By David Born, CFP®
When any discussion of personal finance turns to retirement savings, the focus often settles on a long-standing debate: should you contribute to a traditional or Roth retirement account? If you’re not sure what this question is asking, you’re not alone. Let’s start with some background.
- A traditional retirement account (i.e., IRA, 401k, 403(b)) allows you to save earnings without paying taxes now, but pay taxes when you take the money out.
- A Roth retirement account works in the opposite way—you have to pay taxes on your earnings now, but you never have to pay taxes on the investment earnings in the account.
- The choice between contributing to a traditional, Roth, or a balance between the two is a choice between tax savings now or in the future.
The traditional vs. Roth retirement account question has grown more popular as more employers now offer Roth contribution options.
You’ve probably already guessed that there’s no silver bullet—the best option depends on your circumstances. To answer the question for you, you must consider your financial situation and what it means for your current and expected tax rate. One—or arguably the only—goal of using a retirement account is to minimize your lifetime (or multi-generational) taxes and maximize the amount of your after-tax cash.
Career Tax Rates vs. Retirement Tax Rates
For most folks, a traditional retirement account is the best way to minimize taxes. That’s because a person’s retirement income, including distributions from traditional accounts, is typically less than income during their career. Since retirement income is lower, the tax rate on that income is typically lower, too. As the tax rate in retirement starts to approach the tax rate during work, other factors start to play a greater role.
Max Contribution Limits
The Thai saying “same, same but different” is often used to sell knock-off products that look the same, but aren’t as valuable as the real thing. In that vein, if you contribute $1 in a traditional account and $1 in a Roth account, they look like the same amount. But when you withdraw them, you must pay taxes on the traditional dollar, but not the Roth dollar. That means the after-tax contribution limit is higher for Roth accounts because the nominal max contribution limits are the same. You can effectively save more after-tax dollars in a Roth account by having prepaid the taxes.
Roth IRAs offer owners more flexibility to access funds before retirement without paying the penalty. Two significant opportunities are being able to withdraw your principal after five years and being able to withdraw principal and earnings after five years so long as money is withdrawn in equal periodic installments.
Other factors that influence your tax rate
Essentially anything that impacts your projected tax rate will influence your decision on contributing to a Roth or traditional retirement account. Here are some additional considerations to discuss with your advisor:
- Moving: If you’re planning on moving from a high-tax state like California to a low- or no-tax state like Washington, that’s going to make pre-tax money more appealing.
- Diversification: It’s hard to be sure what tax rate you’ll be in, when you might need money, or how much you’ll have to leave to heirs. That’s why it can make sense to contribute to both types of retirement accounts over time.
- Risk Tolerance: The best time to put money into a Roth is often at the beginning of a career when most people have lower earnings and lower taxes. It’s hard for a young saver to judge how their career will shake out, and whether they’ll earn and save enough for a Roth to be the best choice. Using a Roth at this point often requires a roll of the dice—the conservative approach is often to make sure you’ll have some taxable income in retirement before saving in a Roth account.
Do you have questions specific to your situation? Please reach out to a Brighton Jones advisor today.
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