Roth vs. Traditional
Perhaps the most important election we make in our retirement accounts - pre-tax or Roth?
First - let’s clear up a common misconception. Some people hear Roth, and automatically assume it’s a Roth IRA. While this may be true, it’s not always the case. In this instance, the IRA is the retirement vehicle, and Roth is the tax classification. So Roth (tax classification) IRA (retirement vehicle) is the formula for describing accounts.
Retirement vehicles include 457(b)s, IRAs, 401(k)s, and 403(b)s, among a few others. Each of these can be either pre-tax or Roth. For example, you could be contributing to a Roth 457(b).
The goal with this decision is to ultimately lower our lifetime tax liability. To do this, we must pay tax at this lowest point. This begs the question, when is my low point? Figuring this out is the key.
How it works.
Roth contributions involve contributing after-tax dollars to your retirement account, allowing for tax-free withdrawals in retirement. Traditional contributions are made with pre-tax dollars, resulting in immediate tax savings but requiring taxes to be paid on withdrawals in retirement. Deciding between the two depends on current tax rates, future tax expectations, and desired tax implications in retirement.
If your ordinary income tax rate is the same now as in retirement, each route will yield the same amount of money. Consider Ashley. In this universe, she contributes pre-tax. In another, she contributes Roth. In each scenario, she is taxed at a 20% rate, makes 10% interest, and contributes the same dollar amount.
So, how do we figure out whether tax rates are higher now or in retirement? Consider the following:
Will tax rates go up in the future?
See the historical tax rates to the right. If you anticipate the tax rate to increase, pay them now and contribute Roth.
What does my income look like now?
Are the earners in the family in particularly high-earning years?
Are you working a lot of overtime?
What will my income look like in the future?
Do you have a pension?
Will you have Social Security?
Will I have distributions from other retirement accounts?
What does my spouse’s retirement picture look like?
Does having the taxes paid already give me peace of mind?
Will there be a valley of income
Perhaps you are a candidate for Roth Conversions.
Clearly, there is a lot to consider. Whatever your decision may be, please consult a financial planner beforehand. They can take each of these considerations into account, and guide you to the best tax basis for you.
A distribution from a Roth IRA is tax-free and penalty-free provided that the five-year aging requirement has been satisfied and one of the following conditions is met: age 59 1/2, death, disability.
The examples in this article are hypothetical and for illustrative purposes only. They assume a steady 5% annual rate of return, which does not represent the return on any actual investment and cannot be guaranteed. Moreover, the examples do not take into account fees and taxes, which would have lowered the final results.
