If given the option, would you rather defer taxes or pay them now? That seems like a fairly straightforward question with a no-brainer answer. In fact, most of us would probably take advantage of the chance to defer any type of payment. People work hard for their money and want to hold onto it for as long as possible. Unfortunately, the answer to that question isn’t as simple when determining which type of Individual Retirement Account (IRA), traditional or Roth, to use for retirement.
There are a handful of differences between traditional IRA’s and Roth IRA’s, but the core differences are in how the accounts are funded and how the contributions and earnings are taxed upon withdrawal. Traditional accounts are funded using pre-taxed dollars, which allows for a current year deferral of taxes by reducing your taxable income. Later, when the funds are withdrawn in retirement, the accumulated contributions and earnings are subject to income tax. On the other hand, Roth accounts are funded using after-tax dollars. Although no current tax break is received, the accumulated earnings and contributions are not subject to tax in retirement. There is also an annual Required Minimum Distribution (RMD) that the traditional account owner must adhere to upon reaching age 70.5. Roth accounts do not require any scheduled distributions and can be withdrawn at any time in retirement without a tax penalty.
Choosing a traditional or Roth account depends on many factors, most of which relate to an individual’s current and expected future income tax rates. A key question to consider is whether or not an individual’s income tax rates will be lower or higher in retirement. If income tax rates are higher now than in retirement, the individual is generally better off in a traditional account. Conversely, if income tax rates are lower now than in retirement, the individual is generally better off in a Roth account. Furthermore, if income tax rates are expected to be the same in retirement as they are now, both a traditional and a Roth account will result in the same purchasing power. In addition, another key factor is whether or not a legacy will be left for descendants, as Roth accounts can be “stretched” for decades for children and grandchildren without taxes being incurred.
So, for many, the decision may seem rather simple – just calculate future income. However, predicting future income is difficult, much less guessing whether or not Congress will increase tax rates within the next 10, 20 or 30 years. Instead of trying to predict the future, consider other factors that are more easily determined. Individuals are more likely to earn larger salaries and bonuses as they progress through their career. For a young professional or even a child, their tax rate is likely to be lower than when they would retire. Perhaps a Roth account would be more beneficial initially. It’s important to keep in mind income levels as a person progresses through their career as it may become advantageous to change to a traditional retirement account.
Another factor to consider is where does the individual plan to live upon retirement. States, like New York, have significantly high state tax rates, whereas states like South Carolina and Illinois offer deductions for retirees or even excluded retirement income from state taxes. Better yet, you can choose to retire in states like Florida or Texas, which do not have any state income taxes.
Just because a person is projecting a certain tax rate in retirement or plans to live in a state with minimal or no taxes, an individual can never make a completely wrong decision. Couples often times will look at other factors when choosing the right account for them. If an older couple would like to give a tax-free inheritance to their children, even if it means paying a higher tax rate for the contributions, a Roth account or back-door Roth may be the right fit for them. Or if a young couple is just starting a family and could use the extra tax savings now rather than later, a traditional account may be their best fit.
Whether a person or a couple chooses to defer current taxes using a traditional IRA or waits to receive a benefit upon retirement using a Roth IRA, they can’t go wrong. In either case, they are contributing to their future in an account designed to help them achieve long-term growth of retirement savings. In addition, funds can be converted from traditional to Roth in the future, especially in years of a lower tax bracket. Here at DWM, we strive to give our clients the information they need to make the best decisions for themselves and their family. If you are having trouble deciding which type of account to use or want to review your current strategy, we would be glad to assist.