Ten Reasons To Choose A Roth Retirement Account
For most people in most situations, Roth contributions are 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 types may offer a Roth option.
Recap of the Different Tax Treatments
- A pre-tax 401K or IRA provides a tax deduction in the year in which you make the contributions, but you will pay ordinary income tax on future distributions. You save taxes now but pay them later.
- A 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:
- If you know your current tax rate is higher than your retirement tax rate will be, opt for the pre-tax option.
- If vice versa, opt for the Roth.
- 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 tax rates, especially many years from now. 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.
Advantages of a Roth
1. You’ll 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, this is a psychological argument rather than a financial one but our minds usually work this way.
2. For higher-income earners who maximize their retirement contributions, you’ll shelter more money on an after-tax basis by using 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. The tax treatment of pre-tax distributions offsets much of its benefit.
This is because all the distributions 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. For younger people with many years of capital appreciation, this effect can be significant
For example, if you were to invest $1 for 40 years, it would grow to ~$15, assuming a growth rate of 7% per year. Thus, 93% of this accrued value would be from dividends and capital gains. If saved in a pre-tax plan, this income would be taxed at your ordinary income rate, rather than a more preferential rate for dividends and capital gains. A Roth avoids this shortcoming.
4. Roth distributions do not count toward your income for determining whether Social Security benefits are taxed.
Pre-tax distributions do. For those retirees for whom these distributions could trigger Social Security taxation, this can be costly.
5. Roth distributions are more flexible.
A pre-tax plan 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 taking none at all.
6. A Roth offers more creditor protection.
Generally, both Roth and pre-tax 401Ks are shielded from legal judgments but a Roth allows you to protect more after-tax assets because you won’t be sharing the sheltered assets 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 pre-tax plan. They’ll remember you even more fondly when they find out you left them a Roth inheritance.
8. If you’re facing state or federal estate tax, a Roth can lower the value of the taxable estate.
There is no embedded tax liability as with a pre-tax 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 pre-tax account, you will pay taxes — and often penalties — on early distributions.
10. For lower-income earners, a pre-tax plan offers little tax savings.
If your income is low, you should definitely opt for a Roth. You’ll be in a low — or possibly zero — tax bracket and the tax savings you would receive from a pre-tax plan would be minimal or non-existent.
In most circumstances, go with the Roth. Your older self will be grateful for your foresight.
PS: Note that not all 401K plans offer a Roth option and SEP-IRAs are not eligible.
Update: MarketWatch weighs in on the value of Roth IRA conversions.