It’s a decision we all need to make when investing in our retirement plan: Should we take the Roth or the traditional option? There are general rules of thumb you can follow, but it’s vital to consider your financial situation when making this call.
Before we look at these factors, let’s review the key difference between traditional and Roth retirement accounts.
When you deposit funds into a traditional IRA or 401(k), you save money on this year’s taxes. If your contribution to a traditional IRA is deductible, you declare it on your tax return, which reduces your taxable income dollar for dollar.
A similar thing happens when you use a traditional 401(k). It reduces your taxable income reported on your W-2, which means you avoid (for now) paying taxes on your contributions.
But funding a traditional retirement account is not a free lunch. In essence, you are inviting the federal government (and to some degree the state) into partial ownership of your investment. By the time you take funds out of your account, you will likely owe federal and perhaps state taxes on the amount you withdraw.
Roth retirement accounts present a different bargain. There is no tax advantage when you make a deposit. And as with traditional retirement accounts, you will not be taxed on the growth, interest, or dividends while it accrues inside the account. Where a Roth shines is when you take distributions. Unlike with a traditional IRA or 401(k), with a Roth, you have kept the taxing authorities at bay for the rest of your life (under current law). No taxes will be due as long as you follow the rules surrounding qualified distributions.
So how do you decide if a Roth or traditional retirement plan is best for you? Among the most important factors is your income tax rate now versus the one you will have when you’re taking money out.
For example, let’s say you’re part of a high-earning couple — a software engineer married to a physician with a combined family income of $500,000. Depending on your deductions, that could put you in a 35% federal tax bracket along with Colorado’s 4.4% tax rate. You plan in retirement to move cq comment=” in retirement” ]to a state such as Florida with no state income tax. In this case, odds are you will likely have a lower combined tax rate in retirement than you do now, which means traditional retirement plan contributions could be a viable option for you.
On the other hand, if your family income is not so high, say $90,000, then your marginal federal tax rate is 12%. If you don’t plan on leaving Colorado, then you may be in a higher tax rate when you take funds out of your retirement plan. This would be a strong argument for a Roth retirement plan.
But what if you’re somewhere in the middle, say in the 22 to 24% federal tax brackets, right now? If you’re wavering about this decision (and for good reason, as you’re dealing with the unknowable future), then I would err on the side of the Roth.
I don’t have space to go into the details of Roth retirement accounts, but will at least cover the basics to spur on your investigation.
First, unlike traditional retirement accounts, Roth IRAs and 401(k)s do not have required withdrawals once you turn a certain age.
Next, Roth IRAs are more flexible when it comes to qualified withdrawals if funds are needed before age 59 1/2.
Third, if you save the maximum into Roth retirement plans, you are likely to save more than if you maxed out your traditional plan contribution, because you are prepaying the taxes from outside the retirement account.
Fourth, under current law, individual income tax rates are scheduled to increase in 2026. Historically speaking, our current income tax rates are relatively low, so it could make sense to pay taxes now rather than later.
Fifth, hidden credits and taxes such as ACA subsidies for pre-Medicare health insurance and Medicare premium surcharges favor Roth distributions.
Finally, Roth retirement accounts can work more effectively for your heirs, as they won’t be forced to take large taxable withdrawals over 10 years and are a little easier to use inside trusts if that’s part of your estate plan.
To sum it up, in general, a tie goes to the Roth.
David Gardner is a Certified Financial Planner professional at Mercer Advisors practicing in Boulder County. Opinions expressed by the author are his own and are not intended to serve as specific financial, accounting, or tax advice. They reflect the judgment of the author as of the date of publication and are subject to change. The information is believed to be accurate but is not guaranteed or warranted by Mercer Advisors. The hypothetical examples above are for illustration purposes only. Actual investor results will vary. Every individual’s situation is unique, and you should consider your investment goals, risk tolerance, and time horizon before making any investment decisions. For financial planning advice specific to your circumstances, talk to a qualified professional. Mercer Global Advisors Inc. is registered with the Securities and Exchange Commission and delivers all investment-related services. Mercer Advisors Inc. is the parent company of Mercer Global Advisors Inc. and is not involved with investment services.