Roth vs. Traditional
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.
So, what will taxes be in retirement? Are the tax savings now more considerable than they will be in retirement? It comes down to the following considerations:
Will tax rates rise or lower by the time I retire?
What is my anticipated income in retirement?
How much will I draw from this account in retirement?
What is the purpose of this retirement account?
What is my current tax rate?
After these items are considered, one can begin to formulate a plan to answer the question, what should be the tax basis of my retirement account?
While every individual is different, examples can help guide us to our personal answer. Consider the person below:
Jill is a police officer aged 25. She is just starting at her department, and is wondering what tax basis she should choose for her retirement account. We assume that she, and her husband, would like to contribute $10,000 each per year.
She anticipates having a pension that will pay her $5,000 a month after 25 years of service. She anticipates a social security benefit of $1,500 per month. Jill is a workaholic, so she anticipates working a part time job in retirement that will earn her another $1,500 per month.
Jill is married to a another police officer who has similar benefits to her. He will also work part time. As a result, their combined AGI will be approximately $192,000 in retirement.
Jill and her husband’s combined current AGI is about $157,000.
Because of their earning level, 85% of social security benefits are subject to federal income tax. The pension and part-time income are both fully subject to federal income tax.
Comparison:
After 35 years, they are ready to retire. With the deferral rate above, and an assumed rate of return of 5%, they could expect to have about $1.9 million in their accounts as a whole, if they contribute pre-tax. If they contribute Roth, they would expect to have about $1.4 million under the same circumstances. However, once taxes are paid, the $1.9 will be decreased to the same amount This assumes they will have the same tax bracket in retirement.
First, we need to determine whether Jill and her husband will benefit from a current tax deduction. Since they will be contributing a combined $20,000, they will not drop down a tax bracket; however, they will have tax savings of about $4,800.
Next, we will evaluate Roth. For Jill and her husband, their anticipated taxable income in retirement will be 85% of $36,000 + $36,000 + $120,000 = $186,600. If they were to withdraw over $3,400 from pre-tax accounts in retirement, they would have taxable income above $190,000. As a result, the couple would be pushed into a higher tax bracket, and incur an 8% tax rate increase from 24% to 32%.
Because the anticipated tax rate in retirement is the same, and they will be on the threshold of a tax increase, they should consider Roth contributions. However, this conclusion is based on assumptions made at age 25. Circumstances change from year to year, so it is important to review tax strategy yearly with an advisor.
Conclusion:
Based on their current circumstances, Roth makes more sense. However, circumstances change all the time. If they come upon tough times, a current tax deduction could provide them with some relief. While the goal is to minimize taxes, mental and behavioral considerations are also important. As a result, to determine this answer, it is important to hire the support of a financial advisor, and review the plan yearly for changes.
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.
