We are often asked, particularly by younger clients, if it is better to make tax-deferred contributions or after-tax (Roth) contributions to their IRA or employer-sponsored retirement account. While there are many rules of thumb across the internet and financial media on this topic, it is a very difficult question for financial planners to answer because it depends on each client’s specific situation. That being said, I wanted to go through some of the considerations we take into account when we answer this question.

In general, when saving for retirement in a defined contribution plan or IRA, taxpayers have two options- traditional (pre-tax) savings or Roth (after-tax) savings. Contributions to pre-tax accounts allow the taxpayer to deduct the contribution from their taxable income for the year, reducing their tax liability for that year. When withdrawals are made, the owner of the account must include the amount of the withdrawals in their income each year. Roth style accounts work in the opposite way. Contributions to a Roth account do not allow a tax deduction when they are made, but the account owner can make tax-free withdrawals (after reaching age 59 ½ in most cases). It is important to note that while many employer-sponsored retirement plans allow Roth contributions, this is an option that must be elected by the employer and it is not available to everyone.

The short answer to the Roth versus traditional question is that it all depends on what tax rate you face now versus the tax rate you think you’ll face in retirement. In general, if you think you’ll face a higher tax rate in retirement, if would be preferable to save in an after-tax (Roth) account. If you assume you’ll pay a lower tax rate in retirement, you would want to save in a pre-tax vehicle. While it is easy to determine the marginal tax rate you face today, for those not close to retirement it is virtually impossible to determine what their level of income will be in retirement or what the tax rate will be on that income. For clients close to retirement age, we are more confident in the level of income and tax regime at the start of retirement, but we lose confidence in both assumptions as we make projections further out into a client’s retirement.

When looking tax regimes, we tend to analyze the situation from an historical context- how do today’s tax levels compare historically? As demonstrated in the chart below, Americans currently face tax rates that are low on an historical comparison.

The fact that tax rates are relatively low today does not guarantee they will go higher in the future, but it does give some context. Furthermore, this chart shows how often, and just how dramatically tax rates can change.

Forecasting income in retirement can be just as difficult as forecasting tax rates because there are so many factors that impact income. The percentage of assets held in taxable accounts, interest rates, dividend yields, percentage of assets held in Roth accounts, the size of pretax accounts, and social security can all impact income. Even an unexpected or larger than anticipated inheritance has the potential to push you into a higher tax bracket as it may cause you to receive more income in a taxable account or, under the SECURE Act, withdraw funds from an inherited (non-spousal) IRA within 10 years.

While assumptions on tax rates are crucial to determining how to mathematically maximize tax savings, there are many other considerations that factor into our recommendations. Here are some of the other circumstances we analyze:

Probability of Needing Withdrawals before age 59 ½

In general, withdrawals from tax advantaged retirement accounts are subject to a 10% penalty (plus any applicable income tax) if the withdrawal is made before the owner turns age 59 ½. However, there are several exceptions to this rule that we consider when making a Roth vs. traditional recommendation. Here are some of the most common exemptions. Please note that the IRS has very strict guidelines specifying who does and does not qualify for these exemptions. We strongly recommend working with a CPA to determine your eligibility for these exemptions.

• First-time home buyers may withdraw up to $10,000 penalty free from an IRA. First-time home buyers are obviously anyone who has never owned a home before but this exemption also applies if neither you nor your spouse has owned a principal residence in the last two years. The exemption also applies if you are helping someone else, such as a parent, child, or friend purchase the home. This exemption is a “lifetime” exemption meaning once the $10,000 limit is hit, you can no longer use it in any future years. Schwab has a good article specifically on this topic here.
• Withdrawals for qualified education expenses. This applies to immediate family members and yourself.
• Withdrawals following the death or permanent disability of the account owner
• Withdrawals for medical expenses greater than 7.5% of AGI
• Substantially Equal Periodic Payments (SEPP). A SEPP plan can help you tap IRA funds penalty free, but it comes with some pretty large drawbacks as well. Essentially, a SEPP plan allows you to take “equal” withdrawals from an IRA each year prior to reaching age 59 ½ without penalty. The caveat is that once you start, you cannot stop taking withdrawals for five years or until you turn age 59 ½, whichever is later. If you do stop taking withdrawals, you will owe the entire penalty for all previous years plus interest. There are several IRS approved methods for calculating. If you are considering taking SEPP, we strongly advise working with a CPA to determine the withdrawal amount and ensure you aren’t subject to penalty.

One major advantage to using a Roth is the ability of the owner to withdraw contributions at any time penalty and tax free. This only applies to “contributory distributions” meaning earnings and conversion assets do not apply. However, this flexibility is still a major benefit of making contributions to a Roth and one that we consider when we have reason to believe a client may be at a higher risk for unexpected expenses that may not meet the requirements for the IRS early withdrawal penalty exemptions.

Income Levels

Eligibility for Roth or Traditional IRA contributions or deductions may be limited based on either your level of income, participation in an employer-sponsored plan, or both. If you are covered by a retirement plan at work, deductibility is limited for traditional IRA contributions based on income and tax filing status.

The IRS has very specific rules specifying who is considered an “active participant” in an employer-sponsored retirement plan. Generally, if your employer has established a plan, you are eligible to participate, and “additions” are made during the tax year, you are considered to be an active participant. Additions are considered to be made whenever money is flowing into your account- employer contributions, employee contributions, forfeitures, and profit-sharing contributions are all considered annual additions. If your employer has a defined benefit plan in which you are eligible to participate, regardless of whether or not you do participate, you are also considered to be an active participant. Participation or eligibility in a governmental or nongovernmental 457 plan does not make you an active participant.

For those who are single and active participants in an employer-sponsored retirement plan, the deduction for traditional IRA contributions phases out from $65,000 – $75,000 in modified AGI in 2020. For married couples, the phase-out range is $104,000 to $124,000. Contributions can still be made over this income level, but those contributions will be considered “nondeductible contributions.” We have more information about non-deductible contributions available here. For couples where one spouse works and the other doesn’t or one spouse is an active participant and the other isn’t, the rules are different. We have a guide to Spousal IRAs here. Because Roth IRA contributions are after-tax, there is no deduction. However, the IRS limits contributions to Roth IRAs based on income. For single filers, Roth IRA contributions are phased out over the $124,000 – $139,000 level of modified AGI for 2020. For married couples filing jointly, this level is $196,000 – $206,000. Note that these limits apply to IRAs only- not contributions to employer-sponsored retirement plans.

The deducibility and contribution limits on IRAs often restrict your choices when it comes to making the Roth versus traditional choice. However, for those with an employer-sponsored plan offering a Roth option, we have more flexibility in planning.

Required Minimum Distributions (RMDs)

RMDs, like the name suggests, are the minimum required amount that must be withdrawn from an IRA or other pre-tax retirement account each year after the owner reaches age 72 (for those turning age 70 ½ in 2020 and beyond). The age for RMDs was changed with the passage of the SECURE Act. When withdrawals are made from a pre-tax retirement account, the amount of the withdrawal must be included in the account owner’s taxable income for the year. The penalty for not taking RMDs or for not taking a large enough distribution is 50% of the under-withdrawal. This is one of the most severe penalties in the tax code.

While younger clients tend not to think about the impact of RMDs, older clients will attest to their impact. Retirees with large pre-tax retirement plan balances often find that the amount they are required to withdraw exceeds the amount they need to cover their expenses. This creates a situation where they take the withdrawal to satisfy the RMD and pay taxes on that amount only to move it into a taxable account to reinvest the money. Had the assets been in a Roth IRA instead, the money could have continued to grow tax free because RMDs are not required from Roth IRAs.

Estate Planning Considerations

From an estate planning perspective, there are several factors and rules to consider. For spousal beneficiaries of a traditional IRA, the surviving spouse must take RMDs based on his or her own life expectancy. Spousal beneficiaries of a Roth IRA, just like the original account owner, do not need to take RMDs. Under the SECURE Act, non-spousal beneficiaries of both traditional and Roth accounts must completely deplete the account within 10 years of the owner’s death. Non-spousal beneficiaries are not required to take any annual “RMDs” during the 10-year period. The only requirement is that the account be empty within 10 years. These rules may enhance the value of Roth options, especially in situations where it is desirable to limit RMDs.

Behavioral Factors

We also consider behavioral factors when making recommendations. Certain clients are very tax-averse and want to avoid paying taxes as long as possible. If a client is more likely to save because they can reduce this year’s tax bill, we view that favorably. Likewise, certain clients are drawn to the idea that once Roth contributions are made, withdrawals after age 59 ½ will not be taxed. If this motivates a client to save, that is a good thing too.

Our Most Typical Recommendation

Very often, our recommendation to clients who have the ability to do so is to save in as many different types of accounts as possible. Ideally, this means having savings in a pre-tax account, a Roth account, a taxable account, and a Health Savings Account (HSA). Note that not everyone is eligible to contribute to an HSA. We have more information on HSAs here. Having savings in all four types of accounts affords you a large amount of flexibility while still keeping the tax benefits associated with traditional IRAs, Roths, and HSAs. Having different types of accounts provides a bit of a “hedge” in the event that tax laws are changed in the future. Congress is subject to change the law at any time and it is wise to not have all your eggs in one basket.