she has $6.15 of which $5.15 is non taxable assuming a Roth.  Actually the whole thing is non taxable because she already paid the tax on the $1 of principal.

Under a traditional 401k the whole thing is taxable.  At ordinary tax rates.

So again I had to go against my training and my gut and recommend the Roth.  Margot, being a wise person like her mother, hedged her bet by putting 7% of her income into the Roth and 3% into the traditional 401k.

Somewhere there is some smart aleck with nothing better to do saying "This guy has it all wrong.  The numbers don't add up.  A traditional IRA is a much better deal because..." and so on.  Perhaps and guess what, I don't care. 

The important take away is not that one is better than the other.  The key lesson is that investing, no matter almost what kind of investing, is better than not investing.  If you are not investing for your future, do it now.  Traditional or Roth or whatever, get going.