Deciding Between Roth & Traditional IRA

Get a tax deduction today? Or get tax-free income in retirement? Either way you pay taxes, the difference is when.

Conventional wisdom would say, "pay the taxes when your marginal tax rate is the lowest". And while that may be the right answer, it's difficult to really tell what your marginal tax bracket looks like decades into the future.

On paper, your situation could favor Roth contributions. Then you get to retirement and spending slows, or income tax rates increase, and you find that a tax deduction in your working years would have been better. Neither are uncommon. But despite the ambiguity of the future, there are still questions you can ask yourself to help guide your decisions.

So, how do you plan ahead when so much is unknown? It starts with understanding…

The Embedded Tax Liability in Traditional IRAs

Say your effective tax rate is 22%, and you have $1,000 in a Traditional IRA. $780 is for yourself, and $220 is "on hold" for Uncle Sam. If your IRA grows by 10%, both your share and Uncle Sam's share increase by 10%.

This isn't necessarily a problem since Traditional IRA contributions are tax-deductible. You're getting tax benefits today, and trading them for tax obligations in retirement. The opposite of the Roth IRA, which offers no tax benefits today and no tax obligations in retirement.

The goal is to simply pay the IRS their share when tax rates are the lowest.

Sounds easy, but, as we've discussed…

Taxes Change Over Time

Child tax credits. Child tax credits and other dependent-related deductions can lower your marginal tax rate while your children are young, and disappear as they age out of eligibility. A Roth IRA contribution made during these lower-tax years can be a useful consideration.

Career trajectory. As you move up in your career and earn more, you can expect to pay more taxes. Roth contributions can help in your early career years (pay taxes on contributions while income is lower). While tax-deductions from Traditional contributions can help in your peak earning years.

Income shocks. Relocating, a career change, an unexpected bonus, and maternity leave can all cause short-term shocks to income. Traditional contributions can help in years where your income is higher than average. And Roth contributions are cheaper when income is lower than average.

Legislation. Laws change income tax brackets and how deductions work. Tax credits get added and removed. The rules change over time.

A good financial plan can take out much of the guesswork, but even so…

We don't know what the future looks like

1. We don't know what taxes will look like 30 years from now.
2. Future income (to a degree) is unknown.
3. Life expectancy (which affects total RMDs) is unknown.
4. Healthcare expenses could jump late in retirement, or not.
5. Spending in retirement could be higher (or lower) than anticipated.

It's impossible to definitively tell whether Roth or Traditional best in any given year, but a few questions can guide you.

Traditional vs. Roth IRA: Questions to Ask Yourself

Do you expect to exceed the Roth IRA income limits in the future?

If so, it may be a good idea to make Roth IRA contributions while you can - before your income exceeds the thresholds to contribute.

Notably, if your income is above the Roth IRA contribution limits, you can still add Roth contributions to your retirement savings plan. There are no income limits on Roth 401(k) contributions, provided your employer allows Roth contributions. And backdoor Roth IRAs can be set up if Traditional IRA balances do not trigger the pro-rata rule.

How will your effective tax rate change in the future?

If you expect to be in a higher tax bracket in retirement, you can benefit from the tax-free income in retirement. If you expect a higher bracket today, you can benefit from the tax-deductible contributions from a Traditional IRA.

What does your existing tax allocation look like?

If your 401(k) is already loaded up with pre-tax money, and little or no Roth dollars sit on your balance sheet, it may be a good idea to add Roth contributions. Doing so gives you flexibility in retirement to pull from two different tax buckets, instead of one. This is especially important if income taxes increase by retirement.

Will you have a significant amount of guaranteed income in retirement?

Social Security and defined benefit pensions are both taxable as income in retirement. Those guaranteed payments are an embedded tax liability through retirement. Guaranteed payments for life equal guaranteed tax obligations for life. Adding Roth savings gives you tax-free income to layer on top of your guaranteed income.

What will RMDs look like in the future?

RMDs are the required distributions that the IRS forces you to take from your pre-tax 401(k) and Traditional IRA. That money has never been taxed, so the IRS forces you to make withdrawals and pay taxes.

RMDs do not stop at death! Any Traditional IRA balance your children inherit is subject to the 10-year rule. They must withdraw the full balance and pay taxes over 10 years. The tax owed is based on their tax rate at the time they make distributions. Adult children in high tax brackets are especially penalized.

Why not have both?

Maybe you got answers that pointed to both a Roth and Traditional IRA, based on the questions above. That's actually pretty common. But nobody said you must choose one or the other.

This old commercial popped into my head...

Source: YouTube, Old El Paso Taco Commercial

Think of contributions as a sliding scale instead of a one or the other decision. Maybe you start contributing 75% Roth and 25% Traditional. As your children age out of tax credits and your income increases, you shift towards Traditional contributions to compensate for the tax hit.

Maybe you're a high earner and single, but you plan on getting married soon. The scale could tilt towards Traditional contributions today, since single tax brackets are less favorable than married filing jointly. And as you switch your tax status the scale moves toward Roth.

These are just a few examples. Your contribution mix and the events that trigger a change will vary, which is why it's important to talk them through with your financial and tax advisors.

Working with Voyage

Part of financial planning is helping families understand the tradeoffs that come with different retirement savings and life decisions, and answer questions like:

• How does my savings mix change after a pay bump?
• What if I move from W2 to Self-Employed?
• How should we adjust retirement contributions if I go on maternity leave?
• And much more...

You can share your own circumstances by scheduling a 20-minute Fiduciary Consultation. No need to bring financial documents. We'll get to know where you're at and share how we can help.