The choice between a Roth and a traditional retirement account is one of the most common dilemmas in financial planning. As you probably know, both types of accounts grow tax-deferred. The difference is that contributions to traditional IRAs or 401(k)s may reduce your income tax due today. For Roth accounts there’s no upfront tax benefit, but then withdrawals in retirement are generally tax-exempt.
The typical “correct” answer is that the decision between a traditional and a Roth IRA comes down to the relationship between your tax rate now and your tax rate in retirement. This seems counterintuitive, as it feels like paying taxes on the large eventual balance you’ll have in your retirement account would be much worse than paying a little bit of tax now on today’s smaller contributions. The math does work, however, because the assumption is that you’ll have less to invest in your Roth because you have to pay taxes before you can invest.
Here’s a hypothetical example: Imagine a world where everyone pays a flat 20 percent income tax rate, now and forever, and your investments today will exactly double between now and retirement.
If you have $5,000 of income today that you want to invest in a traditional IRA, you’ll invest all $5,000 today, and it will double. If you pull that money out at retirement, you’ll start with $10,000, but after 20 percent in taxes you’ll end up with a net of $8,000 available to you.
If you have $5,000 of income today that you want to invest in a Roth account, you’ll get no tax benefit today. That means you only have $4,000 to start with after paying the 20 percent tax this year. If you withdraw these funds upon retirement, your money will have doubled and you’ll have $8,000 tax-exempt, which is exactly the same outcome as the traditional IRA example above.
You can see that if you think your tax bracket will end up higher in retirement, you’d lean toward a Roth. If you’re expecting a lower tax rate in retirement, you’d likely prefer a traditional contribution.
The math above is accurate, but for most people that’s not how it works. Very few people think in terms of allocating a certain amount of income to investment and netting out the taxes as necessary (as shown above). A more common plan would be to simply pick a dollar amount, then choose between a traditional IRA or a Roth. All else equal, putting $5,000 (or any fixed amount) in a Roth is likely going to result in more money for you in retirement than putting the same amount into a traditional IRA. That’s because these two hypothetical accounts funded identically will end up with the exact same balance at retirement, but tax would be due on the traditional IRA (while the Roth money would be available to you tax-exempt).
If you made a traditional contribution with the $5,000, you wouldn’t be thinking that you should invest the extra tax savings from funding your traditional IRA — you’d probably splurge on something with your slightly larger tax return next year. If you funded the Roth with $5,000, you’d likely eat out a little less over the year (or otherwise tighten your belt) to make up the difference (probably without noticing), functionally giving up a little consumption today to avoid taxes in the future.
Ultimately, the decision to fund a Roth is a little bit like a choice to prepay taxes. A Roth might be the “wrong” choice if you end up with very low taxable income in retirement, but on the other hand, I don’t know anyone who has ever had big tax problems in retirement from overfunding their Roth! A Roth might not be the optimal financial choice, but, depending on your situation, there can be intangibles (such as peace of mind) that can eclipse the hard numbers on paper.
You and your advisor are fortunate to have taxable, traditional and Roth options available. Together you can combine the facts with your personality to make the decision that allows you to feel confident — and stay invested — on the path toward a secure financial future.
Gene Gard, CFA, CFP, CFT-I, is a Partner and Private Wealth Manager with Creative Planning. Creative Planning is one of the nation’s largest Registered Investment Advisory firms providing comprehensive wealth management services to ensure all elements of a client’s financial life are working together, including investments, taxes, estate planning, and risk management. For more information or to request a free, no-obligation consultation, visit CreativePlanning.com.
