All day long I get questions about traditional IRA’s and Roth IRA’s. Everyone wants to know which is better. And some days, I do wish there was a blanket answer that I could slap on to everyone’s situation. It sure would make my job a lot easier, but unfortunately, there is no secret answer. As with most questions, the answer is “it depends”.
Deciding which retirement account to use is a tax question. And because taxes are one of, if not the biggest expenses you’ll ever have, what you choose matters a lot. Do you want to be taxed now or later? Do you want the tax deduction today with a traditional IRA or the tax-free growth of a Roth IRA? Do you want to deal with RMD’s (Required Minimum Distributions) at age 72?
These questions are often hard to answer because there are a lot of unknowns, the biggest of which is what tax bracket you’ll be in down the road. If we knew that you’d be in a much lower tax bracket in retirement, then it may make a ton of sense to lower your taxes today with a traditional IRA and then pay taxes on that money (and the growth) at a much lower rate.
The one potential issue with this strategy is that we don’t know what changes will be made in the tax law. Tax rates may increase so that you stay in the same bracket even with less taxable income. Tax rates may even go down in the future (I find this unlikely but it is still a possibility). No one knows. One thing we do know however, is that many of the benefits in the Tax Cuts and Jobs Act, which lowered taxes for many businesses and individuals, were written to only last until 2025. It could go either way from there.
In my experience, most people underestimate their tax bill in retirement. Oftentimes, people have most of their money in pre-tax accounts (ie Traditional IRA, 401(k), TSP) which will be taxed at their personal rates when taken out. Not to mention that for most people with income over certain limits (the limits are low), up to 85% of Social Security is counted as taxable income. If people want to live at the same standard of living in retirement as they were during their career (most people do), they will most likely be in a very similar tax bracket as before.
Now, if a retiree has at least a portion of their savings in Roth accounts (Roth IRA, Roth 401(k), Roth TSP), they tend to have much more control over their tax bracket. In years when they know they’ll have higher taxable income, they may choose to take a portion of their living out of their Roth account which doesn’t bump them up into the next bracket. In years when they have lower taxable income they’d be able to withdraw from their traditional accounts without increasing their taxes too much. The power to make those decisions year by year allows them to have at least some control over their tax bill.
I have to mention however, that this sort of strategy doesn’t make sense for everyone. For some it simply makes sense to stick to contributing to a traditional IRA because the tax deduction is too valuable for them now. This often happens for those in the peak of their career with higher incomes.
One of the best times to use a Roth account is near the beginning of someone’s career when they aren’t paying much taxes anyway. This way, their Roth account has decades to grow and all of it can be taken out tax free in retirement.
With all this being said, none of this information is meant to be a recommendation. It is meant to merely educate about the things that I have learned and seen. I don’t know what strategy is best for you because I don’t know your situation. Those that tend to be the most prepared for retirement are those who educate themselves to make informed decisions. I hope that this article can be a part of that education as you make decisions in your life and for your retirement.