TRICKS OF THE TRADE
TRADITIONAL 401(K)/IRA VS. ROTH 401(K)/IRA
Prepared by Michael Menninger, CFP®
A common question that is routinely asked is whether an individual should contribute to a Traditional 401(k) or IRA or a Roth 401(k) or IRA. Like most financial planning questions, the answer is, “It depends.” In this case however, it is generally a function of two things:
- Is my anticipated marginal tax bracket higher now, or when I expect to withdraw it in retirement?
- Might I need access to the money prior to reaching retirement age?
The difference between the Traditional 401(k)/IRA and Roth 401(k)/IRA is that the Traditional receives a Federal tax deduction upon contribution, but is taxable upon withdrawal. Conversely, Roth contributions do not get a tax deduction, but grow tax-deferred and tax-free, so long as the account has been established and funded for 5+ years. In both cases, the age 59½ rule applies, whereby the IRS typically assesses a 10% penalty for withdrawing funds prior to that age. However, in the case of the Roth, the tax and penalty only apply to the growth portion. In addition, there are “ordering” rules that apply, in that the after-tax contributions are considered to be withdrawn first and are NOT subject to tax or penalty.
To ascertain which plan is better is based on estimating the participant’s tax bracket at the time of contribution versus at the time of withdrawal. Conventional thinking is that an individual’s tax bracket is lower in retirement, suggesting that the Traditional IRA is the preferred route. However, when an individual or couple have a pension or large amounts of Traditional IRA assets in retirement, withdrawal of those assets can cause adverse tax effects rendering the Traditional method as not always being the best route.
The adverse effects of Traditional 401(k) /IRA assets and other factors that could cause an individual or couple to be in a higher marginal tax bracket in retirement could be for the following reasons:
- If your taxable income in retirement exceeds a certain amount, Social Security income can also become taxable, rendering it as phantom taxable income. Contributing to a retirement account that is tax-free upon withdrawal avoids this additional tax, as your taxable income includes Traditional IRA distributions but does not include the distributions from the Roth account. See the article, Phantom Taxation of Social Security.
- Required Minimum Distributions (RMDs) from retirement assets and payments from pensions or annuities, combined with Social Security income, could cause your income and marginal tax bracket to be near or higher than it is now.
- Tax brackets will most likely be higher in retirement than they are today, due to the significant tax cuts implemented in 2018, the increased government spending for COVID-19 support, and the mounting national debt.
- If either spouse were to die, the surviving spouse’s income may not drop much, and they would reach the higher tax brackets quicker because of filing as a single taxpayer.
- Traditional IRA income distributed in retirement could cause Medicare premiums to be higher.
- While purely speculative, Social Security payments could be means-tested (amount of Social Security benefit based on other income), and thereby reduced if large amounts of taxable Traditional IRA income are being distributed.
- As a result of the SECURE Act, most non-spouse beneficiaries of IRAs must withdraw the IRA over 10 years, instead of the previous rule of being distributed over a lifetime. This could create an unexpected windfall of taxable income to the beneficiaries, which tends to occur during their highest earning years, and potentially subjecting them to a higher tax rate.
Thus, it is often advantageous for individuals to utilize Roth 401(k) /IRAs, as they lock in the lower tax rate. Similarly, individuals may also consider the strategy of Roth IRA conversions, which is essentially paying taxes on the IRAs at the lower rate now and allowing them to grow tax-free in the Roth IRA until withdrawn.
As noted earlier, there is a tax and an additional 10% tax penalty if Traditional 401(k) / IRA assets are withdrawn prior to age 59½. However, contributions to the Roth IRA are never taxed (or penalized), nor are Roth IRA conversions that have aged over five years. Therefore, liquidity is often a consideration and often applies to younger people who have a longer time until reaching age 59½. The Roth IRA provides the flexibility of having access to the contributions (and eligible conversions) without any tax, which provides additional advantages of accessibility to those assets not offered by the Traditional IRA.
In conclusion, we understand that it can be difficult for the untrained person to compare tax brackets now versus retirement and it is often difficult to predict liquidity needs, but flexibility offers a distinct advantage. If you have any questions as to which alternative may be best for you, feel free to contact us.