Roth vs Traditional IRAs: Which Should You Choose?

Saving for retirement can be a daunting task. For the majority of Americans, tax-advantaged retirement savings accounts comprise a major component of expected retirement income, and the after-tax income available to you in retirement can change based on the choices you make today. Thus, while everyone’s situation is different, tax considerations must be understood and carefully considered in the context of all retirement planning decisions.

Why you need a tax-advantaged retirement account

Our current system consists of different retirement account types, and individuals can choose which account type is right for them. In most cases, you should prioritize tax-advantaged retirement savings over non-tax-advantaged savings, but which tax-advantaged account is right for you? To answer this question, we must understand the mechanics and tax rules governing retirement accounts. 

Non-tax-advantaged accounts are just that — fully taxable. There are no current or future tax benefits when you use these accounts. In other words, current income is taxed and future income is also taxed. 

To illustrate the difference between these account types, it helps to look at a simple example.

Example

A 30-year-old individual makes $100,000/year and needs to have $65,000/year for their living expenses today, after taxes and retirement savings. Any amount above $65,000, they want to contribute to their retirement account. 

They are in the 22% income tax bracket and they expect to be in this same bracket when they retire. They plan to retire in 40 years at the age of 70. The expected long-term growth rate of their investment is 8% per year. 

The results of their retirement account type options can be seen below.

As we can see, both tax-advantaged options result in the same retirement income and both results are 28% better than the non-tax-advantaged account option! 

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Roth vs. traditional IRAs: What’s the difference?

A tax-advantaged retirement savings account is a type of retirement account established by the Internal Revenue Code that offers tax benefits. These include Individual Retirement Accounts (IRAs) and accounts sponsored by businesses, such as 401ks. Generally, there are two types of tax-advantaged retirement accounts: 

• Traditional retirement accounts offer tax savings today 
• Roth retirement accounts offer tax savings when you retire 

In the example above, they both come out the same because the tax rate didn’t change. Our hypothetical saver started out in the 22% tax bracket and ended up in the same tax bracket in retirement. Now, let’s look at what happens if that tax bracket changes.

Considerations for changing tax rates

The type of account that’s best for you depends mostly on whether you expect your tax rate to be higher or lower in your retirement than it is today. The good news is that based on your expectation of future tax rates, the decision between which account to use is fairly straightforward. 

Scenario 1: Tax rates go down

Invest in traditional tax-advantaged accounts

If your current tax rate is higher than your expected retirement tax rate, the traditional tax-advantaged account will result in the best economic outcome. 

Scenario 2: Tax rates go up

Invest in Roth tax-advantaged accounts 

If your current tax rate is lower than your expected retirement tax rate, then the Roth option will result in the best economic outcome. 

These scenario outcomes make sense because if your tax rate is higher now, you would rather save taxes now with a current tax deduction offered by the traditional account. Conversely, if your current tax rate is low and you expect your retirement tax rate to be high, you would rather pay tax now at the low rate and pay no tax during retirement by using a Roth account. 

Future tax rate complications

While the impact of changing tax rates is obvious, the decision is complicated because future tax rates are unknown. 

Additionally, your future tax bracket is impacted by not only your retirement account balances but also your other income. Specifically, if you expect to receive Social Security benefits in addition to income from your tax-advantaged accounts, all else being equal, your tax rate in retirement will be higher than your current rate simply because of the mechanics of how Social Security income is taxed or not taxed. 

In general, under current rules, if you have less than $25,000 in taxable income in retirement, then your Social Security income is not taxed. However, if you have more than this (including the income from your traditional retirement account withdrawals), then your Social Security income will be taxed. 

Thus, all else being equal, if you expect to receive Social Security benefits in retirement, even if your tax rate does not change, your effective tax rate will go up because your Social Security income will become taxable. Therefore, a Roth account will result in the best economic outcome because of the increase in your effective tax rate. 

Should you convert your traditional IRA to a Roth IRA?

As we can see, both tax-advantaged options are better than non-tax-advantaged savings accounts, and a Roth account is better if you expect tax rates to go up. 

But what should we do if there are unexpected changes in the value of your retirement investments due to stock market declines?

We all know retirement accounts are long-term investments and you consistently contribute throughout your career, regardless of market fluctuations. Nevertheless, if you’re in the middle of an obvious bear market, you can be smart about your tax-advantaged retirement account options and maximize your after-tax retirement outcomes. 

Specifically, if you believe the stock market is currently experiencing a significant but ultimately temporary decline, you should seriously consider converting your traditional tax-advantaged account to a Roth account. When you do this, you pay tax on the amount of the conversion, but all future earnings grow tax free. If the decline is indeed temporary and long-term growth rates return, the economic benefit of this outcome is compelling. 

Referring back to the original example, we invested $16,667 in a traditional account. If there’s a bear market and the value declines by 50%, we now only have $8,333 in our account. Not good! … Or is it?

If we convert this traditional account to a Roth account, we pay tax on $8,333 (the value on the date of conversion). However, we already received a tax deduction for the full $16,667. In other words, we still get a 50% deduction, and now all our future growth is tax free. 

Of course, this is only a simple example, but if the assumptions hold and the decline proves temporary, our economic outcome will be 68% better than if we didn’t use a tax planning strategy. While no one likes a bear market, it is good to know tax planning offers a silver lining. 

Start planning now

Retirement planning is intimidating, but as with all things, learning the rules and understanding the results of your decisions is critical. Everyone’s situation is different, and the high-level examples and explanations offered here do not constitute investment or tax advice. So speak to your tax and financial planner today!