Should You Use a Roth or Traditional Retirement Account?
Retirement accounts are powerful savings tools. Whether it’s an IRA, 401(k), or 403(b), they can help you minimize the impact of taxes and get the most out of your savings.
But you have a choice to make.
There are (basically) two types of retirement accounts: traditional and Roth. The difference between these two accounts comes down to how they allow you to minimize your tax burden.
Traditional accounts allow you to deduct your contributions from your current income, but you have to pay income taxes on anything you take out in retirement. Since you’re pushing the taxes off until retirement, these are often called tax-deferred accounts.
Roth accounts are essentially the reverse. You put in after-tax money, so you don’t get the deduction on your current income, but you don’t owe anything when you withdraw that money in retirement. Once the money is in your Roth account, it’s tax free (and there are a couple other benefits we’ll talk about later). These are often called tax-exempt accounts.
Both options are really good deals, so how do you pick? Well, as usual, it comes down to your specific situation.
What Will Your Tax Rate Be In Retirement?
The most important factor to consider when weighing a Roth vs. a traditional retirement account is whether you expect your tax rate to be higher in retirement than it is now. Since you’re basically deciding whether you want to pay your taxes now or in retirement, you should use the account that will allow you to pay the lower rate.
If you think your taxes will go up in retirement – either because you’ll have more income in retirement than you do now (reasonably likely if you are a younger saver), or you just think tax rates will rise in the future – then a Roth account can make sense. If you think your taxes are higher now than they will be in retirement, then you should consider a traditional account.
But this doesn’t need to be a one-time decision. As your situation changes, you can pick and choose which account you put your money into.
If you have a year where you have lower taxable income – say you decide to make a big charitable donation – then you can take advantage of your lower tax rate (assuming you drop into a lower tax bracket) and contribute to a Roth account.
It works the other way, as well. If you have a really good year at work and end up in a higher tax bracket, you can contribute to a traditional retirement account to reduce your current tax burden.
This is an active decision that you get to change whenever you want – at least with the new money you’re saving. While this should be the biggest factor in your decision, there are other things to consider.
Managing Your RMDs
When you have money in a traditional retirement account, the IRS wants to make sure they get paid, so you have to take required minimum distributions (RMDs) starting in the year you turn 72.
Roth accounts aren’t subject to RMDs since the money has already been taxed, so the IRS is perfectly happy if you want to let it sit there and (hopefully) keep compounding. If you’ve used Roth accounts, you’ll be able to be more flexible with your retirement income.
While certain techniques can help you manage your RMDs (for instance Roth Conversions and asset location), if the money is in a traditional retirement account, you can’t avoid them. And if you’ve been diligently saving everything into traditional retirement accounts throughout your career, you may be looking at the possibility of large RMDs, which means big tax bills.
While this does not necessarily mean you should switch over to saving in Roth accounts, it does mean you should take a close look at the situation.
Laws Change
One of the other things to consider is that laws change over time. What Congress gives, it can take away.
Traditional accounts have immediate benefits (deductible contributions), but Roth accounts bank on a future benefit (no taxes upon withdrawal). The tax exemption for Roth accounts may look different thirty years from now, or it could even be nonexistent.
Deciding between Roth and traditional retirement accounts is an important choice. They both give you big tax benefits but in different ways.
The decision really comes down to whether you expect your taxes to go up or down in retirement. If you think they’ll go up, consider a Roth account. If you think they’ll go down (or stay basically the same), look to traditional accounts.
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