Author: Brent Lemieux CFA® CPA
Roth IRAs have grown increasingly popular and are available to many. Even if your income level excludes
you from contributing to a Roth IRA, your employer may have a Roth 401(k) option, which permits even the highest income earners to participate.
If you have the option between a Roth and a Traditional, which should you choose? This is an important question that can make a big difference in the after tax value of your assets in retirement, and the right answer largely depends on your situation.
What’s the difference?
There are many differences between the two options, but the two main differences are related to:
- When the money is taxed. For a Roth contribution you pay the tax today, and it grows tax-free forever (even after you die), which is the main appeal for Roth IRAs. Conversely, for a Traditional contribution you receive a tax break today, but pay tax when you take the money out.
- When you are required to make withdrawals from the account. For a Roth IRA you are never forced to make withdrawals, which is another plus. For Traditional IRAs you will be forced to begin taking RMDs (Required Minimum Distributions) at age 70½. At this point in time the assets are taxed at your ordinary income rate.
How should you decide what to do?
The key point to focus on is your tax rate today compared to your expected tax rate in retirement (or whenever you begin spending the assets). The difference in your current vs. future tax rate will mainly be determined by two factors:
Your earnings level now vs. then
If you expect you’ll be earning much more when you begin withdrawing retirement assets, a Roth may be the better option. Likewise, if you believe you’ll be earning much less, a Traditional may be the better option. Don’t forget that RMDs from a Traditional IRA will be included in your taxable income.
Future changes to tax rates by the US Government
Tax hikes are almost always unpopular, so it may be unlikely for the foreseeable future. However, if concern over the deficit grows, tax hikes could become a reality. After all, raising taxes is one of two ways to reduce the deficit. It is also possible that tax rates could fall.
Summary
Because it is impossible to know for sure what your future earnings and tax rate will be, the best you can do is make an educated guess. It may be prudent to accumulate assets in both a Roth and Traditional overtime. We call this “tax diversification”. It’s important to note that there are many other factors to consider. If all of this seems confusing, we are here to help. At Windward, we help clients with decisions like this all of the time.
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