If you’re saving for your retirement in a 401(k), 403(b) or an IRA, you’ve probably seen that you can choose Traditional or Roth for your account. What does that mean, and which is better for you?
Very simply, a retirement account described as “Roth” is one where you pay taxes on the invested money before it goes into your savings. In contrast, with a “Traditional” account you are saving your dollars tax-free, but you’ll owe taxes when you take a distribution during retirement.
At first glance, that might make “Traditional” seem like the better choice for everyone. After all, if you don’t pay taxes up front, then you’ll be investing a higher percentage of your earned dollars right into your retirement savings. More savings is always better, right?
Not necessarily. More after-tax income during retirement is better, but that may not always be the result of more total dollars saved initially.
If you’re still working, and you’re in the later years of your working career, the odds are good that you’re in a higher tax bracket now than you will be after you retire. Assuming, of course, that tax brackets and percentages don’t change – which they sometimes do.
That’s also assuming that you haven’t saved so much that your income during your retirement years is going to be higher than it has been while you’re working. If you did, you are a rare person, indeed.
If that describes you, and you paid the taxes up-front with a Roth account, you’d be paying a higher percentage in taxes than you would if you waited and paid the taxes after retirement with a Traditional account.
On the other hand, if you’re in the first couple of decades of your working life, you’re likely in a lower tax bracket now than you will be after you retire (i.e. you’re earning less now because you’re just getting started, so to speak). If that’s so, it might be better to pay the lower taxes now (using a Roth account) instead of paying higher taxes later (using a Traditional retirement account).
Another difference between Traditional and Roth if you’re only looking at IRAs is that you can deduct your contributions to a Traditional IRA (up to the maximum allowed) in the year you make the contribution – when you may be in a higher tax bracket and need more deductions. With a Roth IRA, you can’t deduct the contributions in the year you make them, but your withdrawals aren’t taxed when you take them during retirement (that’s if it’s your own Roth IRA – if you’ve inherited it, you’ll be subject to taxes).
If you need to make early withdrawals from your retirement IRA to meet some unexpected expense, the Roth IRA allows you more flexibility without penalties. You can withdraw from the contributions you made into a Roth IRA (not the earnings it has generated, only the original amount you’ve contributed) with no penalty and no extra taxes. If you are 59 ½ years or older, you can withdraw whatever you want from a Roth IRA, as long as it’s been open for at least 5 years. With a Traditional IRA, it’s more difficult to withdraw anything early without owing a 10% penalty plus extra taxes to the I.R.S.
Suppose you want to work past 70 ½ years of age. You can’t make additional contributions into a Traditional IRA at that point, but you can keep making contributions to your Roth IRA at any age, as long as you meet the income requirements.
Your income doesn’t limit how much you can contribute into a Traditional IRA each year, but it does for a Roth IRA. In fact, people with higher incomes don’t just have limits – some aren’t eligible to contribute to a Roth IRA at all.
What’s best for you also depends on what happens with tax rates and tax brackets in the future, and all anyone can do is make an educated guess about that. If tax rates increase, as they tend to do over time, the Roth accounts look even better. But if taxes drop (yes, that does happen occasionally), you might benefit more from having saved in a Traditional retirement account.
It’s not quite the clear and obvious answer it seems to be at first. It depends upon your personal situation, both now and after retirement.
And then there are the other considerations.
For example, there are Required Minimum Distributions (RMDs) to consider. If you have your retirement savings in a Traditional or Roth 401(k) or in a Traditional IRA, the federal government requires that you withdraw a certain percentage of your retirement savings each year beginning at age 70 ½. If you don’t, you get hit with a tax penalty.
But Roth IRAs aren’t subject to RMDs. And that can help you to minimize your tax burden during your retirement years.
For example, say you’re 71 years old and you have your retirement savings in both a Traditional 401(k) and a Roth IRA. You might want to get the bulk of your income from disbursements coming out of your 401(k). After all, it has RMDs, and the government forces you to take a certain amount out each year. But then you might choose to get the rest of the income you need for that year’s expenses from your Roth IRA (since you can take as little or as much out of the Roth IRA as you wish, with no tax penalty even if you don’t need or want to take anything out that year).
Or suppose you’re 71 and you have your retirement in both types of 401(k) – Traditional and Roth. You can’t avoid RMDs (since they apply to both types of 401(k)), but you’ve already paid taxes on the Roth account. That means you might be able to keep yourself in a lower tax bracket by carefully withdrawing just-so-much from each account. You wouldn’t have that kind of flexibility if everything you saved was in a Traditional 401(k).
For many people, some combination of Roth and Traditional savings may work best.
Traditional vs Roth, or both – it can get complicated, and the best answer for one person might not be best for someone else. That’s one reason it can be helpful to visit with a professional financial planner.
The team at Montini&Co spend their days helping people navigate all the choices they need to make to get the most out of their retirement savings. Contact us today to ask about a free initial visit. If it seems like they’re a good match for you, they’ll review your current and expected finances, discuss your goals for retirement, then help you to develop a written plan to guide you as you navigate to your retirement.
Roth vs Traditional, 401(k) vs IRA – Montini&Co’s goal is to use whatever financial tools seem to fit best to help you to make the most of your retirement years and minimize any tax burden on you and your heirs.