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Money School: Retirement Savings - Traditional vs Roth


Most of us have access to some kind of tax-advantaged retirement savings account, either via a plan offered by an employer, or through an IRA, or possibly even both. In general, you should take advantage of this as much as possible, but there’s no general rule that determines what that means for a specific individual or family. 

There’s a further complicating factor in the tax advantage itself: in some cases (for traditional 401k, 403b, and IRAs) the tax break comes up front, and for Roth accounts it comes later. This presents a valuable opportunity that allows you to pick and choose what to do at different points in your life and career, but it can be confusing. What's the right thing to do? First, let's review those tax advantages. 

Traditional savings: the contributions made offer a present-day tax deduction, meaning the IRS is giving you an incentive to save by lowering your taxes this year. This is an attractive feature because everyone likes lower taxes now. If, for example, you earn $50,000, and contribute $5,000 to a traditional 401k, 403b, or IRA, you will only pay income taxes this year on $45,000 (ignoring other deductions and credits, etc). That $5,000 grows tax-free, is hopefully joined in subsequent years by more contributions, and eventually in retirement you can - in fact, you must - take the money out, at which point you will pay income tax on it as if it were a salary you were earning. This is why we call these kinds of accounts tax-deferred: you are pushing the tax payment later, when you will probably be in a lower bracket, but taxes will still be paid. 

Roth savings: for Roth savings, the tax advantage is the opposite. The same $5,000 contribution on the same $50,000 gives you no tax deduction this year. Like traditional tax-deferred contributions, the money set aside grows tax-free. But later, you can take money out without paying taxes at all. And for a Roth IRA, you're not required to distribute when you reach a certain age, so depending on your situation and needs in retirement, that could mean many more years and decades of tax-free growth to enjoy. Roth IRAs also have a much more lenient policy on early withdrawals, leading them to be viewed as a source of funding for things like a first home or children's education. This can be a very smart strategy, but certainly one to do your research/talk to an advisor about before you embark on it since you can easily run afoul of the rules. 

As the above general overview illustrates. which to choose is really a matter of which tax advantage you think is most valuable to you this year. You might think you know, but you probably don't! Taxes can change in myriad ways, and very few people know what their personal situation will be in retirement (Where will you live? Will you retire completely from one day to the next, or ease into it via part-time work and consulting? How old will you be?). For these reasons, it's a good idea to accumulate assets in a variety of tax buckets in your net worth as you go through your career. 

In general, Roth contributions make the most sense when you are young, just starting out in your career, and not making that much. If you're in a low tax bracket, the tax break isn't worth as much and the forever tax-free growth is much more valuable. In fact, I prefer Roth contributions for most of my clients. Even if you are starting to climb the tax bracket ladder, the tax-free withdrawals in retirement outweigh a lot of the present-day tax break.

Ask yourself this: if you realized $1,000 of tax savings this year from making tax-deductible contributions, did you save that $1,000? Put it toward debt, invested it, did something proactive and intentional with it? Even spent it on an experience of some kind? Probably not. You probably wouldn't do anything with it and after a year, the savings would have vanished. On the other hand, foregoing that tax break today means you will never have to pay taxes on the contribution again. Certainly there are some situations where it makes sense to lower your taxable income now: to qualify for lower Federal student loan payments if you're on one of the income-driven plans;  if you're near the threshold for qualifying for certain credits; so it's always worth talking over your circumstances with a tax pro or financial planner; and indeed we also don't want to bet the house on distribution rules remaining the same for decades. So it's still wise to diversify your tax exposure. But I think focusing on Roth savings is a compelling strategy for most people.

The other consideration is what's available to you, based on your income. Again, a general breakdown: 

Contributions to employer plans (401k's, 403b's, and the like) are not constrained by income limits. There are limits to how much you can contribute each year - that maximum is $18,500 for 2018, plus a catchup for workers over age 50. Any money your employer contributes on your behalf is counted separately from this limit. Often nowadays, you can make your employee contributions as Roth contributions (employer contributions always go into the tax-deferred traditional bucket). Because you can save much more in these plans than in an IRA, where the limit is $5,500, it makes sense to look here first. Certainly if your employer offers any sort of a match, you should contribute enough to get that match. 

There is a common misconception that your ability to make a Traditional IRA contribution is subject to income limits. It isn't. Anyone can make contribution to a Traditional IRA, as long as they have earned income, whether that earned income was $1,000 or $10,000,000. What your income usually does limit, however, is your ability to deduct the contribution: an important difference that often means the two get conflated. After all, the whole point of making these contributions is to capture a tax deduction today, right? Generally yes! But as we will see in the next post about the backdoor Roth IRA, this is a key element in making that strategy work. If you are not covered by an employer plan, you are entitled to deduct the full contribution (the lesser of your earned income or $5,500 for 2018). For those covered by a retirement plan at work, those income limits are described here. As you can see, the limits are quite low! 

Contributions to a Roth IRA, on the other hand, are subject to income limits. These limits are much higher than those limiting the deductibility for Traditional IRAs as described above. So it's much more likely that someone would be able to pair 401k contributions and Roth contributions. The maximum Roth contribution is the same as the Traditional IRA contribution; the lesser of your earned income for the year or $5,500. In fact, this is a combined limit - you can contribute the maximum $5,500 to both, not to each. 

Important planning point: the spousal IRA (which is not an actual account type; it's just a Traditional or Roth IRA that a nonworking spouse contributes to, based on joint income) is an important planning tool for single-income married couples. Don't overlook it!

Let's say you are aiming to save 10% of your pretax earnings for retirement, a common benchmark. In this scenario, you earn $100,000 so you'll be saving $10,000. Where should that $10,000 go?

  1. do you have an employer plan available to you, and is there a match? If yes, contribute at least as much as you can to maximize the match (as Roth if possible). Let's say your employer matches 100% of the first 3% of salary that you contribute, so there's $3,000 you're saving (really $6,000 since you've maximized that match). 

  2. Is the plan a good one? Is it reasonably low-cost? Good diversified options? If yes, great! Keep saving. Just put the whole 10% in the 401k. 

  3. If your plan choices aren't great, though, max out the Roth at $5,500 (you can invest this money however you like) and make your 401k contribution for the rest, or 4.5%. You'll reduce the impact of high fees and subpar diversification on your overall portfolio. 

Of course, you can try to save more than 10%. An optimal scenario is to make the maximum 401k contribution and then still be able to make a Roth IRA contribution, either directly or via the backdoor strategy. It's a good idea to assess your savings capability at the beginning of the year, after a refreshed look at your expenses, and creating a plan to reach your savings goals. And really, don't let all these different decisions stop you from just getting started: that's really the most important step you can take. You can always adjust your strategy as you go!

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