As a wealth manager, one of the most common questions I get is whether to use a Roth account or a traditional retirement account like an IRA or 401k. To complicate things even more, you may have the option to use a Roth 401k. In this blog, we’ll examine 5 factors you should consider when trying to decide whether to use a Roth or traditional retirement account.
Saving for retirement in a tax-deferred account helps you save for retirement while taking advantage of compounding interest. By investing in a tax-deferred retirement account, you can earn interest not only on your original investment, but also on the interest you’ve earned on your investments. Since you aren’t paying taxes on the growth, it compounds like this, over and over. An IRA and a Roth are both tax-deferred and each has certain benefits or restrictions that should be reviewed before making this decision. Let’s dive into the 5 factors you should consider.
Factor 1: Tax Treatment.
With a Traditional IRA or 401(k), you might get tax deductions upfront, which would reduce your taxable income now. However, you would pay taxes on withdrawals during retirement. Roth accounts, on the other hand, are funded with after-tax dollars, meaning no tax deductions now, but qualified withdrawals in retirement are tax-free. Consider whether you prefer tax benefits now or in the future.
There is some guesswork to this factor, and it partially depends on the next one. If you have a high income today, your first assumption might be that you will not have the same income and consequently you will not need the tax deduction as much. However, if tax brackets change, they could increase the taxes on your income.
Another thing to consider is how much income you will be taking in retirement and how that might affect your Medicare rates. According to the Social Security Administration (SSA), “the law requires and adjustment to your monthly Medicare Part B (medical insurance) and Medicare prescription drug coverage premiums” if your income is higher (https://www.ssa.gov/benefits/medicare/medicare-premiums.html). Since this is based on your modified adjusted gross income (MAGI) and Roth income is not considered income for MAGI purposes, choosing to use a Roth could impact your income taxes and your Medicare premiums.
If you have a difficult time with this decision, you might want to think about whether you can afford to pay the taxes today and still be on track to achieve your goals. If that is the case, you might want to plan for the possibility that future tax brackets could increase taxes on your taxable income.
Factor 2: Current vs. Future Tax Bracket.
While this goes hand-in-hand with the first factor, there could be other reasons you are in a higher tax bracket in retirement. An inheritance or working later in retirement could put you in a higher tax bracket. With this factor, think about your tax bracket today versus what you expect it to be in retirement. If you're in a lower tax bracket now, a Roth account might be advantageous, allowing you to pay taxes at today's rates and enjoy tax-free growth. Conversely, if you expect to be in a lower tax bracket in retirement, a Traditional IRA or 401(k) could be more beneficial, deferring taxes until later.
Factor 3: Required Minimum Distributions, or RMDs.
Traditional IRAs and 401(k)s require you to start taking distributions at age 73 for people who haven’t already started taking required minimum distributions, even if you don't need the money. These RMDs are subject to taxes. Roth IRAs, however, do not have RMDs during your lifetime, providing more flexibility in managing your retirement funds. Roth 401(k)s used to require RMDs, but recent legislative changes with Secure 2.0 removed the RMD requirement.
For many people, withdrawals from retirement accounts are necessary to survive and what they withdraw often meets or exceeds RMD requirements. However, if you think your withdrawals are going to be less than RMD requirements, you might want to shift some or all your retirement to a Roth. By doing this, you can make that call later in life, rather than being forced to take out more than you need.
Factor 4: Contribution Limits and Income Restrictions.
Both Traditional and Roth IRAs have the same contribution limits, but Roth IRAs have income limits that may prevent higher earners from contributing directly. Traditional IRAs offer an option to take deductions only if your income is below a certain threshold, especially if you or your spouse are covered by a retirement plan at work. With 401(k)s, there are no income limits, but your employer's plan may influence your options.
These income limits can change annually, so you should work with a financial advisor or tax advisor to make sure you meet the requirements for making contributions. On more than one occasion, I’ve had clients contribute to their Roths and then have to reverse those contributions based on their income increasing.
If your income is too high to contribute directly to a Roth, but you still want to build up a Roth for retirement, there may still be a way to make this happen. Roth conversions and backdoor Roths involve contributing to traditional retirement accounts and then moving those contributions to a Roth. There are no limits on how much you can convert. However, keep in mind that you will likely have to pay income tax on the conversion. If that pushes you into the next tax bracket, it still might be worth it but consider the tax consequences before pulling the trigger. The IRS no longer allows a Roth conversion to be reversed.
Factor 5: Estate Planning.
Roth accounts can be advantageous for passing wealth to heirs since they won't pay taxes on the inherited funds. Traditional accounts will result in taxable income for your beneficiaries upon withdrawal. Depending on the size of your estate, your beneficiaries’ income, and the size of your beneficiaries’ estates, this could decrease the amount of your inheritance your beneficiaries might enjoy. If legacy planning is a priority, a Roth account might be the better choice.
Ultimately, the decision between a Roth and a Traditional IRA or 401(k) or even some combination of these types of retirement accounts hinges on your current financial situation, future expectations, personal priorities, and goals. This is one reason setting your financial goals and financial planning are so important. There are other considerations, so consulting with a financial advisor can help tailor the right strategy for you.
Find out more about how you can save or invest for your retirement by visiting my website at milliganwealth.com, where you can check out my video on this topic, along with tools, calculators, articles, and other helpful videos. You can also visit and subscribe to my Milligan Wealth YouTube Channel (https://www.youtube.com/@milliganwealth), to get the latest videos on hot financial topics as they are released.
This article contains only general descriptions and is not a solicitation to sell any product or security, nor is it intended as any financial or tax advice. No strategy assures success or protects against loss.
Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 1/2 may result in a 10% IRS penalty tax in addition to current income tax.
A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 1/2 or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.