Roth vs. Traditional – How Do I Choose?

Taxes, now or later?

That’s the real gist behind the two main versions of IRAs and 401(k) accounts. But given that both 401(k) and similarly styled accounts, as well as IRAs, are now driving the show for our retirement savings, the decision to use a Roth or a traditional version of the account is a big one.

Both traditional IRA and 401(k) accounts offer savers the ability to make pre-tax contributions to their account as long as they fall below certain income limits. In the case of a 401(k), this reduces taxable income off the top. Traditional IRA account contributions provide a deduction later on when you file your taxes. Both accounts allow investments to grow and compound tax-deferred. With Uncle Sam providing tax savings now, he wants his piece of the pie later on. That’s when traditional 401(k) and IRA account holders will have to pay up.

Distributions from a traditional account are subject to taxes at the saver’s ordinary income tax rate. This could be as high as 37% plus the additional 3.8% Medicare surcharge. The kicker is that the IRS won’t let you compound your traditional account forever. The tax agency requires that savers take Required Minimum Distributions (RMDs) from these accounts starting at age 72 and pay taxes on those amounts.

Roth 401(k) and IRA accounts are a little different. Both accounts allow investors to contribute on a post-tax basis, i.e., after the Fed takes taxes off of your paycheck or after that money hits your bank account. Since you’ve already paid taxes on the money, Uncle Sam won’t be looking for it later on. As such, distributions from a Roth account are tax-free. Just like a traditional account, Roth accounts allow for compounding of growth to occur tax-deferred.

But Roth accounts also have some drawbacks. For one thing, not everyone can contribute to them. Income limits apply: single person tax filers must have income of $140,000 or less, while married filers are capped at $208,000. Secondly, Roth 401(k)s are still subject to RMDs; albeit, while the distributions are tax-free, investors are still required to do them or pay penalties.

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Historically, the decision between a Roth or a traditional account for investors has come down to future income and the current tax bracket. If you’re younger and just starting out in your career, odds are you’re in a lower tax bracket today followed by a higher one later in life. This makes a Roth an ideal choice. You don’t need the tax deduction today, but the tax-free income later on will make more sense. Higher income workers are usually directed into a traditional account to take advantage of the tax savings today.

However, this normal paradigm may not always work in the new economy.

A prime example is the growth in gig and 1099 workers. Normally, taxes aren’t taken out of gig workers’ salaries, and they are responsible for paying all their taxes through quarterly or year-end payments. Even if income levels are low, a traditional IRA can help reduce their outlay and significantly help ease their burden.

Additionally, the idea of work has continued to evolve. We hardly ever stay with a single company or even in the same line of work for multiple decades anymore. Current data suggests that the average person will have around 12 different jobs in their lifetimes. Meanwhile, encore careers, monetized hobbies, side-gigs and even part-time work are becoming norms for many retirees and younger workers. All of that throws certain pre-planning assumptions out the window.

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With the numerous variables in work and income potential, choosing between a Roth or a traditional account may come down to not using one or the other, but having both. Tax flexibility has become the new norm for retirement savers.

If you have a traditional 401(k) plan and you’re eligible for a Roth IRA, using both would provide tax savings now as well as tax-free income later on. The sequence of withdrawals could actually lower your long-term tax burden by having both accounts. For a married couple, one spouse could use a Roth 401(k) account, while the other chooses a traditional 401(k). Here again, this option provides both tax savings now and also potentially later on.

Moreover, there’s nothing stopping a saver from opening both a Roth and traditional IRA at the same time. As long as the total amount contributed to both accounts doesn’t go over the limits, Uncle Sam will let you do so. Better still is that you wait until you file your taxes in April to make your contributions for the previous year. This can provide additional tax flexibility. Depending on income for the year, you can choose Roth or traditional to get the best tax savings.

In addition, savers may want to consider a taxable account as well. Thanks to low-cost ETFs and automated tax-harvesting strategies, a taxable account can be very tax efficient in its own right. Even more so when combined with Roth and traditional 401(k)/IRA accounts.

The idea is that savers can’t simply predict anymore what the future will hold for them. The equation has essentially gotten too complex. In that regard, the old rules of paying taxes either now or later on based on the Roth vs. traditional account models no longer apply. An investor’s success lies within being flexible with their contributions.

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