Creating a disciplined retirement savings plan is one of your greatest tools for building wealth on the road to financial independence, with compound interest on your side. Retirement accounts are available in two popular flavors – Traditional and Roth – ‘simply’ identifying the tax characteristics. Having multiple options can make saving for retirement more complicated, but understanding the important advantages and disadvantages of each can help you make educated decisions and substantially improve your long-term financial journey. Financial planning is ‘more art than science’ and there is no definitive answer for going one way or another, but let’s study the road map before arriving at our retirement destinations.
Whether you choose to contribute to retirement accounts through an employer plan (401k, 403b, 457b) and/or individual retirement accounts (IRA), all of the investment earnings (growth and income) are tax-deferred (not taxable along the way) until the money is finally withdrawn.
You may be given the following contribution options when opening your retirement accounts:
- Traditional (Pre-Tax): Contributions are made with dollars that have not yet been subject to income taxes, effectively reducing taxable income in the year of deposit. All earnings within the account grow tax-deferred, but all future distributions are taxable as ordinary income. There are no income limits to deduct contributions made to work retirement plans (401k, etc.), but traditional IRA deductibility is subject to income thresholds – depending on your filing status and retirement plan coverage.
We view traditional retirement accounts as assets, but the IRS sees them instead as income that has not yet been taxed. All withdrawals are fully taxable, including your original contributions and account earnings, and the government wants a bite!
- Roth (After-Tax): Contributions are made with dollars that were already subjected to income taxes. All earnings within the account grow tax-deferred, then all distributions may be withdrawn tax-free. There are no income limits to contribute to a Roth 401(k), Roth 403(b), or Roth 457(b), but there are income thresholds to contribute to a Roth IRA.
Roth retirement accounts are no longer of interest to the government, since they received the income taxes in the years of contribution. As long as you meet the qualified distribution rules, the withdrawals are all yours. If you want to know more about Roth IRAs and their specific rules, here is a concise yet comprehensive summary.
So – which one do I choose? Should I pay the taxes now or later?
Contributing to a traditional retirement account receives a tax benefit this year, reducing your current taxable income and effective tax rate. This can be beneficial if your last dollar of taxable income falls within the higher federal tax brackets (24%, 32%, 35%, 37%).
A side note: Discretionary employer contributions always go into the traditional bucket, since they are not taxable to you in the current year.
Contributing to a Roth retirement account receives no tax benefits today, but your future withdrawals can be received tax-free, reducing your taxable income and effective tax rates in retirement. This can be beneficial if your last dollar of taxable income falls within the lower federal tax brackets (10%, 12%, 22%).
Most people stop here and you may be tempted to base this decision solely on what your tax rate is this year and what you expect it to be when taking distributions, but I urge you to challenge your assumptions and consider the benefits and unintended consequences of each route, as listed below. Also keep in mind that you don’t have to go 100% in one direction, and you can take detours along the way; tax location is a balancing act!
- Your taxable income is reduced in the year of contribution, saving you money right away.
- Your taxable income and effective tax rates may be lower in retirement, especially if your lifestyle expenses are reduced.
- Future tax legislation may reduce overall tax rates in the year you distribute this income in retirement.
- Traditional account assets can later be converted to Roth when income is lower, particularly if you expect to have gap years between retirement and when you begin to receive other recurring taxable income (Social Security, pensions, or required minimum distributions).
- Deductible retirement plan contributions may lower your current income enough to make you eligible for other opportunities, such as health insurance subsidies or financial aid.
- You can gift traditional IRA assets directly to charity without incurring taxes once you reach age 70 1/2. These are called Qualified Charitable Distributions (QCDs).
- You may contribute while living in a state with state income tax, then distribute the assets while living in a state with lower or no state income tax.
- Every dollar that is distributed in retirement is fully taxable, subject to ordinary tax rates.
- Your taxable income and effective tax rates may be higher in retirement, based on your future lifestyle and major unplanned expenses (health care, travel, large purchases). Your expenses are likely to fluctuate during the go-go, slow-go, and no-go stages of retirement.
- Future tax legislation may increase overall tax rates in the year you distribute income in retirement.
- Distributions are added to taxable income, and may increase Social Security taxation and Medicare Part A + D premium surcharges by thousands of dollars in your 60s and beyond.
- Required minimum distributions (RMDs) begin at age 72, forcing you to withdraw taxable income each year even if you don’t need the money to cover living expenses. The mandatory withdrawal percentage increases each year, and can become a heavy tax burden.
- Traditional retirement accounts must be fully withdrawn by non-spouse beneficiaries within 10 years of inheritance (based on current legislation). Large pre-tax accounts can cause an unexpected tax burden for heirs.
- Surviving widow(er)s may be subject to higher tax rates and Medicare premium surcharges if high levels of pre-tax income continue to be received when filing single. Don’t miss this!
- All withdrawals can be received completely tax-free, including the earnings if you properly follow the qualified distribution rules.
- Contributions to Roth IRAs may be withdrawn at any time for any reason without taxes or penalties. This is not recommended since your Roth accounts have the greatest potential for tax-free growth, but it is still an option.
- Your taxable income can be reduced in retirement if you strategically withdraw from your Roth and after-tax brokerage accounts, particularly if you incur large, unexpected expenses.
- Reducing your taxable income in retirement may open up eligibility for other opportunities, such as health insurance subsidies, financial aid, and even 0% income tax (if income is below the standard deduction amount).
- Since Roth distributions do not count toward taxable income, you may be able to strategically reduce Social Security taxation and Medicare premiums in retirement.
- Inherited Roth assets can be withdrawn completely tax-free if meeting the distribution rules, eliminating the tax burden to heirs.
- Roth IRAs do not have required minimum distributions (RMDs)!
- Your contributions are not tax-deductible, thus your current taxable income is not reduced.
- If you elect to contribute to Roth instead of traditional in your employer’s retirement plan, your net paycheck will be reduced due to tax withholding.
- Your taxable income and effective tax rates may be lower in retirement than in the years of original contribution – an opportunity cost.
- Future tax legislation may change or remove the favorable tax-free characteristics of Roth accounts. This is out of our control, but I wouldn’t focus heavily on this.
- Direct contributions to Roth IRAs have income limitations and open up backdoor Roth contributions – subject to pro-rata rules that may cause additional taxation. It is best to consult a tax professional to ensure accurate reporting.
- Roth IRA distributions could incur a 10% penalty if withdrawing earnings before meeting the qualified distribution rules.
- Having no traditional accounts or taxable income in retirement can limit your ability to take advantage of “tax-free” taxable income – the effective 0% tax rate up to the standard deduction amount. Wow.
I hope these comparisons help you think more critically about your long-term retirement savings plan. Although there seem to be only two options on the surface, there are endless possibilities for the balance of taxation, cash flow, and investments during the accumulation (saving for retirement) and decumulation (spending in retirement) stages. As the site suggests, it is important to ‘measure twice’ before making financial moves. I highly recommend that you consult a fiduciary financial planner in your area if you need assistance with your financial plan, not limited to the ‘Traditional vs. Roth’ decision.