Traditional or Roth: How to Choose

[Note: The terms IRA, 401(k), and 403(b) can be used interchangeably for the purpose of this article, and they may be referred to as retirement savings accounts. The terms Roth, post-tax, and after-tax are interchangeable, as are the terms pre-tax, traditional, and tax-deferred. I will be assuming that you are eligible for both Traditional or Roth contributions through a retirement savings account for today’s article. Please read the disclosure statement for MHFG if you have not]

Let’s clear the air because today’s post is a contentious one: Traditional vs. Roth

This topic is like a heavy-weight boxing match. Everyone has an opinion, with most people adamant that their’s is correct. Does an answer exist to this age-old question? If so, is it the same for everyone?

(Feel free to read these using an announcer’s voice!)

Without further ado, I present today’s contenders:
Traditional Savings – King of the ring and the deferrer of taxes

Roth Savings – Newcomer and boasting tax-free growth

Synopsis

As discussed in the ABCs of (Retirement) Investment Accounts, there are two main ways to save when it comes to tax preferential investment accounts: Traditional and Roth. So often, the question is presented as paying taxes now or later. But as I implored you to consider in my previous article, this should be a question of which costs you less in taxes and how much flexibility do you need?

Many people fall into two categories: They either like to get things done right away, or they prefer to put them off until the last minute. However, when it comes to traditional or Roth contributions, throw this tendency out the window because your hard-earned dollars are at stake!

What does it cost?

The first question is, which costs you less in taxes? No one should pay more than required, whether you pay them now or in the future. What determines how much you will pay in taxes? If you answered income, you would be correct. If you said the government, you would also right.

But Mile High Finance Guy, doesn’t the government decide taxes based on your income? While true that the government does this, you will see soon why I list them as separate points. First, you need to start by determining your current income and compare it to your expected income and needs in retirement. Secondly, once you have done this, you need to weigh the government’s chances of changing tax rates by or during your retirement.

(I say government’s chances because Democrats and Republicans disagree on what an appropriate tax rate is; thus, changing them requires chance. Chance, in this case, means the likeliness a majority of Congress, and the President will come together to agree on such a change)

Fun Fact Alert! If tax rates never change and you have the same tax brackets in retirement as while working, traditional or Roth savings will always be a wash and not matter.

An overly simplified example
Blair is in the 10% tax bracket and wants to invest $10,000 one time
•In a traditional account, Blair would contribute the full $10,000 since Blair is waiting to be taxed until the future
•In a Roth, Blair would contribute $9,000 since 10% is taxed now; $10,000 – ($10,000*0.1) = $9,000

Blair’s money grows for ten years with a 10% return
•In a traditional IRA, the money has grown to $27,177.61
•In a Roth IRA, the money has grown to $24,459.85

Blair now withdraws the money
•From the traditional IRA, Blair takes out the full amount and pays Uncle Sam 10%
$27,177.61 – ($27,177.61*0.1) = $24,459.85 left for Blair
•From the Roth, Blair withdraws the $24,459.85

Thus as seen in our example, Blair walks away with the same amount of money! While Blair technically pays more dollars in taxes, $1,000 initially versus $2,717.76, both are equal to 10% when they are taxed. Pretty neat, right?

Now, the matter is that almost no one will end up in Blair’s situation, and everyone’s situation will vary. This is because people tend to make a different amount each year. In retirement, their income needs and sources will vary yearly as well. Since everyone’s situation is different, no two people will have the same tax situation.

Simply put, there is an answer to traditional or Roth, but it will depend on you. So throw what you have been told out the window! As demonstrated in the above Fun Fact example, Blair had a straightforward situation; real life is more complicated. Do your best to guesstimate your income now versus in retirement and then weigh what the government may change in the future. Additionally, if your income changes much, always revisit this topic.

Before moving onto the government and the future, let’s cover some final points, and an example to summarize everything learned so far:

•Assume you currently make $85,000 a year, have an effective tax rate of 15% with the federal government, and your local state has a 5% rate. In retirement, your income needs are less, so you will only need to withdrawal $45,000. This is because your house is paid off, and you receive a modest social security check (Remember for traditional accounts withdraws equal taxes since they are income). You have a 10% federal tax rate at this income, but you have now moved to a state without income taxes. You would be better off saving traditional retirement dollars in this situation since your taxes will be 10% less!

•The finer point in this example is state tax rates can be a significant factor if you plan to move to a high tax or low tax state in retirement. For those moving to New York in retirement, Roths could save them money if they moved from Texas. The opposite holds for New Yorkers moving to Texas; traditional IRAs could save them money. If you plan to move to a different state in retirement, consider the tax differences. If not, then ignore them since we cannot make an educated decision.

We now have seen why knowing your income in the present versus in retirement is essential for the pre-tax and Roth decision. The second factor we must now consider is the government, because tax rates may change!

Currently, as of 2021, tax rates are near historic lows for modern history. Does this mean they will have to go up as our national debt rises? The answer is unknown.

If you believe tax rates will change in or by retirement for you, consider your income needs and do your best to hedge with the appropriate account. This could be pre-tax or Roth, and while no one officially knows (not even the government), it doesn’t mean don’t try! Make an educated guess, ask an accountant, or do both.

My theory right now is that taxes will go up in the future, but I also don’t think I will be in a high tax bracket come retirement. Importantly this doesn’t mean you shouldn’t be concerned; you may retire sooner or later than me, and it is a given that your income situations will be different. Also, my theory could be wrong; it is a guess after all. One last point on taxes before we discuss flexibility is Social Security.

Social Security can become taxable if you have income on top of it, and withdrawing from a traditional retirement account is considered income. Medicare premiums can go up if you make too much from withdrawing as well, so depending on how analytical you want to be, you can factor both of these considerations in! If you expect to draw large amounts out of your retirement accounts someday, Roths could potentially be the better choice.

However, if you are not comfortable trying to guesstimate on your own and you are as detail-oriented as me, pay an accountant to give you their advice!

How flexible does your money need to be?

Okay, we have made it past taxes and onto a more straightforward subject, hooray! This section is about how flexible you need your money to be. For example, is it okay if your dollars cannot be folded? What if your dollars cannot hold their shape? Okay, maybe not that type of flexibility. Instead, we are referring to the chances you will need your money before 59.5, thus incurring a penalty if you are not careful!

As covered in the prior post, if you do not need your money until you are 59.5, then traditional or Roth savings are both adequate! On the other hand, if you may need access to the money before then and do not have an exemption to the early withdrawal penalty, Roth IRAs may be a better choice! Why is Roth potentially better in these situations?

(I will be writing a future post on penalty-free withdrawal strategies and link it here once it is complete)

If you remember from the ABCs of (Retirement) Investment Accounts, Roth contributions can always be withdrawn without penalty, as can Roth conversions after five years. Thus, Roth accounts provide additional flexibility for those retiring early or likely to need their savings before the government ordained retirement age. With Roth accounts, any gains are taxed and penalized if you are under 59.5. So watch out and do not touch anything besides your contributions or converted amounts!

[Interested in Roth conversions? Read this comprehensive post]

In Summary – Determining the Winner

As seen through everything covered so far, choosing a winner can be complicated. Remember, you cannot plan for every variable, so try not to stress too much. Instead, determine your basic situation and future needs, decide if tax rates are likely to change, and choose the account that works best for you! For higher-income people that know they will spend less in retirement, traditional accounts can be a better option. For those that plan to move to higher tax states and their income will be similar, Roths could be a better choice. For people who need increased flexibility, Roth conversions or contributions can provide just that. So use this as a starting point and explore your situation! Where should you start if you want to determine your situation?

Ask yourself the following questions:

•How much do I make now versus need in retirement?

•How much will my tax rates be in retirement given my income, state of residence, and potential government changes?

•How much flexibility do I need?

You now are prepared to choose the best account for your situation. I save in a pre-tax status currently because I plan to do conversions down the road. I also have existing Roth dollars because I want to hedge if I am wrong about the future. Always remember to think things through. No one should pay more taxes than they need to! You can also diversify your taxes just like investments. Whether you like to hedge or you cannot decide, diversify! Thanks for reading today’s article. Let me know in the comments below, who is your heavy-weight winner: Traditional or Roth?