User:Jacotus/Value of Roth vs taxable

It can be helpful to quantify the value of investing in a Roth account versus a taxable account. While it is intuitively clear that a dollar in a Roth account is more valuable than a dollar in a taxable account, quantifying the benefit can be complex. Examples are useful to illustrate the magnitude of the difference.

This applies to the standard Roth IRA, direct Roth IRA, Roth 401k, or Mega Backdoor Roth IRA. This page, for example, can help answer the question "How should I value my 401(k) plan's option to use the Mega Backdoor Roth?"

Overall, the result depends strongly on individual taxation circumstances, assumptions on return, and the time period. The longer the investment period, the greater the value of the Roth.

This spreadsheet can be used to quantify the value of the Roth. Google Spreadsheet for Roth vs. Taxable

Example
Consider a specific example comparing $25,000 placed either into a taxable account or in Roth (via the Mega Backdoor Roth). Assume the following:
 * An investment today of $25,000, with an investment time frame of 30 years. After 30 years, the shares in the taxable account are sold.
 * The investment's total return rate is 7% per year, 1.5% of which is in the form of qualified dividends
 * During the 30 year time frame, the federal qualified dividends tax rate is 15% and NIIT is applicable with a 3.8% tax rate
 * The state income tax rate is 9.3%
 * After 30 years, when selling the shares in the taxable account, the federal capital gains rate is 15% and NIIT does not apply. The state income tax rate is 9.3%.

Results
After 30 years, the $25,000 in a Roth account has grown to $190k.

In a taxable account, the initial $25,000 has grown to $169k prior to realizing capital gains. After realizing the gains and paying taxes, the final value is $140k. The difference between the Roth and taxable account is $50k.

The $50k benefit of using the Roth account instead of taxable is measured 30 years from now. How should that be measured in terms of value today? One way to answer this is to determine how much additional money would be needed to invest in taxable to produce $50k after tax. In this case, one needs to invest an additional $9k today.

That is, $34k invested today in taxable will produce $190k after tax, which is the same result as $25k invested today in Roth.

Since one invests using after-tax dollars, the additional $9k needed for taxable requires more than $9k in salary. If one's marginal income tax rate is 41.3%, one needs an additional $15k in salary to have $9k after tax.

To conclude, for the specific set of assumptions used here, one might say that "The value of the Mega Backdoor Roth (used at 25k per year) is comparable to an additional $15,000 of salary without the Mega Backdoor Roth."

Comments

 * Even if one never realizes capital gains in the taxable account, due to either donating shares to charity or passing the shares on to heirs at a stepped up basis, the Roth is still more valuable, albeit at a lesser extent. That is because the taxable account still suffers from tax drag on dividends.