To Roth or Not to Roth?
Updated: Jan 23, 2020
That is the question (I get all the time). “Should I save into a Roth or a Traditional IRA?” As is often the answer to so many financial questions: it depends. I was recently perusing a commentary on the assumptions used in our financial modeling software at the firm where I work when I came across a statement that encompasses so many financial planning approaches. The author, Harold Evensky, writes, “practitioners should not treat long term planning as an exact science with a focus on the accuracy to the second decimal place but rather as (an) educated art designed to provide reasonable guidelines in assisting clients (to) plan their future.” He goes on to say, “long term planning is not a case of plan and forget but rather plan, monitor and modify as necessary.” When it comes to choosing between Roth and traditional IRA contributions, Mr. Evensky’s approach is helpful and I’ll explain why in a second, but first let’s review the differences between the two types of contributions.
When it comes to saving for retirement, there are a lot of ways to go about it. You can save by having some of your paychecks contributed to a retirement account at work, you can open up your own retirement account, you can save into your checking account, or hide dollars under your mattress. Ideally, you want to be saving into an investment account that has tax advantages because this means saving more in the long-run due to both tax savings and compounded returns. These types of employer-sponsored accounts are often referred to as “qualified accounts” because they “qualify” for favorable tax treatment. This qualification applies to accounts such as 401(k)s, 403(b)s, profit-sharing plans, as well as SIMPLE and SEP IRAs. While traditional and Roth IRAs aren’t considered “qualified” because they don’t fall under the same tax code as employer sponsored plans, they do still receive favorable tax treatment. With regards to deciding between Roth and Traditional contributions, what we’re really deciding is when we want to get the tax break: now or later.
Traditional IRA and qualified accounts receive contributions of what’s known as pre-tax money. It’s considered “pre-tax” because when you contribute, you get a tax deduction in the year you make it (the money is contributed before it is taxed). However, when you pull that money back out you do pay taxes on each distribution as if it’s income. To summarize: traditional, pre-tax contributions give you a tax benefit now but result in you paying taxes when you withdraw the money later.
Roth contributions are made with after-tax money. Some employer-sponsored retirement plans have the option to contribute after-tax money, but not all do. It is a plan specific feature and worth asking about when setting up your contributions. Roth or after-tax contributions are made with money you’ve already paid taxes on, hence the “after-tax” description. This means that you do not receive any type of tax benefit in the present, but the funds contributed grow tax free and can be withdrawn tax free in the future assuming they are withdrawn after you’ve attained 59.5 years of age (this age qualification applies to all qualified accounts – withdrawing prior results in a tax penalty with some exceptions).
So which one? The typical rule of thumb is to make Roth contributions in the early years of your career while you’re in a lower tax bracket with the assumption that your tax bracket will increase and be higher when you retire. The idea is that it’s preferable to pay taxes on the money while you’re in the lower tax bracket. As your career progresses and your income hopefully increases, you may want to consider switching to traditional contributions to receive the tax deduction in the year of contribution. This is a pretty good approach and one we typically recommend. But, as previously mentioned, financial planning is not an exact science. It is an art and one that requires monitoring and modification. The Roth rule of thumb makes some very serious assumptions – both about tax law and your situation. We don’t know how tax brackets will change over time, nor do we know how your situation will change over time. That being said, we do know what the tax status will be of those funds going forward. If you make Roth contributions now, that money will be tax-free in the future regardless of your tax situation and that’s a nice thing to have. This is why we often recommend that if possible, you make use of the Roth option – in consultation with your tax advisor. Furthermore, while choosing one over the other is important, the most important decision being made is that you are saving! You can check out this article on saving enough to learn more about that. And if you’re still concerned about which choice is best for your specific situation, it might be a good idea to contact your CPA and financial advisor who will be best suited to help you make that judgment call.