There are several considerations when determining whether a Roth IRA, 401(k) or 403(b) is better than a traditional retirement vehicle, such as the traditional IRA.
The first is based on income tax rates when the contributions are made as compared to the rates upon distribution. If the income tax rates are the same at contribution and distribution, then the Roth and non-Roth products are economic equivalents.
If, however, the applicable income tax rates are higher at the time of contribution, when the contributed amount is subject to income tax for a Roth, then the traditional retirement vehicle is economically superior.
Alternatively, if the applicable income tax rates are lower at the time of contribution, then the Roth retirement vehicle is economically superior.
As an example, say that $15,500 is contributed to a traditional 401(k) and grows at 5% for 10 years, producing a value of $25,248. If that amount is distributed to the participant and tax is triggered at 35%, the participant will be left with $16,411 after-tax.
By comparison, if the participant allocates the same $15,500 to a Roth 401(k), tax will be paid up front and, assuming the same 35% tax rate, the participant will have $10,075 left in the account. If the $10,075 earns the same 5% as assumed for the traditional 401(k), the account will grow to $16,411 after 10 years.
The result, then, for both the traditional and Roth 401(k) is the same: $16,411 of after-tax funds after 10 years.
But what if tax rates are higher when the distribution is made from the traditional 401(k)?
Assuming the above facts are the same but that the marginal tax rate applicable to the 401(k) distribution has increased to 45%, then the $25,248 of pre-tax 401(k) dollars is only worth $13,886 after 10 years. That is significantly less than the $16,411 the Roth 401(k) provides on an after-tax basis.
The above income tax rate analysis leads to a question: Will income tax rates likely be lower or higher in the future? While it is difficult to make any prediction about future legislation, federal income tax rates appear to be at a historic low. (The top marginal federal income tax rates have fluctuated over time, but were in the 50-92% range from 1946-1986. From 1986-2002, the top marginal income tax rates have ranged from 28-39.6%. The current top marginal rate, as of early 2007, is 35%.)