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 avoid 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 or income, 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. There are also a couple of reasons to opt for a pre-tax plan that I’ll mention at the bottom.
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 some 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.
4. Roth distributions do not count toward your adjusted gross income for determining whether you pay Medicare surcharges (IRMAA).
Pre-tax distributions do. For those high-income retirees for whom these distributions could push their AGI high enough to trigger a Medicare surcharge, this can be costly.
5. 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.
6. A Roth offers more creditor protection.
Generally, both Roth and pre-tax 401Ks may be shielded from a bankruptcy claim 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, 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.
Advantages of Pre-Tax Plan IRA or 401K
There are at least two circumstances in which you’ll want to opt for a pre-tax plan instead of a Roth.
1. Your current tax bracket is higher than what you expect it to be in retirement.
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, it may also make sense to opt for a pre-tax plan.
2. You want to minimize your AGI during this tax year.
Eligibility for certain benefits may be tied to your adjusted gross income. If you want to qualify for any of these programs, a pre-tax plan may be a better option as your contributions to it will reduce your AGI. Some examples include: need-based college financial aid, medicare surcharges (IRMAA), pandemic relief checks, and ironically, eligibility for a Roth IRA.
In most circumstances, go with the Roth. Your older self will appreciate your foresight.
PS: Note that not all 401K plans offer a Roth option and SEP-IRAs are not eligible to do a Roth.