Roth vs Traditional: Why All Retirement Accounts Aren’t Equal

When any discussion of personal finance turns to retirement savings, the focus often settles on a long-standing debate: traditional vs. Roth? You’re not alone if you’re unsure what this question is asking. Let’s start with some background.

A traditional retirement account, such as an IRA, 401(k), or 403(b), lets you save earnings tax-free now but requires you to pay taxes when you withdraw the money. In contrast, a Roth retirement account requires you to pay taxes on your earnings upfront, but you won’t owe any taxes on the investment earnings when you withdraw. Deciding whether to contribute to a traditional, Roth, or a mix of both accounts involves choosing 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 there’s no silver bullet—the best option depends on your circumstances. To answer the question, 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 approaches the tax rate during work, other factors 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, 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.

Access flexibility

Roth IRAs offer owners more flexibility to access funds before retirement without paying the penalty. Two significant opportunities are the ability to withdraw principal after five years and 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 affects your projected tax rate will influence your decision to contribute to a Roth or traditional retirement account. Here are some additional considerations to discuss with your advisor:

• Moving: If you plan to move from a high-tax state like California to a low- or no-tax state like Washington, pre-tax contributions to a traditional account may be more appealing.
• Diversification: Since it’s difficult to predict your future tax rate when you might need funds, or how much you’ll leave to heirs, it can be wise to contribute to both retirement accounts over time.
• Risk Tolerance: The best time to contribute to a Roth is often early in your career when earnings and taxes are typically lower. However, young savers may find it challenging to predict their future earnings and savings. Contributing to a Roth at this stage can be a gamble, so a more conservative approach might involve ensuring you have some taxable income in retirement before focusing on a Roth account.

Do you have questions specific to your situation? Please reach out to a Brighton Jones advisor today.