Roth or Traditional? For most people in most situations, a Roth is better.
Let’s first recap the different tax treatments:
- With a Traditional, you receive a tax deduction in the year in which you make the contribution to your retirement account, but you will pay ordinary income tax on all distributions. This is sometimes called a “pre-tax” plan — i.e., your contribution is tax-deductible but you will pay tax later.
- With a Roth, you receive no tax deduction at the time the contribution is made but the distributions are tax-free (with a few early withdrawal exceptions that I won’t detail). This is sometimes called an “after-tax” plan — i.e., your contribution is not tax-deductible but you will not pay any tax later.
In theory, it’s simple — shift taxable income to the lower tax rate:
- If you know your current tax rate is higher than your retirement tax rate will be, opt for a Traditional.
- If vice versa, opt for a Roth.
- And, if you know they will be the same, it shouldn’t matter.
In practice, it’s more complicated:
- No one knows with certainty what her future tax rate will be.
- Capital gains and dividend income is typically taxed at a significantly lower rate than ordinary income. The younger you are, the more this matters.
There are many reasons that tilt in favor of a Roth that can sum up to be meaningful over a lifetime of saving. Not all apply to everyone but surely some will.
1. The sub-optimal tax treatment in a Traditional account offsets much of its benefit, particularly for younger people with more years of capital appreciation. This is because all the distributions in the account are taxed at ordinary income rates even though much of the account growth will likely be through capital gains and dividends which would have been taxed at a lower rate. A Roth avoids this issue. This effect can be significant for younger people.
For example, if you were to invest $1 for 40 years, it would grow to ~$21, assuming a growth rate of 8% per year. Thus, 95% of this accrued value would be from dividends and capital gains. If saved in a Traditional plan, this income would be taxed at your ordinary income rate.
2. For high-income earners who maximize their retirement contributions, you can save more money on an after-tax basis by using a Roth. The annual maximums are the same for both and a dollar sheltered in an after-tax account is worth more than a dollar that will be taxed later.
3. You’ll probably save more with a Roth. Most of us would put aside the same amount each year in either structure. This means you will have amassed a larger nest egg by retirement because the Roth savings will be tax-free. Yes, I know this is a psychological argument rather than a financial one but our minds usually work this way.
4. Roth distributions do not count toward your income for determining whether Social Security benefits are taxed. Traditional distributions do. For those retirees for whom these distributions could trigger Social Security taxation, this can be costly.
5. Roth distributions are completely flexible. A traditional IRA has required minimum distributions beginning at age 70 1/2 and these RMDs increase every year for the rest of your life. With a Roth, you control the timing and size of distributions, including making none at all.
6. A Roth offers more creditor protection. Generally, both Roth and Traditional retirement plans are shielded from legal judgments but a Roth allows you to protect more after-tax assets because you won’t be sharing the distributions with the IRS.
7. A Roth is a better asset to inherit. Your heirs will not pay tax on distributions from a Roth whereas they would with a Traditional. They’ll remember you even more fondly when they find out you left them a Roth IRA.
8. If you’re facing state or federal estate tax, a Roth can lower the value of the taxable estate since there is no embedded tax liability as with a Traditional account. Yes, the federal estate tax exemption is quite high, but that’s not the case for many states.
9. A Roth is more accessible in an emergency. You can take out contributions penalty-free and in some cases, you can also distribute the earnings penalty-free. With a Traditional account, you will pay taxes — and often penalties — on early distributions.
In most circumstances, go with the Roth.
PS: Note that not all 401K plans offer a Roth option and SEP-IRAs are not eligible.
Questions about IRAs? Please get in touch.
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