Deciding which type of retirement account to open and fund can be complicated. Although the main difference between Roth and Traditional accounts is straightforward, their implications and regulations can be confusing. A Roth IRA or 401k is funded with post-tax money, and it grows tax-free. This means that any money you withdraw from the account during retirement is tax-free. On the other hand, a Traditional IRA or 401k is funded with pre-tax money, which lowers your current tax bill. It grows tax-deferred, so no taxes are paid on earnings until you start withdrawing, at which point you will pay taxes on the total amount you withdraw.

The ideal type of account or mix of accounts will depend on various factors, such as how much non-retirement account money you anticipate having in retirement (such as other investments, pensions, real estate rents, wages, etc.), your current tax bracket, and the tax situation you expect to be in during retirement. 

For example, if you don’t anticipate having much additional income besides social security and your tax-sheltered retirement accounts, then it’s likely that you will want to put more into traditional accounts. Conversely, if you expect to have significant additional income during retirement, it’s better to have a greater portion of Roth accounts. The chart below illustrates this point using an example of a married couple making $125,000 per year, saving 10%, and retiring in 30 years. 

This couple is making just enough to have a marginal tax rate (the tax on the next or last dollar earned) of 22% while having a current effective tax rate (the blended tax rate on all income) of around 10%. If they don’t expect to have significant other retirement income, they should take advantage of the 22% savings while expecting to pay something closer to 10% in retirement. If they had all their savings in a Roth retirement account in this scenario, they wouldn’t have any taxable retirement income according to the IRS. While this might seem beneficial, it’s important to note that at lower income levels, taxes are typically quite low. For instance, a married couple’s first $26,000 is taxed at a 0% rate.

I have developed a dynamic tool that takes these inputs and shows the projected optimal mix for the highest retirement income. The tool accounts for taxes on social security and other factors such as Medicare premiums. Feel free to reach out to me if you would like to look at your situation.

There are a few other key considerations when comparing the two types of accounts and they illustrate why I generally prefer Roth accounts over traditional when the projections are similar:

1. Some people argue that taxes are bound to increase, making Roth accounts the better option. I feel it’s best to plan based on current tax laws and adjust as tax code changes are made. 
2. The IRS has imposed limits on how much individuals can contribute to tax-sheltered retirement accounts, including traditional and Roth IRAs. Additionally, there are income restrictions and overall caps on contributions. Despite these limits, it’s typically possible to find ways to optimize your account mix.
3. One of the key differences between Roth and traditional accounts is flexibility. With a Roth account, you can withdraw your contributions before retirement age if needed. While this can be a valuable safety net, it’s important to use this feature judiciously so as not to compromise your long-term savings goals. Roth accounts can also be very advantageous when passing on to heirs as the withdrawals will likely also be tax-free for them. 
4. If your employer’s 401k plan doesn’t offer a Roth option, don’t worry. You can still supplement your traditional 401k with a Roth IRA. However, it’s always recommended to      contribute enough to your employer’s plan to maximize any matching contributions before exploring other savings strategies.
5. The SECURE 2.0 act just made Roth versions of SIMPLE and SEP IRAs possible. 

If you need help setting up a retirement account or understanding how best to save, please reach out. I am happy to help whether you are nearing retirement, just starting out with little to no savings, or anywhere between.