What You Need to Know When Deciding Between Roth and Traditional

• Roth and traditional retirement accounts are taxed differently.
• Which account you choose should be based on your current and future marginal tax rates.
• Choosing the right account can help you avoid paying excess taxes.

“The main thing you’ll want to consider when choosing between Roth and traditional accounts is whether your marginal tax rate will be higher or lower during retirement than it is now,” says Young. If you think your tax rate will be higher, paying taxes now with Roth contributions makes sense. If your tax rate is likely to be lower in retirement, you can use traditional contributions to defer taxes instead. Federal tax rates are scheduled to revert to pre-2018 levels after 2025, which may make Roth contributions more attractive today. In addition, investors who expect to leave a legacy may want to consider the tax impact on their beneficiaries.

Of course, tax rates are hard to predict due to changes in the law as well as uncertainty around your future income levels.

Consider which account type may be most beneficial given several hypothetical investor scenarios.

Here are three situations where a Roth probably makes the most sense:

1. You are currently in a lower tax bracket, but you expect that to change. Let’s say you are a young professional who is anticipating salary increases, which will put you in a higher tax bracket down the road. Contributing to a Roth IRA or Roth 401(k) means you pay the relatively low rate on taxable income now. Once you’ve retired, you will not pay any taxes on qualified distributions from the plan.

2. You are close to retirement and are concerned about RMDs. “If you’ve been a disciplined saver and have contributed a healthy percentage of your income to traditional accounts for many years, eventually you’ve got to pay the piper,” says Young. Beginning in the year you reach age 72 (age 70½ in 2019), you must begin taking RMDs from Traditional IRAs and from 401(k)s—including Roth 401(k)s—the later of age 72 (age 70½ in 2019) or once you’re retired. As the name suggests, these withdrawals are required, even if you don’t need the income at the time.

RMDs could bump you to a higher tax bracket. Qualified distributions from a Roth 401(k) or Roth IRA, on the other hand, would not create taxable income or increase your tax rate. Therefore, a Roth contribution may be preferable in order to limit the RMD income taxed at a higher rate.

Someone in this position may also want to consider the effect on their beneficiaries. The SECURE Act, passed in 2019, requires most non-spouse beneficiaries to withdraw all retirement account balances within 10 calendar years. This change increases the likelihood that traditional account withdrawals will push them into a higher tax bracket, which makes Roth assets even more attractive.

3. You are a prodigious saver. Suppose you can contribute the maximum amount to a retirement plan ($19,500 for 2020 or $26,000 if you’re over age 50), even if you don’t get a tax break. In this case, the Roth account effectively enables you to save more in a tax-advantaged manner. Saving the maximum amount ultimately results in more after-tax retirement assets for the Roth account balance than a traditional contribution that is pretax.

While a Roth is a good choice for many people, it’s not best for everyone. Here are two examples where pretax contributions, such as to a Traditional 401(k) or a Traditional IRA, may be a better strategy:

1. You are in your peak earning years. When you retire, you might eliminate expenses, such as mortgage payments or college costs. Additionally, withholdings for payroll taxes and retirement contributions will go away. As a result, your income from Social Security and the amount you need to draw from retirement accounts likely will be less than what you earn today. So your federal tax bracket could be lower in retirement. Your state tax rate also could decrease, for example, if you move to an income tax-free state.

In this case, taking the tax benefit now with a traditional contribution may make more sense than the Roth contribution. You’ll reduce your current taxable income while paying a higher tax rate and then make withdrawals at a potentially lower tax rate later in retirement.

2. You are struggling to save. The traditional pretax approach may enable you to get your employer’s full 401(k) match with less impact on your take-home pay. This is because taxable income is reduced by the amount of your contribution.

“If you’re still unsure of what to do in your situation, the tiebreaker often should be in the Roth account’s favor,” says Young. That’s because:

• Roth accounts generally are better for heirs, since assets usually will be withdrawn tax-free.
• If, like many people, you have more assets in traditional accounts than in Roth accounts, adding to your Roth assets improves tax diversification. This hedges against the risk of changes in tax laws or your personal circumstances.
• Roth IRA contributions (but not necessarily the gains) always can be withdrawn at any time or at any age without tax or penalty. But be careful—it’s not as flexible for Roth 401(k) assets or assets that were converted from a Traditional IRA to a Roth IRA.

"While you should devote more energy to making sure you’re saving enough,” Young says, “a thoughtful decision between Roth and traditional contributions can help you take full advantage of those savings.”