For those opening their first retirement accounts, the question is inevitable: Roth or traditional—which should I choose?
There's no correct answer to this question, and the benefits of each option will depend on a number of factors, such as your current and future salary, which tax deductions you will claim now and in retirement, and how the U.S. tax code will change over the next several decades. Unfortunately, many of these factors are impossible to predict. Still, understanding the basics of how your retirement contributions are taxed will help guide your decision-making process.
Here's what you need to know to determine which type of retirement account is right for you.
Roth or traditional: what's the difference?
Typical retirement accounts, such as an IRA or an employer-sponsored 401(k), come in both Roth and traditional forms. Before you choose which account type is right for you, you need to understand differences between them.
Traditional accounts allow you to defer federal income taxes on your contributions until you withdraw your money in retirement. This means your taxable income for the current tax year will be reduced by the amount you contributed to your traditional accounts. But when you take out these funds in retirement, you'll owe taxes on both the money you contributed and the interest it generated.
In most states, this deferral applies to your state and local taxes as well. However, you'll still have to pay Social Security and FICA taxes on your traditional contributions. And in at least one state, Massachusetts, you'll still have to pay state and local taxes on your contributions in the year they're earned.
On the other hand, Roth accounts allow you to make post-tax contributions. This means your contributions are taxed like ordinary income in the year that money is earned. However, both your contributions and the interest they generate can be withdrawn tax-free in retirement.
Despite receiving opposite treatment, both Roth and traditional accounts provide excellent tax benefits to boost your retirement savings. By contrast, any ordinary taxable investment account is funded with post-tax money now, and its interest is taxed when it's withdrawn, reducing the ultimate amount you earn. That's why investing any money at all into a retirement account is a smart move. However, once you've committed to saving for retirement, it's still wise to think through which account provides the best benefit for your situation.
How do I determine which is best for me?
If all other conditions remain the same, traditional contributions will yield the same results as Roth contributions. For example, let's say your marginal tax rate is 12% both now and in retirement; you have $10,000 (before taxes are applied) to invest in your retirement account, and you plan to withdraw that money 30 years from now.
If your money earns an annual average return of 7%, and it's invested in a traditional 401(k), you'll have about $81,165 in 30 years. Once a 12% tax rate is applied to that amount, you're left with $71,425.
If you chose to fund a Roth account instead, you'd only be able to invest $8,800 now, since you'd owe taxes on the $10,000 up front. However, if you earned that same 7% annual return, you'd end up with the same result in 30 years—$71,425, which isn’t subject to taxation.
So what does this example teach us? First, neither account type is inherently better than the other. Second, since all of the other conditions affecting your finances are unlikely to remain the same between now and retirement, they will dictate which type of account is right for you in any given year.
Chief among these conditions are your current and future tax rates and the amount you can afford to contribute to retirement each year.
Think about your tax rates
A lot of people are tempted by the immediate tax deduction they'd get from a traditional account. But according to Adam Bergman, senior tax attorney at the IRA Financial Group, taking that deduction probably isn't the best move for young people.
"Students just entering the workforce—their salaries are probably lower than they will be down the road," said Bergman. "Because of this, the deduction they'd get on their traditional contributions is less valuable than what it would be for a higher income earner."
In order for traditional contributions to earn you more than Roth contributions, the tax deduction applied to those contributions now needs to be greater than the tax rate you'll pay for your withdrawals in retirement. While this is plausible for people at the height of their careers it's less likely for new workers in lower tax brackets, especially since 2017's Tax Cuts and Jobs Act, reduced federal income tax rates until 2025.
"It's hard to believe, but these are actually historically low tax rates," said Bergman. "We don't know what will happen in 40 years, or what tax rates will be, so my strategy is to resist the temptation to take a deduction, and lock in the tax-free growth."
Your current tax rate is easy to determine; just reduce your salary by any deductions you'll claim this year to arrive at the rate that will be applied your last dollar earned.
Here are the 2018 marginal tax brackets based on your filing status.
|Tax rate||Income subject to tax bracket|
|Single||Married Filing Joint||Head of Household|
If you just graduated or are still in the early years of your career, you're probably earning significantly less now than you will be down the road. Because of this, your marginal tax rate—the tax rate applied to your last dollar earned—is probably lower now than it will be 10 or 15 years from now.
For example, a single worker with an annual salary of $45,000 would appear to fall into the marginal tax bracket of 22%. This doesn't mean their entire salary is taxed at 22%, however. First, as you can see in the table above, different sections of their income are subject to different rates, rising as they earn more money. Second, various deductions will lower their taxable income further.
If our worker claims the individual standard deduction of $12,000 when they file their taxes, their taxable income would be reduced to $33,000, making their true marginal rate only 12%. This is the rate that will be applied to any Roth contributions they make for the year (unless their contributions are large enough to also include funds from a lower tax bracket—unlikely in this scenario).
For a person in this situation, it might make sense to pay the 12% rate now and secure tax-free growth for the future. If their income increases enough to raise their marginal rate later in life, they can consider switching to traditional contributions at that time.
Think about how much you want to contribute
Although your current and future tax brackets should be your main consideration when determining whether to make Roth or traditional contributions, some people should also think through how much they want to put away for retirement.
In the example above, you saw how a $10,000 traditional contribution yielded the same interest as an $8,800 Roth contribution, once a common tax rate was applied. This is because the $10,000 traditional contribution represents pretax dollars, while the Roth contribution represents post-tax dollars. In all actuality, the two figures represent the same amount of money.
However, if you're planning to contribute the maximum amount of money allowed in a given year, and if you can afford to max out a Roth account, you'll effectively invest more money than you could in a traditional account. For example, the maximum amount you can contribute to an IRA in 2018 is $5,500, regardless of whether it's a Roth or traditional IRA. If your marginal tax rate is 12% and you max out a traditional IRA, it's the same as contributing $4,840 to a Roth IRA. However, if you can afford to put $5,500 into a Roth account, it's like putting $6,250 into a traditional account—more than would otherwise be allowed.
If you're planning to max out a retirement account, take this rationale into consideration as well as your tax brackets.
You can have it all
Fortunately, you don't have to commit to only carrying a Roth or traditional account. As long as your retirement plan allows it, you can contribute to both types of accounts in a single year or switch between them as your annual income changes.
Carrying both types of funds might be a good idea if you're unsure of how much retirement income you'll receive. Having both types of funds available to you in retirement will provide the flexibility to take out traditional funds during a year when your tax bracket is low and Roth funds if unexpected income pushes your tax bracket higher.
Regardless of which type of contributions you choose, the most important decision you can make is to start saving early, and to take advantage of the tax incentives provided by any retirement account.