Ode To A Roth IRA

For most people in most situations, a Roth retirement account is better than a pre-tax 401K or IRA, but keep in mind that either is better than not contributing at all.

First, to clarify, a 401K is a retirement plan sponsored by your employer; an IRA is a self-administered retirement plan. Both plans may have a Roth option.

Recap of Retirement Account Tax Treatments

  • pre-tax 401K or IRA provides a tax deduction in the year in which you make the contributions, but you’ll pay ordinary income tax on future distributions. You save taxes now but pay later.
  • Roth 401K or IRA provides no tax deduction at the time of the contribution but the future distributions are tax-free (with a few early withdrawal exceptions that I won’t detail). You pay taxes now but save them later.

In theory, the choice is simple — shift taxable income to the period with the lower tax rate:

  1. If you know your current tax rate is higher than your future retirement tax rate, opt for the pre-tax option.
  2. If vice versa, opt for the Roth.
  3. And, if you know they will be the same, it shouldn’t matter.

In practice, it’s more complicated because you don’t know your future income or tax rates. As Yogi Berra said, “It’s hard making predictions, especially about the future.”

There are several 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. There are also a couple of good reasons to opt for a pre-tax plan that I’ll mention at the bottom.

Advantages of a Roth

Consider these:

1. You’ll save more with a Roth.

Most of us would contribute 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 distributed tax-free.

2. For higher-income earners who maximize their retirement contributions, you can shelter more after-tax money with a Roth.

The maximum contributions are the same for both and a dollar saved in an after-tax account is worth more than a dollar that will be taxed later.

3. Roth distributions are more flexible.

A pre-tax plan has required minimum distributions beginning at age 72 and these RMDs increase every year for the rest of your life. With a Roth, you control the timing and size of distributions, including taking none at all.

4. A Roth offers more creditor protection.

Generally, both Roth and pre-tax accounts may be shielded from certain creditor claims, but a Roth allows you to protect more after-tax assets because you won’t be sharing the sheltered assets with the IRS.

5. A Roth is a better asset to inherit.

Your heirs also won’t pay tax on distributions from a Roth whereas they would with a pre-tax plan. They’ll remember you even more fondly when they find out you left them a Roth inheritance.

6. 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 pre-tax account, you’ll pay taxes — and often penalties — on early distributions.

7. For high-income earners, Roth distributions don’t increase your adjusted gross income for determining whether you pay Medicare surcharges (IRMAA).

Pre-tax distributions add to your AGI. For those high-income retirees for whom these distributions could push their AGI high enough to trigger a Medicare surcharge, this can be costly.

8. For low-income earners, a pre-tax plan offers little benefit.

If your income is low, definitely opt for a Roth. You’ll be in a low — or possibly zero — tax bracket and you may not receive any tax savings from a pre-tax plan.

Advantages of a Pre-Tax Plan

There are at least two circumstances in which you’ll want to opt for a pre-tax 401K or IRA instead of a Roth.

1. Your current tax bracket is higher than what you expect it to be in retirement, including state taxes.

If you expect your retirement income — and tax bracket — to be lower than now, then you’ll get a greater net tax savings with a pre-tax plan. Closely related to this, if you’re working in a state with a high income tax (e.g., NY or CA) and you expect to retire in a state with no income tax (e.g., NH or FL), it may also make sense to opt for a pre-tax plan.

2. You want to minimize your adjusted gross income during this tax year.

Qualifying for certain benefits is tied to your AGI. Some examples include:  Obamacare health insurance subsidies, need-based college financial aid, medicare surcharges (IRMAA), pandemic relief checks, income-dependent student loan repayment plans, and ironically, eligibility for a Roth IRA. Contributions to a pre-tax plan will reduce your AGI in the current year.

In most circumstances, go with the Roth. Your older self will be grateful.


PS:  Note that not all 401K plans offer a Roth option and SEP-IRAs are not eligible to do a Roth.

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