"Should I save for retirement in a Traditional or Roth account?" This is one of the most frequently asked questions we get.
There are many types of retirement accounts, but when it comes to tax treatment, they fall in one of two broad categories: tax-deferred and tax-free. Included in the tax-deferred category are the Traditional IRA, 401(k), 403(b), and Traditional TSP, SEP IRA, and more. Many of these have tax-free counterparts: Roth IRA, Roth 401(k), Roth 403(b), and Roth TSP. Each account has different rules for eligibility, how much you can contribute, sources of funds, and timing of withdrawals.
A tax-deferred account generally (not always) uses pre-tax dollars, meaning the income you contribute to your retirement account is not taxed. Then your savings grow tax free until you start withdrawing. At that point, you'll be paying ordinary income tax on everything you withdraw at the prevailing tax rate at the time.
A tax-free account uses after-tax dollars, meaning you've already paid income taxes on the amount you contribute. Then your savings grow tax free, and you'll never pay more tax (unless they change the rules on us) no matter how much your investments grow or how much you withdraw at once.
Most people have access to at least one tax-deferred and one tax-free account choice. Which is better? To save on taxes now and pay later or have a higher tax bill now and be tax free later?
When to pay taxes depends on your tax rates now and later
There's little difference in end result between a tax-deferred and tax-free account unless your tax brackets are different between the time you are saving and the time you are withdrawing.
Whether it is better to pay taxes now or later depends on whether you believe your tax rate will be higher now or in the future and whether you can afford the extra tax now.
Gambling on tax rates?
Tax rates have declined significantly since their peak in the 1940s where the highest tax bracket paid 94%, and the lowest tax bracket paid 23%.
Where will tax rates go from here? Nobody knows. Tax rates are unpredictable in the long run, can move sharply, and can go nowhere for an extended length of time.
There must be a better way than gambling on future tax rates to decide whether to invest in a tax-deferred account or a tax-free account.
You can end up in a high tax bracket in retirement
Another way to decide is to use expectations about future income to get a sense of what your taxes will be like, assuming the same tax system we have today.
Today I earn an income. When I retire, I will spend my time on the beach and earn nothing. Therefore, my tax rates will be lower in retirement. Tax-deferred is the way to go.
How many things can you spot that are wrong with this statement?
A typical retirement can last for 20-30 years or longer. After the initial period of retirement where it feels like a great vacation, people get bored and depressed if they feel they are without purpose. Often, the search for post-retirement purpose leads one to take a job or start a business that fits their lifestyle.
Even without working, you can end up in a high tax bracket if your tax-deferred investments do well enough.
Most retirement accounts have a feature called Required Minimum Distributions (RMDs) that force you to withdraw from a retirement account once you hit a certain age. The older you get, the more you're required to withdraw from your account. The more you withdraw, the higher your tax rate.
Source: RightCapital, screenshots from actual client retirement plan. Does not imply you or this client will achieve these outcomes.
Behold the power of compounding over many years! These screenshots are taken from an actual client's retirement plan to illustrate how it might be possible to go without work in retirement yet end up in a higher tax bracket thanks to compounding investment returns over time and frugal spending.
This client is hovering at the 22% tax bracket right now and could end up well into the 28% tax bracket, assuming their retirement accounts perform well, and that tax rates increase in 2025 when the Tax Cuts and Jobs Act expires.
Choosing a retirement account type is not a trivial decision
Choosing the right type of retirement account requires considering how it fits in with your overall retirement plan.
Factors to consider:
Eligibility
Contribution limits
Your income today, in retirement, and in between
Your cashflow needs
Your lifestyle
Your goals for the future
How much you save
The composition of your investment accounts and risk tolerance
Knowledge of upcoming changes to tax rates
We take the time to consider all these factors when working with our clients on their retirement plans.
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