In the family of financial planning products, the Roth IRA or 401(k) sometimes looks like the cool younger brother of traditional retirement accounts. Indeed, the Roth version, first introduced in 1998, offers a number of attractive features that their standard siblings lack: the absence of required minimum distributions (RMDs), the flexibility to withdraw money prior to retirement without penalties, and the ability to make contributions past the age of 70½.

A Roth indeed makes sense at certain points in your life. At others, however, the traditional version of the IRA or 401(k) has strong allure as well. Often, choosing between one or the other comes down to how much you’re making now and how much you expect to bring in once you stop working.

Key Takeaways

  • A Roth IRA or 401(k) makes the most sense if you're confident of higher income in retirement than you earn now
  • If you expect your income (and tax rate) to be lower in retirement than at present, though, a traditional account is likely the better bet
  • A traditional account allows you to devote less income now to making the maximum contribution to the account, giving you more available cash

Different Accounts, Different Tax Treatments

Here’s a quick refresher on the respective major types of retirement accounts. Both types offer distinct tax advantages for those squirreling away money for retirement. However, each works a little differently.

With a traditional IRA or 401(k), you invest with pre-tax dollars and pay income tax when you take money out in retirement. You then pay tax on both the original investments and on what they earned. A Roth involves just the opposite. You invest money that’s already been taxed at your ordinary rate and withdraw it—and its earnings—tax-free whenever you want, provided you've had the account for at least five years.

In choosing between Roth and traditional, the key issue is whether your income tax rate will be greater or lesser than at present once you start tapping the account's funds. Without the benefit of a crystal ball, that’s impossible to know for sure; essentially, you’re forced to make an educated guess. For instance, Congress could make changes to the tax code during the intervening years. There's also a time factor: If you're opening the Roth late in life, you need to be sure you'll be able to have it for five years before starting to take distributions, in order to reap the tax benefits.

The Case For Getting a Roth

For younger workers who have yet to realize their earning potential, Roth accounts have a definite edge. That’s because, when you first enter the workforce, it’s quite possible that your effective tax rate, expressed as a percentage, will be in the low single digits. Your salary will likely increase over the years, resulting in greater income—and quite possibly a higher tax bracket—in retirement. Consequently, there’s an incentive to front-load your tax burden.

“We advise younger workers to go with the Roth because time is on their side,” says financial advisor Brock Williamson, CFP, with Promontory Financial Planning in Farmington, Utah. “Growth and compounding is one of the beautiful truths about investing, especially when the growth and compounding is tax-free in the Roth.” 

Another reason: If you're young, your earnings have decades to compound and, with a Roth, you will owe zero taxes on all that money when you withdraw it at retirement. With a traditional IRA, you'll pay taxes on those earnings.

On the other hand, if you choose a traditional IRA or 401(k), you have to divert less of your income to retirement in order to make the same monthly contributions to the account—because the Roth would essentially require you to pay both the contribution and the taxes you paid on that amount of income.

That's a plus for a traditional account, in the short term at least. But look a little harder. Let's say that after making the maximum contribution to your traditional retirement fund, you then choose to invest all or part of the tax you saved compared with investing in a Roth. However, those additional investments will not only be in post-tax dollars but you'll be taxed on their earnings once you cash them out. Because of those differences, you might end up paying more tax in the long run than if you put the entire sum you can afford to invest in a Roth account in the first place.

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When Not To Open A Roth IRA

Forgoing the Roth Due to Taxes

The tax argument for contributing to a Roth can easily turn upside down if you happen to be in your peak earning years. If you’re now in one of the higher tax brackets, your tax rate in retirement may have nowhere to go but down. In this case, you’re probably better off postponing the tax hit by contributing to a traditional retirement account.

For the most affluent investors, the decision may be moot anyway. That's because of IRS income restrictions for Roth accounts. In 2019, individuals can't contribute to a Roth if they earn $137,000 or more per year—or $203,000 or more if they’re married and file a joint return. (Contributions are also reduced, but not eliminated, at lower incomes. Phase-outs begin at $122,000 for single filers and $193,000 for couples filing jointly.) While there are a few strategies to legally circumvent these rules, those with a higher tax rate may not have a compelling reason to do so.

If your income is relatively low, a traditional IRA or 401(k) may let you get more plan contributions back as a Savers' Tax Credit than you'll save with a Roth.

By contrast, you won't be disqualified due to income from contributing to a traditional IRA. You may, however, have your contributions capped at below the full maximum if you qualify within your company as a Highly Compensated Employee (HCE).

A traditional IRA or 401(k) can also result in a lower Adjusted Gross Income (AGI) because your pre-tax contributions are deducted from that figure, where post-tax contributions to a Roth are not. And, if you have a relatively modest income, that lower AGI can help you maximize the amount you receive from the Saver's Tax Credit, a tax credit for eligible taxpayers who contribute to an employer-sponsored retirement plan or to a traditional and/or Roth IRA.

Under the program, the percentage of contributions credited back to your taxes depends on your AGI. Since the credit is designed to encourage lower-income workers to contribute more to their retirement plans, the lower the AGI, the higher the percentage credited back to you. In 2019, joint filers with an AGI of above $64,000 receive no credit, but those with a lower AGI get between 20% and 50% of their contributions credited back to them.

Consequently, pre-tax retirement contributions can boost the credit by lowering your AGI. That lowering can be especially useful if your AGI is just above a threshold figure that, if met, would deliver a bigger credit to you.

Skipping the Roth to Boost Immediate Income

There's another reason to hedge on a Roth, and it relates to access to income now versus potential tax savings down the road.

A Roth can take more income out of your hands in the short term because you're forced to contribute in post-tax dollars. With a traditional IRA or 401(k), by contrast, the income required to contribute the same maximum amount to the account would be lower, because the account draws on pre-tax income.

If that immediate windfall from using a traditional account is invested, we argued above, a Roth can actually offer the better option taxwise. But there are many other uses for the money other than investing it. The amount "saved" by making a maximum contribution to the account in pre-tax dollars could instead be used for any number of useful, even vital, non-investment purposes—buying a home, creating an emergency fund, taking vacations, and so on.

The upshot here: A traditional retirement account increases your financial flexibility. It allows you to make the maximum allowed contribution to the IRA or 401(k) while having extra cash in hand for other purposes before you retire.

The Argument for Both Roth and Regular

If you’re somewhere in the middle of your career, predicting your future tax status might seem like a complete shot in the dark. In that case, you can contribute to both a traditional and a Roth account in the same year, thereby hedging your bet. The main stipulation is that your combined contribution in 2019 can’t exceed $6,000 annually or $7,000 if you’re age 50 or over.

There can be other advantages to owning both a traditional and a Roth IRA or 401(k), says James B. Twining, CFP, founder of Financial Plan, Inc., in Bellingham, Wash. “In retirement, there may be some ‘low tax’ years due to large long-term care expenses or other factors. Withdrawals can be taken from the traditional IRA in those years at a very low or even a 0% tax bracket. There may also be some ‘high tax’ years, due to large capital gains or other issues. In those years, the distributions can come from the Roth IRA to prevent ‘bracket spiking,’ which can occur with large traditional IRA withdrawals if the total taxable income causes the investor to enter a higher graduated tax bracket.” (For related reading, see "How to Open a Roth IRA")