To Roth or not to Roth; That is the Question

Congratulations!  You’re saving for retirement!  You’re making plans for a life full of choices that only people with independent wealth get to make.  Saving, however, is complex.  Many of us get “lost in the weeds” of retirement saving, get frustrated, and just don’t get the details right. 

Let me say this to begin….you’re saving money.  You’re living below your means. That in itself is a great choice that will literally pay dividends into your future.  Even the most inefficient savers still have more money than those that don’t save at all. 

If you have a corporate retirement plan at work, most offer 2 methods of deferring your salary.  One is Roth (post-tax), and the other is Traditional (pre-tax).  If you don’t have a retirement plan at work, you may have access to either a Roth traditional IRA.  A literal fork in the retirement road.

Which path is best for you?  As with most things we tackle here, the answer is complicated. 

Roth

Saving is post-tax.  You don’t get to take a tax deduction for the money you save with this method.  That’s not great for your tax picture today.  That’s its only drawback, though. The money you take out of the plan (as long as you meet the eligibility rules) is completely tax-free.  There also aren’t any required distributions from a Roth account when you turn 73, like there are from a traditional account.  Even your heirs can benefit, as they can inherit the entire balance completely free of income taxes. 

Let’s say that Sam saves $250,000 in a Roth 401k over his working lifetime.  His contributions into that account were $100,000 over time and earned $150,000 in interest.  He paid taxes on the $100,000 he invested, but he will get the $250,000 back tax-free.  He uses $200,000 of it over his life to fund his retirement, then leaves $50,000 to his children upon his death.  The kids get that money completely tax-free as well.  The takeaway is that Sam elected to pay taxes on $100,000 and got the benefit of never paying taxes on the $150,000 of growth.

Traditional

Saving is pre-tax.  You should get to reduce your taxable income by the amount you choose to save.  That’s great for your tax picture today.  There are strings attached, however.  You have to pay taxes on the entire balance as you use the money from the account, even if you wait until you’re 59.5 years old.  You will also be forced to take some money out of the account starting at your age 73, even if you don’t need it, and your kids could have significant tax implications to inheriting the money.

Now let’s look at Sam if he were to save the same $250,000 in a traditional account.  He got to deduct the $100,000 from his income over time.  Someone will, however, have to report the entire $250,000 as taxable income at some point.  Sam will report the $200,000 he used to fund his retirement, then his children will have tax implications of the $50,000 that they received upon his death.  The takeaway is that Sam got to deduct $100,000 from his income, but will eventually report the entire $250,000 as income.

Which is right for you?

Some basic ideas are pretty relevant to that choice.  In many cases, the Roth makes a lot of sense over the traditional, with some very notable exceptions.  Older savers get less benefit from Roth savings, as they have less time for their money to grow.  People that anticipate being in a lower tax bracket in retirement also get less benefit from Roth savings, as the tax deduction from traditional money today may be worth more than any future tax breaks from the Roth. 

This is a big issue that will greatly affect your financial present and future.  It’s a great idea to consult with your trusted financial advisor before making such an important choice.  Find out if you’re eligible to save either way, what the annual limits are, and what the financial impact is for you.  Re-evaluate every year to make the proper choice, as your method may need to change with your personal circumstances over time.

As always, you can find this and many other articles about basic financial planning on our website, www.paducahfinancialconsultants.com.  Just click on the “blog” section and the entire library is at your fingertips. 

A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply. Examples herein are hypothetical situations based on real life examples. Names and circumstances have been changed. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investments or strategies may be appropriate for you, consult your advisor prior to investing.

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