Roth vs. Traditional- Which one is right for me?
Whether you contribute to an IRA, 401(k), 403(b), or TSP, most retirement plans offer you a choice between a Traditional (pre-tax) plan or a Roth (after-tax) plan. How do you know which one is the best choice for you?
There are a lot of factors to considering when determining whether to choose a Traditional or Roth plan for your contributions. These include your age, when you plan to retire (time horizon), your income tax bracket, and how much you want to contribute.
First, let’s look at the difference between a Traditional and Roth 401(k):
The money comes out of your pay check before the tax is calculated. For example, If your gross pay is $5000 and you contribute 10% ($500), you will only pay tax on the remaining $4500. If you are in the 24% tax bracket, you save $120 in taxes by putting $500 into a pre-tax investment. As the money grows over time, the interest, dividends, and investment growth are all tax-deferred. Once you retire and withdraw the funds, you pay tax on the entire amount.
Let’s say that one $500 contribution grows at 8% per year for 30 years until retirement. At that point, it would be worth over $5000. If you withdraw the entire $5000 at that point, and you are still in the 24% tax bracket, you would pay $1,200 in taxes.
Keep in mind that we talked about $500 per pay check. If you get paid biweekly 26 times in a year, that is $13,000 per year, which is $390,000 over 30 years. Total tax savings would be $3120 per year, which is over $93,000 of tax savings over 30 years. Sounds pretty good! At the same 8% hypothetical annual return, the investment value would be worth over $1.6 Million at retirement. If all of that is withdrawn and taxed at 24%, the total tax liability would be around $390,000!
You can see how the amount of taxes paid over the long term can end up being much greater than the annual tax saved each year while contributing.
With a Roth, the money comes out of your pay check after the tax is calculated. This means you do not receive any tax savings in the year you make the contribution. However, the funds grow tax-free so that when you withdraw them in retirement, you don’t pay any tax at all. Take the same example we gave above with $500 per pay check for 30 years. In a Roth 401k, you would not get the $93,000 of tax savings over 30 years, but you would get the entire $1.6 Million at the end, tax-free!
There are other important considerations as well. A Traditional pre-tax plan requires that you start taking annual distributions at age 70 ½., called Required Minimum Distributions (RMDs). Roth plans do not have the same requirements. Traditional plans are also taxable to beneficiaries while Roth plans are not.
Not always equal
In the illustrations given above, we assumed the same tax rate during working years as retirement years. However, this is not often the case. Often, we are in a higher income tax bracket while working than after retirement. It is important to consider current and expected future tax brackets, as well as your overall tax situation. Some high earners may find themselves subject to additional taxes that come into play once income exceeds a certain threshold. Pre-tax contributions could help them stay under these thresholds.
Traditional IRA and Roth IRA
Contributions to Traditional IRAs and Roth IRAs are subject to income limitations. These do not apply to Traditional and Roth 401k, 403b, or TSP. High earners may be ineligible to contribute to receive a tax-deduction for Traditional IRA plans, especially if they are also contributing to an employer-sponsored retirement plan. Roth IRAs are also subject to income limits. Check with your tax advisor to see if you are eligible.
A financial advisor can help you determine which type of plan is best for you, taking into consideration your overall tax situation, current resources, and future resources.