Smackdown Match: Team Roth vs. Team Traditional
There are some personal finance questions that are simply unanswerable, and this is one of them: “Which is better: A pre-tax traditional retirement account (401(k), TSP, or IRA) or a post-tax Roth account?”
Of course, there actually is a simple answer: “It depends.” This is (almost) everything it depends on.
Why Go Traditional?
Current vs. Future Tax Rates. I am starting here because this is where most people start their analysis. (The problem is that too many people end here!) The simplest form of this question is, “Do you expect to be in a lower tax bracket after retirement?” For many people, this seems like a pretty good bet. This may be the case if you are a high-income earner now and are close enough to retirement to forecast with confidence that you will later fall into a lower tax bracket. If so, then it seems pretty clear that you will want to delay paying taxes until later.
Cash Flow. For many, devoting even a modest 5% of their salary to their workplace retirement account threatens to bust their budget. Contributing “traditionally” results in less of a hit to your paycheck, as the contribution comes “off the top” before taxes. That is, a $250 monthly contribution to your 401(k) will only reduce your paycheck by perhaps $215 or so, depending on your tax withholding percentage. Or, to state it another way, you may be able to afford to invest more for your future retirement if you make the contribution pre-tax.
Tax Credits & Deductions. Come tax season, you will surely be hunting for all possible juicy tax benefits. However, the ability to take advantage of many tax credits and deductions is a function of the Adjusted Gross Income (AGI) figure on your 1040 form. Contributing to a traditional retirement account allows you to “manage down” your AGI, and may put you in the arena to qualify for benefits such as the Child Tax Credit, American Opportunity Credit, Lifetime Learning Credit, just to name a few headliners.
Federal Student Loan Payments. This isn’t new, but it is newsy with the restart of student loan payments and the SAVE repayment program. Under SAVE, your monthly payment is based on your income. Lower AGI, lower student loan payment. If you are trying to minimize your student loan payment (for example, if you are working towards forgiveness under PSLF), contributing to your retirement pre-tax maximizes the amount of loan forgiveness you will eventually receive.
Then again, Roth looks pretty tasty too!
Current vs. Future Tax Rates, Again. This is the inverse of the above. If you believe that the tax rate you are at now is as low as it will ever be, then it makes sense to pay your taxes now. This may be the case if you are early in your career. The reality is that US tax rates are currently, by historical standards, really low. It is perfectly reasonable to hypothesize that regardless of what your income may be 30 years hence, your tax bracket could be higher.
Health Insurance. What does health insurance have to do with this? Let’s start with the scenario in which you retire early after age 59 ½ (or even 55), but before the age of 65 when you are eligible for Medicare. You are shopping for health insurance. Under the Affordable Care Act, you may qualify for assistance with the monthly premium (the Premium Tax Credit, formally) if your income is low enough. And how can you make it low? If you are taking distributions from a traditional retirement plan, this is considered income. But if you are taking distributions from a Roth retirement account, this is not income. Get it? Less income, lower health insurance premium.
The other way that your choice of retirement account affects your health insurance payment is after the age of 65 when you are eligible for Medicare. The Medicare Part B premium is about $164 per month for everyone…unless you have a high income, in which case you pay considerably more. (It’s called IRMAA – Income-Related Monthly Adjustment Amount.) So, the story is the same; if you can keep your reportable income low by taking distributions from a Roth account rather than traditional, you may avoid this surcharge (or at least reduce it).
Leaving an Inheritance. Your heirs will thank you if you leave them your retirement account in the Roth form. That is because the taxes have already been paid, allowing them to receive your generosity completely intact. What’s more, if your loved ones, such as your children, inherit your traditional retirement account, the distributions that they will draw from the account are added to their own taxable income, possibly bumping them up into an uncomfortable tax bracket.
Lumpy Expenses. You are retired, and life is good. You are regularly drawing your income from your traditional retirement account, paying taxes as you go, and all is well. Until you need a new car. Or roof. No worries, though; you have the savings for it in your traditional 401(k) or IRA. The problem, of course, is that now your taxable income has jumped by at least five figures and the tax due is painful. (It may even put you into the realm of IRMAA, as described above.) Having at least some assets in a Roth account allows you to meet these moments without the added tax hit.
So where does that leave us? I have presented an equal number of arguments on each side (and undoubtedly have left some out). While you may be able to dismiss some of these factors as not being relevant to your own life, without a working crystal ball it is hard to be sure about all of them. For that reason, many people simply split the difference, using both kinds of retirement accounts. But most importantly, whatever choice you make, you cannot set it and completely forget it. Which type of retirement account is most ideal for you may change throughout your working career. In this tournament, there are no losers!
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