Roth vs. Traditional - what do I choose?

Retirement accounts can be a powerful tool for building wealth. Plans such as a 403(b), 401(k), 457(b), or an individual retirement arrangement (IRA), are all examples of retirement savings plans. Retirement accounts are available in two varieties, traditional and Roth. Both accounts allow you to save for retirement, but the rules (especially tax treatment) are different.

So the traditional plan...  Any money contributed to a traditional plan is excluded from taxes for the current year, so you don’t pay any taxes on that money this year (its tax deferred). Everything grows tax free, but when you take money out in retirement, the entire withdrawal is taxed at whatever tax rate is in place in the future.

Remind me, what is a Roth?  The Roth account is named after the senator that helped sponsor the law that created Roth accounts. Taxes are paid now, when the money goes into the Roth account. Everything grows tax free, and when you take the money out in retirement it all comes out tax free (including the EARNINGS)!

Not just a tax rate question! – There are pros and cons to both options. Lets look Both Ways:

Traditional (pre-tax) Pros:

+ Current income is reduced for contributions (tax savings today). This includes state income taxes, if you live in a high income-tax state.

+ Traditional retirement assets can later be converted to Roth assets when income is lower. Withdrawals from traditional accounts can help “fill up” the lower tax brackets during gap years before other sources of income begin, such as social security or pensions.

+ If you are trying to qualify for health insurance subsidies (premium tax credits) or student financial aid, then traditional contributions may lower your income to qualify.

+ Charitably inclined? Assets inside an IRA can be donated directly to charity once you reach age 70 ½. You won’t pay taxes on the money being used for charity. These are known as Qualified Charitable Distributions.

 Traditional (pre-tax) Cons:

x  We don’t know what the tax rate will be in the future. Taxes could be higher, they could be lower. Would you take out a 30 year mortgage without knowing the interest rate?

x Taxable distributions may increase the amount of social security benefits included in taxable income (up to 85%) and increase the Medicare part B & D premium surcharges by up to thousands of dollars per year.

x Required minimum distributions (RMDs) begin at age 72-75 (depending on year of birth + Secure Act 2.0 timing). RMDs force taxable distributions – the IRS and government need their tax revenues – so you will have to take distributions even if you don’t need the money.

x If inherited by an adult child, traditional retirement accounts must be withdrawn within 10 years, including the full tax burden.

x If you need to access funds before turning age 59 ½, there may be penalties (10% is most common) for early access.

 Roth Pros:

+  All withdrawals can be received completely tax-free, including the earnings if you meet the qualified distribution rules!

+ Direct contributions to Roth IRAs may be withdrawn at any age for any reason without taxes or penalties.

+ Since Roth distributions are not included in taxable income, they may help to reduce the premiums (IRMAA) in traditional retirement.

+ Unlike traditional retirement accounts, Roth IRAs do not have required minimum distributions (RMDs).

 Roth cons:

x You may pay taxes at a higher rate today than in retirement.

x Earnings on Roth accounts could incur a 10% penalty if funds are withdrawn before the qualified distribution rules have been met. The Roth account must be open for five years, among other rules. 

 Be Honest – what do you Recommend?  I started saving inside my 401k account in my early 20s. Back then, I didn’t give it much thought and put 50% in Roth and 50% in pre-tax 401k. With perfect hindsight, I would have been better off using just Roth in those early years. But that’s ok, the important thing is to make good use of the retirement accounts available.

In retirement planning we have three main sources available to create our retirement paycheck: pre-tax, Roth, and taxable brokerage. Having diversity of funds in the different taxable sources provides year-round tax planning opportunity. It also provides flexibility.  

It’s not just a tax rate question! Your individual goals for the money can help direct which choice is right for you. Are you earmarking the funds for a legacy to be passed down to children? If so, then Roth may be the better pick. If you plan to leave the funds to charity, then pre-tax traditional is optimal. Reach out to Look Both Ways Financial for your solution.

Look Both Ways Financial does not earn any commissions on investment products. Although Kaki Perdue is a CPA, Look Both Ways Financial is not a CPA firm.