One of the more common questions in retirement planning is whether to contribute to a Roth or Traditional retirement account — TSP, 401(k), or IRA. While the Roth offers the potential for tax-free growth & retirement income, the traditional option offers an up-front tax break (fully tax-deductible contributions) & tax-deferred growth. But which is right for you? More than likely your accountant doesn’t like the Roth, while you are drawn to the idea of tax-free income.
How to decide
Here’s the deal; both options have value so in most cases it makes sense to take advantage of each. Most employer plans will allow you to split your contribution (If you receive matching contribution it stays tax-deferred). Many clients whom we work with want a current year tax break, but having tax-free retirement income and an easy way to pass the account on as a legacy are also high on the list. For these reasons it was surprising to learn that only 13% of workers are currently saving using the Roth (according to a 2016 study by Vanguard). Splitting your contributions 50/50 is always a good option, but let’s look at reasons to slant your contribution in one favor or the other.
Pay Now or Pay Later
From a mathematical standpoint, the difference between the two options is all about tax rates. If your tax rate remains constant now and in the future the Roth & traditional outcome will be exactly the same. You can take the tax-break now through deductions or later with tax-free distributions. However, very few things remain constant over time and it’s doubtful that taxes will be one of them, in which case the following applies:
The traditional option is more valuable when
- You have few tax-deductions
- You are a high-earning individual or family. Spousal or increasing income may be kicking you into a higher tax-bracket.
- You will retire on less income and/or in an area with a lower cost of living
- You believe tax rates will decrease in the future
The Roth is more valuable when
- Deductions are less important because you are currently tax-advantaged in your working situation (deployment, overseas work, housing allowances, etc.)
- You earn too much to contribute to a Roth IRA (phase-out starts at $118,000 for individuals, and $186,000 married)
- You prefer to pay now and eliminate the guess work on tax rates in the future
- You want to efficiently pass money to your children or other heirs
- You believe tax rates will increase in the future
By now you get the point about tax rates and the role your income plays in evaluating this decision from an analytical standpoint. But let’s talk about two things I think are really powerful! Wealth transfer and flexibility.
Wealth Transfer & Legacy Planning
The Roth IRA is a fantastic tool for wealth transfer and legacy planning. Think about this: your beneficiaries will inherit a tax-free asset that continues to grow tax-free with no requirements to take any money out of the account. In theory this tax-free growth could be passed on for multiple generations! How cool is that? The one caveat with this strategy is that your Roth TSP or 401(k) must be rolled over into an IRA, as they require distributions after age 70.5.
Flexibility and Freedom
I love the idea of tax-free income in retirement as much as I love the idea of paying off your mortgage. The fewer expenses we have the more freedom and flexibility we will ultimately have. The intangible mental benefits are enormous! Not to mention it takes the guesswork out of the equation with tax rates.
How to decide
Examine your gross taxable income - are you the border of any tax brackets, and will a certain amount of deductions help reduce you to a lower level? In this case consider the traditional option for a heavier weight.
If you are in a tax-advantaged working situation at the moment, you might consider shifting more of the contributions toward the Roth option as your tax rate is likely lower now than it will be in the future.
Examine how the above points apply to your situation to help shape your strategy. We recommend a balanced approach as this acts as a hedge against the future direction of tax rates, provides you with a current year tax-deduction, as well as the potential for tax-free retirement income and a plan for future wealth transfer.
I am happy to help you explore options and walk through a strategy that fits your current situation. As always, we would love to hear your thoughts, planning strategies, and success stories. Please share them with us! I can be reached directly by messaging firstname.lastname@example.org.
*The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor
The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions apply. Withdrawals prior to age 59.5 or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRA’s. Their tax treatment may change.
No strategy assures success or protects against loss.