You’ve just been given a $1000 bonus and you want to save it for retirement. What’s the best place to put it? The difference is in the tax treatment. First, let’s take a look at what happens if you put it in a standard investment. Say your current tax bracket is 25%, but you figure it will be only 15% in retirement. Suppose you expect to get 8% on your investment.
Here’s what happens.
First you need to pay taxes on the bonus, which leaves you with only $750 to invest. Each year the investment pays dividends, which are then taxable. When you finally retire in 20 years your $1000 bonus has grown to $2424, even after paying all the taxes. Not bad.
Let’s see if you can do better using a Roth IRA.
With a Roth you still need to pay taxes on the income before you can invest it, but then it grows tax-free and there are no taxes due when you withdraw it.
You end up with more than $1000 extra due to the tax savings.
Now what about a standard IRA or a 401(k)? The tax treatment is the same for either one: You don’t need to pay taxes on the bonus if you put it directly into the account, but you pay taxes on everything you draw out in retirement. Here’s how that turns out.
Here’s the Roth or std IRA spreadsheet used for this comparison. Try some different numbers and see what happens. You can change any of the numbers in blue.
If you play around with it a while, you’ll probably notice that
- The standard IRA is better if you expect to be in a lower tax bracket in retirement. People generally expect to downsize in retirement, so this may be a reasonable assumption. This is also the case if you have Roths or other funds that may be tapped without taxes.
- The Roth is better if you expect to be earning more in retirement. This may be true if you are early in your career, expect to be earning more in later years, and are saving well for retirement.
- If you expect to maintain the same standard of living in retirement, then it makes no difference whether you choose the standard or the Roth IRA. You may want to have a mix, to give you more flexibility in tax planning during retirement.
- Standard investments are never as good as tax-advantaged plans. The exception, by the way, is if you have a standard investment whose growth comes in the form of capital gains, but that’s a subject for another analysis.