MoneyMonday: To Roth or Not To Roth

We think of your financial life as unfolding in three stages. The first is Financial Safety with a focus on building a good foundation. Next is Wealth Accumulation where we gather resources for the final stage, and Financial Freedom where we have the money and resources, we need to do the things that bring joy and fulfillment to our lives.

This session is a Stage 2 topic.

Let’s set the stage by reviewing the terminology we’ll use in this workshop. These definitions will be important as we compare different concepts.

IRAs, 401ks, and 403bs are similar, but different, retirement accounts. This workshop focuses on the types of contributions you can make to these accounts. The method you choose determines when you pay tax on your contributions and withdrawals. Let’s start with traditional contributions.

When you make traditional contributions, you add pre-tax dollars to your account. That means you contribute directly to your savings account BEFORE your paycheck passes by Uncle Sam.

Since you bypassed taxes when you contributed, Uncle Sam requires you “settle up” when you begin taking withdrawals from your traditional account. When you take withdrawals, you pay tax on the entire amount. So, we think of traditional contributions as the “pay taxes later” method.

Alternatively, if your plan allows it, you can contribute to the Roth method. These Roth contributions are after tax. That means you settle up with Uncle Sam before contributing to your account. Because you are contributing after tax, we call this the “pay taxes now” method.

You might wonder why anyone would make Roth contributions. Well, the payoff comes in retirement. That’s because withdrawals from Roth savings are TAX-FREE after age 59 ½. In other words, there are “no taxes later” on your Roth savings.

There is one more hurdle to overcome before your withdrawals are tax-free. You must have the account for 5 years.    

But if you’re over 59.5 and have been making Roth contributions for at least 5 years, withdrawals from your account go straight to your wallet without passing Uncle Sam.

Let’s recap…

Traditional means you're contributing pre-tax dollars. Roth contributions are after-tax.

Traditional savings grow tax-deferred which means you pay tax later when you take withdrawals. Roth savings grow tax-free if you’ve had the account for 5 years and reached age 59.5 before taking distributions.

You pay tax on contributions AND investment earnings in the traditional method. With Roth, you pay tax on your contributions only.

Traditional savings are better if your tax rate is higher now than you expect it will be in retirement. Roth savings, on the other hand, are better if you think you’ll be paying more tax in your golden years.

So, which option is best for you…? traditional, Roth, or a combination of both? Let me pause to emphasize an important piece of information. This is a complex topic that can get you in the weeds quickly. There are many things about your situation that might make one method better than the other.

Let’s consider taxes first. Assume this is the current table of tax brackets. Notice your tax rate increases as your household income increases.

So, if you are in a low tax bracket now but expect to be in a higher bracket later, the Roth is for you. Conversely, if you are in your peak earning years and your tax rate is high, traditional savings may be more beneficial when it comes to managing your taxes.

Keep in mind that even if you can predict your income and correspondingly your tax bracket, these tax brackets are subject to change by the IRS. That means future tax liability will always be somewhat unknown. 

Let’s consider some situations to see when To Roth and Not To Roth. Meet Emma. She is a 25-year-old, single taxpayer earning $40,000 annually. Since she’s already started saving for retirement and assuming she continues to save throughout her career, Emma is likely ahead of the game when it comes to her retirement readiness.

At her $35,000 income level, Emma is in a relatively low tax bracket. And, as a 25-year-old, we might assume her income will increase between now and retirement. That means Roth savings may be beneficial for her.

That brings us to our second consideration, tax diversification. If your employer makes contributions to your 401k, then you automatically have traditional savings. That’s because employer dollars go into your account pre-tax. Similarly, if you’ve been saving for a while, you’ve likely accumulated a good portion of your total retirement savings pre-tax. Traditional savings are a common source of regular monthly withdrawals but, since they are taxed like a paycheck, distributions might affect how much of your social security check will be taxable. Similarly, if you take large withdrawals from traditional savings, you might find yourself in a higher tax bracket.

Roth savings, which are Tax-Free, can be used to pay for large expenses without impacting your Social Security tax rate or your income tax bracket.

As you can see, there are pros and cons to both. Just as you diversify investments when building a portfolio, it can be a good idea to diversify the tax liability of your retirement savings accounts.

Let’s consider Jack. He is a 40-year-old married taxpayer. Their household income is $95,000 and they are on track with their retirement savings.

Their household income puts them in the middle of our tax table. That means it’s probably hard to guess if their taxes will be higher or lower later.

It’s not uncommon to feel like you can’t predict whether your taxes will be lower now or later. In fact, most people would be hard-pressed to guess this accurately.

Rather than thinking about what percentage you’ll pay in taxes now or later, perhaps think about whether you want to pay those taxes now or later.

Since qualified Roth withdrawals are tax-free, by paying tax on your contributions, you are, in essence, pre-paying your retirement tax bill when you make Roth contributions.

This is worth considering if you think you’ll be in the same tax bracket now and in retirement.

Another consideration for Jack is the benefit of tax diversification. He might think about building both traditional and Roth savings.   Let’s say Jack’s employer offers a matching contribution if he saves up to 6% of his pay. He might save his first 6% in the traditional bucket.

But it’s recommended you aim to save 10-15% in order to be on track for retirement. So, Jack might consider adding 1% to his savings rate annually. But, instead of adding to the traditional savings, he might elect to build his Roth savings instead.

Another component of the To Roth or Not To Roth decision is how many working days are still ahead of you, or as we refer to it, your retirement time horizon. The further away from retirement, you are, the more time your Roth contributions will have to grow. This is another reason why “it depends” on Jack. At age 40, he probably has 25 years of tax-free accumulation which could make the Roth a valuable piece of his retirement picture.

On the other hand, if your working days are limited, odds are traditional savings might be a better choice.

I know I’ve said it a few times already, but it’s worth repeating. Making the Roth or Not To Roth decision is tricky. 

Meet Tim. He is a 55-year-old married taxpayer with a household income of $185,000. Tim got a late start with his retirement savings, so he is not entirely on track with his savings.

Tim’s household income puts him in the middle of our tax table. Since he’s behind on his retirement savings, it may be challenging to save enough to replace all of his income in retirement. If his income goes down, his tax rate will too. For Tim, traditional savings might make the best sense.

This is not an easy or straightforward decision. There are several things to consider when trying to make the decision that is best for your present and your retirement future. But your MoneyNav coaches are here to help. Just schedule a meeting right from your MoneyNav dashboard.

Then just keep taking the best next step. Google is full of advice. So are family and friends. But not all advice matches your situation.