Roth IRAs

3 People Who Benefit from a Roth (and 2 Who Don't)

Who should go with a Roth and who should go with a traditional IRA or 401(k)? If you don't want to pay more in taxes than necessary, choose wisely.

Let’s say you’re working and saving for retirement and you have a choice between a traditional IRA or 401(k) or a Roth version of the same type of account. How do you choose?

As you can imagine, taxes are the primary factor to consider. That’s because the way you put money into these accounts and then later take it out is very different:

  • Traditional retirement accounts are funded with money on a pretax basis, meaning it comes straight out of your paycheck before you pay any taxes on it. That reduces your taxable income and essentially gives you a tax break for the same year. However, that tax break comes with strings attached. When it's time to start taking money out of those accounts, you’re going to have to pay taxes on every dollar you withdraw.
  • Roth accounts, on the other hand, are funded with money that you’ve already paid taxes on. So contributing to a Roth doesn’t reduce your taxes today. However, qualified distributions are tax-free. (Generally, a distribution is qualified if taken at least five years after the year of your first Roth contribution and after you’ve reached age 59½.)

Working individuals who meet IRS income limitations can contribute to a Roth IRA or make pretax contributions to a traditional IRA. And increasingly, retirement plans like 401(k)s allow designated Roth contributions in addition to pretax contributions. So, more people are going to have the choice to make — Roth or traditional? Here are some of the factors to help guide their decision.

Ask Yourself: Will Your Tax Rates Be Higher Now or Later?

The main thing you’ll want to consider is whether your marginal tax rate will be higher or lower during retirement. If you think your tax rate will be higher, paying taxes now with Roth contributions makes sense. If your tax rate is likely to be lower in retirement, you can use the pretax approach to defer taxes instead. The recently lowered federal tax rates are scheduled to revert to pre-2018 levels after 2025, which may make Roth contributions more attractive today.

Of course, tax rates are hard to predict, due to changes in the law as well as uncertainty around your future income levels.

When a Roth May Be Right for You

Here are three situations where a Roth probably makes the most sense:

1. You are currently in a lower tax bracket, but you expect that to change.

Let’s say you are a young professional who is just a few promotions away from a higher tax bracket. Contributing to a Roth IRA or Roth 401(k) means you pay the relatively low rate on taxable income now. Once you’ve retired, you will not pay any taxes on qualified distributions from the plan.

2. You are close to retirement and are concerned about RMDs.

If you’ve been a disciplined saver and have contributed a healthy percentage of your income to pretax accounts for many years, eventually you’ve got to pay the piper. Generally, beginning in the year you reach age 70½, you must begin taking required minimum distributions (RMDs) from traditional IRAs (and from 401(k)s, including Roth 401(k)s, once you’re retired) even though you may not need all of that income to live comfortably.

RMDs could bump you to a higher tax bracket. Qualified distributions from a Roth 401(k) or Roth IRA, on the other hand, would not create taxable income or increase your tax rate. Therefore, a Roth contribution may be preferable in order to limit the RMD income taxed at a higher rate.

3. You are a prodigious saver.

Suppose you can contribute the maximum amount to a retirement plan ($18,500 for 2018 or $24,500 if you’re over 50), even if you don’t get a tax break. In this case, the Roth account effectively enables you to save more in a tax-advantaged manner. Saving the maximum amount ultimately results in more after-tax retirement assets for the Roth account balance than a pretax contribution.

When Traditional May be the Way to Go

While a Roth is a good choice for a wide range of people, it’s not best for everyone. Here are two examples where pretax contributions, such as a traditional 401(k) or a traditional IRA, may be a better strategy:

1. You’re in your peak earning years.

When you retire, you might eliminate expenses, such as mortgage payments or college costs. And if not, withholdings for payroll taxes and retirement contributions still go away. As a result, your income from Social Security and the amount you need to draw from retirement accounts will likely be less than what you earn today. So, your federal tax bracket could be lower in retirement. Your state tax rate could also decrease, for example, if you move to an income tax-free state.

In this case, taking the tax benefit now with a pretax contribution may make more sense than the Roth contribution. You’ll reduce your current taxable income now while paying a higher tax rate, and then make withdrawals at a potentially lower tax rate later in retirement.

2. You are struggling to save.

The pretax approach may enable you to get your employer’s full 401(k) match with less impact on your take-home pay. This is because taxable income is reduced by the amount of your contribution.

Some Examples to Consider

ProfileExample*Likely Benefits From
Young person in a low tax bracket who is likely to be in a higher bracket laterEarns $50,000; 12% tax bracket (single). Next higher bracket is 22%.Roth
Someone who already has large pretax balances and wants to minimize RMDs in retirementEarns $160,000; 22% tax bracket (married). Approaching retirement with a $3.2 million 401(k) balance. RMD (around $171,000 at age 80) plus Social Security is more than spending need, and could bump household into 24% tax bracket.Roth
A prodigious saver who can afford to contribute the IRS maximum either wayEarns $130,000; 24% tax bracket today (single), with uncertain outlook for future tax rate. Can comfortably save $18,500 in a 401(k). After-tax savings are effectively $4,440 higher per year with Roth contributions.Roth
Person in peak earnings years who could be in a lower bracket during retirementHousehold income $360,000; near bottom of 32% tax bracket (married). The next lower tax bracket is 24%.Pretax
Someone with tight cash flow who wants the company 401(k) match while maximizing paychecksEarns $30,000; 12% tax bracket (single). Contributes 6% to 401(k) to get full company match. Pretax savings provide $216/year more net pay.Pretax

* Brackets are for federal taxes, based on rates as of Jan. 1, 2018. While rates are scheduled to revert to pre-2018 levels after 2025, those rates are not shown in this table. Income refers to gross earnings; current bracket reflects the standard deduction and potential retirement contributions. State taxes are not considered in the examples. Married status reflects joint filing.

Final Tip: The Tie Goes to the Roth

If you’re still unsure of what to do in your situation, the tie-breaker should often be in the Roth account’s favor because:

  • Roth accounts are generally better for heirs, since assets can continue to grow tax-free.
  • If you’re like many people and have more assets in pretax accounts than Roth accounts, adding to your Roth assets improves diversification. That hedges the risk of tax law changes or significant changes in personal circumstances.
  • Roth IRA contributions (but not necessarily the gains) can always be withdrawn at any time or any age without tax or penalty. But be careful — it’s not as flexible for Roth 401(k) assets, or assets that were converted from a traditional IRA to a Roth IRA.

While you should devote more energy to making sure you’re saving enough, a thoughtful decision between Roth and pretax contributions can help you take full advantage of those savings.

About the Author

Roger A. Young, CFP®

Senior Financial Planner, T. Rowe Price

Roger Young is Vice President and senior financial planner with T. Rowe Price Associates in Owings Mills, Md. Roger draws upon his previous experience as a financial adviser to share practical insights on retirement and personal finance topics of interest to individuals and advisers. He has master's degrees from Carnegie Mellon University and the University of Maryland, as well as a BBA in accounting from Loyola College (Md.).

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