Many people struggle when it comes to choosing the best retirement account because, in part, choosing the right account involves making predictions about the future. But how can you tell if a traditional or Roth IRA is best for you?
Roth accounts are relatively new, as they were only introduced in 1998. In the most basic sense, Roth IRAs can help you to avoid tax ramifications down the road since any contributions are made after taxes, meaning that withdrawals are not taxed. They also have a number of benefits; for instance, you are able to withdraw prior to retirement without penalty and continue making contributions after turning 70 ½ (traditional IRAs require you to take required minimum distributions starting at this age).
While these benefits may make Roth accounts sound attractive, they do not always make sense for everyone. Generally, the decision between Roth or traditional IRAs comes down to how much a person is currently making and how much that person plans to make in the future. Roth accounts make the most sense when people think that they will have a higher income in retirement than they do now, meaning that they would be taxed at a higher rate later than they are now. Individuals who expect to earn less during retirement than now typically should opt for a traditional account since it will allow them to enjoy a lower tax rate in retirement.
The Benefits of Roth Accounts for Young Earners
Typically, a Roth account makes the most sense for young workers who have not yet fully realized their earning potential. Young workers often have an effective tax rate in the low single digits, and it is highly likely that they will be in a higher tax bracket once they retire. Front-loading the tax burden makes sense for them since it will save money down the road. In addition, investments grow tax-free in Roth accounts, an important consideration for young workers as the money will likely accrue compounded interest over the course of decades. When these individuals reach retirement, they will be able to spend all the money they have accrued without worrying about paying any taxes.
However, young workers should also consider that, since their contributions are taxed, they will need to divert more of their monthly income to retirement to make the same impact as non-taxed accounts. In a sense, Roth accounts require that individuals pay both the contribution and the taxes to a retirement fund.
At the same time, if a young worker made maximum contributions to a traditional retirement fund and then invested the tax they saved into a Roth, they would likely end up paying more in taxes than if they used a Roth to begin with, due to the required tax on the investment growth.
The Primary Strategy for Older and Higher Earners
Once individuals start to approach the peak of their careers, a Roth account stops making a lot of sense. Individuals who have high salaries, and who are thus in higher tax brackets, will likely experience a lower tax rate during their retirement years. As such, they may do best to choose a traditional account, which will defer taxes for the future.
For the highest earners, this may actually prove a moot point since there are income restrictions for opening Roth accounts. In 2019, the IRS is prohibiting people from contributing to a Roth account if they earn more than $137,000 annually as a single person or more than $203,000 as a married couple. There are some strategies for getting around this rule, but people generally do not have a compelling reason to do so, especially considering that traditional IRAs do not have income caps for contributions.
Higher earners with traditional accounts can also enjoy a lower adjusted gross income (AGI). Pre-tax contributions are deducted from the AGI, whereas post-tax deposits into a Roth IRA are not. A lower AGI can help maximize the Saver’s Tax Credit for people who make contributions to traditional plans, although this credit mostly applies to individuals with modest incomes or AGIs below $64,000 for joint filers.
The Benefits of Having Both Traditional and Roth Accounts
The people who may have the most difficulty deciding between a Roth or traditional account are those in the middle of their careers. These individuals probably do not have a clear idea about their future tax status. In this case, it can make sense to contribute to both a Roth and a traditional account at the same time. This strategy is akin to hedging their bets, although individuals should note that combined contributions cannot exceed $6,000 annually or $7,000 for people over the age of 50, according to current tax law.
However, there are some other advantages to investing in both. During retirement, people may have low tax years, such as when they have significant long-term care expenses. During these years, it makes sense to take from traditional accounts. These same individuals can also have high tax years, especially with large capital gains. In these years, distributions can come primarily from Roth accounts.