What Are They?
At the risk of sounding a little redundant: Join me for a deeper dive into the mechanics and logistics of the Roth versus traditional retirement account debate!
First of all, it is important to know that the terms “Roth” and “traditional” are classifications used to describe retirement accounts.
When you set up a retirement account through your employer – a 401(k), for example – or you set up your own individual retirement account (IRA), you are usually provided the option to make your contributions as Roth or traditional. But what does this mean?
Both choices are considered tax-advantaged in the sense that they reduce the taxes you must pay the federal government. The difference is in when the tax benefit is realized:
- Traditional account contributions act as a tax credit in the year that you make the contributions (but your withdrawals in retirement will be taxed).
- Roth account withdrawals are tax-free in your retirement (but they don’t provide a tax reduction when you make the contributions).
Traditional Retirement Accounts
The biggest advantage of traditional contributions is that they reduce your yearly tax burden.
If you are a high income earner in an upper marginal tax bracket, or want to contribute to your future without significantly reducing your take-home pay, the ability to use your contributions as a tax credit may appeal to you. You are able to chop the full amount you contribute (up to certain caps depending on the type of account) off your yearly taxable earnings for when it’s time to file taxes.
For instance, if you make just enough of a contribution to drop your highest marginal tax bracket from the 22% category to the 12% category, you have effectively saved an amount of money equal to 22% of the amount you contributed!
The trade-offs?
- As mentioned above, you will ultimately owe taxes on your withdrawals in retirement.
- You no longer have full and immediate access to the money you sock away in your retirement account.*
Many people reason that their taxable income in retirement will be less than what they are currently earning, and therefore they will be taxed at a lower marginal rate. As long as this turns out to be true, making traditional contributions will save money on taxes paid (total) by deferring a higher tax burden in their earning years to a lower tax burden in their golden years.
*Money CAN be withdrawn from traditional accounts, but taxes will be owed on the withdrawals AND you will incur a 10% early withdrawal penalty (with some exceptions).
Roth Retirement Accounts
The highlight of the Roth account is the long-term tax sheltering of your snowballing investments. While you pay your taxes up front with no reduction in your taxable earnings for the year, your contributions grow with interest over time and can ultimately be withdrawn free of taxes.
You can even build yourself an eternal, tax-free money machine! As long as you have saved enough so that you can withdraw less money than what the account earns in interest each year during your retirement, the account will be able to sustain itself indefinitely.
Starting a Roth account early in life, particularly when in your lower marginal tax bracket earning years, provides you the benefit of low effective taxation coupled with tax-free long-term investments gains. It’s also worth noting that Roth accounts allow you to make withdrawals of your contributions at any time with no taxation and no early withdrawal fees,* technically allowing the account to function as an additional safety net.
So what’s the trade-off in this instance?
- As mentioned from the start, your contributions don’t provide a tax reduction each year. If your earnings place you in a high marginal tax bracket, or if your living expenses necessitate a certain amount of take-home pay afforded by receiving tax credits, then you will likely want to write off your retirement account contributions.
Roth accounts are a newer alternative and, as a result, not all employer-sponsored programs offer them.
That said, Roth account can provide you with a lot of tax flexibility in your retirement. You may choose to draw from taxable accounts first (Social Security, pensions, other traditional accounts) up to the cap of a particular marginal tax bracket, and then make withdrawals from your Roth account to meet the rest of your spending needs.
*However, any withdrawals that pull from the interest earnings of the account are subject to additional taxation AND a 10% early withdrawal penalty (with some exceptions).
What Makes the Most Sense for You?
There’s not really a right or wrong way to save for retirement; it’s mostly just important that you’re saving something. That said, whether you go Roth or traditional with your accounts tends to vary with your level of earnings and your outlook on the future.
- Are you making a lot of money now, but suspect that you will require less income during retirement? Perhaps you will choose a traditional account to alleviate your tax burden now.
- Are you comfortable paying taxes on money now if it means more flexibility in retirement? Perhaps you will choose a Roth account to ensure that you have a tax-free income option later in life.
- Do you speculate that taxes are going to be lower in the future? Perhaps you will choose a traditional account to reduce the higher taxes paid to our current system.
- Do you speculate taxes are going to be higher in the future? Perhaps you will choose a Roth account to benefit from the lower taxes paid to our current system.
For some perspective, I have begun my career with exclusively Roth contributions for the following reasons:
- I want to maximize the tax-free interest earnings I can accrue by starting the account early in life.
- My current salary (after tax deductions and credits) places my taxable earnings into the bottom two tax brackets (10% and 12%), which I consider to be plenty low from a historical perspective.
- I work for a State government and pay into a pension plan. I like that Roth withdrawals will provide me with tax flexibility after drawing upon Social Security and the pension in retirement.
My plan is to shift some of my yearly contributions to a traditional account as my salary increases with promotions, such that I can keep my taxable earnings within the 12% bracket for as long as possible.
Some might argue that I (or you) should go about saving in a different way. They may even be correct, but we won’t know for sure until the decisions have already been long made. Since we can’t know the future conditions of our tax system, I am perfectly happy with the way that I am choosing to hedge my bets.