Deciding between traditional retirement plan contributions and Roth retirement plan contributions
Whether or not to make investments into “traditional” tax-advantaged employer accounts and IRAs versus investing in “Roth” tax-advantaged employer accounts and personal IRAs is never a straightforward nor simple financial planning decision. The decision on the trade offs happens to be one of the most complex aspects of lifetime personal financial planning.
A broad array of factors can influence whether a traditional retirement plan account contribution or a Roth retirement account contribution decision would be optimal. Given the significant importance of this decision on your lifetime financial plan and the build-up of your retirement savings, it would be worth taking a closer look at this decision. For most people’s lifetime circumstances, making deposits in traditional retirement accounts is the preferred decision, when those contributions would be deductible against current income taxes and would reduce level of total earned income that would be subject to current income taxes.
Factors favoring Roth plan contributions over traditional plan contributions
Many people struggle with the traditional versus Roth contribution decision for their personal financial and lifetime investment planning. The trade-offs over a lifetime are very complex. Rules-of-thumb, back-of-the-envelope calculations, and simple retirement planning spreadsheets cannot model all the important personal financial factors. The decision is not simply about present versus future tax rates and whether the income tax rate schedule might be higher or lower in the future when you are retired.
What is far more important is your long-term success or failure to build up both substantial tax-advantaged and taxable account investment asset holdings. If you do not build up substantial retirement financial assets, then future changes in tax rates will be far less relevant, since you would have fewer assets to tax. In contrast, if you build a substantial retirement asset portfolio with significant tax-deferred assets, then your future income tax obligations could be substantially higher whether future total federal, state, and local income tax rates rise, fall, or stay the same in the intervening years.
Instead of only thinking about current versus future income tax rates, this decision requires a personalized and comprehensive projection and valuation of cumulative effects of an investor’s lifetime income, expenses, debts, asset appreciation, and taxes along the way. The best way to get realistic understanding of this is with an automated retirement planning software application that can easily perform a combined IRA retirement calculator and 401k retirement calculator projection analysis, while simultaneously acting as a retirement tax calculator and a retirement withdrawal calculator. While this might seem like a tall order for the do-it-yourself home financial planner, the answer is right here on this website. Just click the underlined hyperlink in this sentence to learn about our bargain priced home Roth IRA and Roth 401k calculator retirement tool that fully automates this traditional versus Roth retirement plan analysis process for you.
Whether or not a person or family will save enough and invest efficiently across a lifetime dominates the Roth retirement plan versus currently deductible traditional retirement plan contribution decision.
If an investor does not earn sufficiently high income, does not save aggressively, does not control investment costs, and/or does not grow a sufficiently substantial investment asset portfolio retirement nest egg, then that investor will not have to worry about being in high tax brackets in retirement — whether or not state and federal income tax brackets had moved up or down in the interim. If an investor will not have substantial assets and income in retirement, then the current tax savings an investor could get from contributing to a traditional tax-advantaged retirement savings plan will tend to be much more economically advantageous over a lifetime.
For an investor to justify making current Roth contributions in lieu of currently deductible “traditional” contributions, here are eight personal circumstances, taken together, that might reverse the average person’s preference for traditional tax-advantaged plan contributions.
Roth retirement plan contributions might be more advantageous over currently deductible traditional retirement plan contributions, when a retirement investor:
- has a long time for her assets to appreciate before and during retirement,
- is likely to earn high enough taxable income over her working lifetime to have a realistic chance of amassing enough assets to cover her retirement expenses easily and still build up financial assets,
- is more likely to have increasing earned income that is expected to continue to rise in real dollar terms across a working life cycle, enhancing that investor’s ability to feed her investment program through increasing savings,
- saves at sufficiently high percentage rates across her working lifetime (This normally means consistently saving at rates that are well in excess of 10% of gross earned income.),
- will fully fund either traditional and/or Roth tax-advantaged accounts up to maximum annual contribution limits,
- may have proportionately higher front-loaded itemized deductions (e.g. mortgage interest and real estate taxes) and lower earned income that effectively lowers an investor’s nearer term federal, state, and local marginal ordinary income tax rates compared to her more distant retirement years,
- will adopt a very low-cost investment strategy to improve her chances of capturing higher asset appreciation rates, and/or
- will maintain an investment asset allocation that is skewed more heavily toward equities (versus toward cash and bonds), and when her stock market and stock mutual fund financial assets continue to grow at rates that are similar to long-term historical rates of return on equities.
Given all these factors, an investor may find that her assets in traditional tax-advantaged accounts would grow to be so substantial that when they are distributed under the mandatory distribution rules after age 70 and 1/2, she is pushed into much higher marginal tax brackets. If her traditional tax-deferred assets are sufficiently large, then ordinary income taxes on these mandatory distributions COULD wipe out the value of the tax shield assets that an investor gained by making traditional account contributions that reduced her taxable earned income in earlier years. This is the crossover point where Roth contributions become more desirable on a present value basis compared with currently deductible traditional retirement new investments. Again, the majority of those saving for retirement are less likely to be in this position and should therefore prefer reducing their currently taxable income through traditional retirement plan contributions.
Currently deductible traditional retirement plan contributions versus Roth retirement plan contributions.
Also, please note carefully that the discussion in this article focuses ONLY on situations where an investor has the choice of making either a currently TAX-DEDUCTIBLE traditional IRA, 401k, or other tax-advantaged account contribution VERSUS a currently NON-TAX DEDUCTIBLE Roth IRA or designated Roth 401k tax-advantaged account contribution. For many people, this may be their situation, because they have not maxed-out their current opportunities to make tax-deductible traditional retirement plan account contributions that reduce total current income subject to federal and state income taxes.
If under the U.S.’s incredibly complex tax-advantaged retirement account rules, an investor does NOT have any further opportunities to make currently tax-deductible retirement account contributions, then a Roth contribution is the preferred choice to make. Since such an investor cannot reduce their level of current subject to income taxation and since Roth account contributions would avoid future taxation of asset appreciation during retirement, then Roth contributions are preferred, if they are allowed under IRS rules. Roth contributions would be preferred over traditional retirement account contributions, under such more limited circumstances of current non-tax-deductibility of any type of plan contribution.
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