I often hear people claim that one of the key advantages of a Roth account over a Traditional retirement account is the tax-free growth and compounding. I am trying to wrap my head around what this benefit really means because, assuming your tax bracket stays the same between contribution and withdrawal, the final amount you withdraw in retirement seems to be the same.
For example, if I invest $100 today in a Traditional account and it grows 10x to $1,000, with a 25% marginal tax rate, I’ll end up with $750 after taxes.
On the other hand, if I invest $100 in a Roth account, I first pay the 25% tax, leaving me with $75 to contribute. That $75 grows 10x to $750, which I can withdraw tax-free.
I know there are other differences between Roth and Traditional accounts, but I am specifically asking about the commonly mentioned “tax-free growth” advantage. The math seems to show that you don’t end up with more money just because the account grows tax-free. So, what exactly is meant by this benefit?
How so? There is no capital gains tax on Roth IRAs. If you bought $6k worth of Apple stock early in your career in a Roth IRA, and it’s now worth $250k, you can withdraw the $244k in earnings without paying any taxes. It is a great benefit.
Calculate your math using your actual tax (net) rate after deductions. Even with the standard deduction, your rate should be below 25%. Additionally, you need to consider your adjusted gross income from a pre-tax contribution, which will also reduce your tax obligation.
When withdrawing from a traditional IRA, you pay ordinary income tax on the amount you withdraw, not capital gains tax. This means you will be taxed at your current income tax rate on the entire withdrawal, which could be higher than the capital gains tax rate you might have paid if the funds were invested in a taxable account. Since you don’t have a traditional IRA, it’s understandable if you’re less familiar with this.