On the path to financial independence (FI), a retirement savings plan is one of the most powerful tools for building wealth, with compound interest on your side. Retirement accounts are available in two popular flavors, traditional and Roth. These words simply indicate the tax treatment of the account’s contributions and distributions.
Although having multiple contribution options makes retirement planning more complicated, we will explore the advantages and disadvantages of each so you can make well-informed decisions in alignment with your unique opportunities and desired outcomes. You may continue your current retirement savings strategy, but you will have greater clarity and confidence when you understand the what, how, and why to support your decisions. Let’s study the road map before moving in either direction.
Whether you choose to contribute to retirement accounts through an employer-sponsored plan, such as a 401(k), 403(b), 457(b), or an individual retirement arrangement (IRA), the investment earnings within the account are tax-deferred (not taxable along the way) until the funds are withdrawn.
You may be offered the following contribution options for each of your retirement accounts:
Traditional (Pre-Tax): Contributions are made with income that is either excluded or deducted from taxable income, effectively reducing taxes owed in the year of deposit. There are no income limits when making pre-tax contributions to employer-sponsored retirement plans, but the deductibility of IRA contributions is subject to income thresholds, depending on your tax filing status and family’s access to employer-sponsored plans. The earnings within traditional retirement accounts grow tax-deferred, but future distributions are taxable as ordinary income.
We view traditional retirement accounts as assets on the balance sheet, but the IRS sees them as income that has not yet been taxed. The withdrawals are fully taxable, including your original contributions and the account earnings that compounded along the way.
Roth (After-Tax): Contributions are made with dollars included in taxable income. All earnings within the account grow tax-deferred, then all distributions may be withdrawn tax-free if qualified distribution rules are met. There are no income limits to contribute to a Roth employer-sponsored retirement plan, but there are income thresholds to contribute to a Roth IRA directly. If you want to learn more about Roth IRAs and their specific contribution and distribution rules, here is a comprehensive article.
As mentioned, traditional retirement account contributions receive a tax benefit in the current year, reducing taxable income and taxes owed. On the other hand, Roth contributions receive no tax benefits today, but future withdrawals may be received tax-free, reducing taxable income in retirement.
Side Note: Even if you contribute to a Roth retirement plan at work, any employer matching or non-elective contributions are still recorded as traditional contributions since they are deducted by the employer and not taxable to you in the current year. We see a Roth 401(k) as one big pot, but the IRS is waiting in the wings for the pre-tax portion, including earnings on those amounts. If you contribute to Roth as an employee, the employer portion may provide a balance between pre-tax and tax-free growth.
Although you may be tempted to base your contribution decisions solely on your current tax rate vs. your anticipated tax rate in retirement, I encourage you to consider the various benefits and unintended consequences of each route, as listed below.
I hope the advantages and disadvantages of both contribution options help you think more critically about your personal savings strategy. As with dozens of financial decisions, there is no rule of thumb or definitively right answer for choosing traditional or Roth on the path to retirement.
Review your balance between pre-tax, taxable, and tax-free accounts each year. Viewing each account individually then understanding them together as a total portfolio can provide insightful opportunities to align your money with your unique retirement objectives.
“Traditional vs. Roth” goes beyond tax rates. Be careful not to make contributions solely based on your current marginal tax rate, even if your taxable income falls within the lowest 10% or 12% tax brackets. As shown below, the 12% marginal tax bracket for a married couple filing jointly starts at an adjusted gross income (AGI) of $46,451, but the 12% effective tax rate doesn’t appear until AGI of $144,640. It could make sense for a family with lower income while working to contribute to traditional 401(k)s if expecting to derive retirement income solely from account distributions. Likewise, I have seen instances where it is rational for high-income families to contribute to Roth, anticipating significant pension income and RMDs in traditional retirement.
Although there seem to be only two options on the surface, there are endless possibilities for balancing taxation, cash flow, and investments during the accumulation (saving for retirement) and decumulation (spending in retirement) stages. You do not have to go full speed in one direction, and you can take detours along the way. “Plan” is a verb, not just a noun!
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