Wealth in Our Woods: To Roth or Not to Roth

For The Sherwood Sun

One of the most common questions I hear about retirement savings is also one of the hardest to answer: Should I make traditional contributions or Roth contributions?

With a traditional contribution, you generally get the tax benefit today. If you put $5,000 into a traditional retirement account, that $5,000 may reduce your taxable income for the year. The money is invested and grows without being taxed along the way. When you eventually take the money out in retirement, you generally pay income taxes on the withdrawal.

A Roth contribution works in the opposite direction. You don't get a tax deduction today. You pay the income taxes now, contribute the money to the Roth account, and then it can grow tax-free. If you follow the rules, you can withdraw the money in retirement without paying income taxes on it.

Traditional IRAs have been around since 1974, when they were created as part of the Employee Retirement Income Security Act. Roth IRAs came along much later. They were created by the Taxpayer Relief Act of 1997 and named after Sen. William Roth of Delaware. Americans could begin contributing to them in 1998.

So, which one is better?

It depends on taxes.

There is an interesting piece of math behind this that often gets overlooked. If your tax rate is exactly the same today as it will be in retirement, traditional and Roth contributions are essentially equal, assuming you start with the same amount of money before taxes.

Imagine you have $10,000 available before taxes and your tax rate is 20%. You could put the entire $10,000 into a traditional retirement account. If it grows at 7% annually for 30 years, you would have about $76,000. Pay 20% in taxes when you withdraw it, and you're left with about $61,000.

With the Roth, you pay the 20% tax first, leaving $8,000 to invest. If that $8,000 grows at the same 7% for the same 30 years, you end up with about $61,000 — and the money is tax-free.

Same result.

That's why I don't think the question should simply be, "Is Roth better?" The real question is whether paying your taxes today or paying them in the future is likely to work in your favor. If your tax rate is higher in retirement, the Roth looks better. If your tax rate is lower in retirement, the traditional contribution looks better.

The problem is that none of us knows what tax rates will look like 10, 20 or 30 years from now. We don't know what Congress will do. We don't know exactly what our retirement income will be. We don't even know what our own financial circumstances will look like.

That's why it helps to have some of both – some tax diversification.

Traditional retirement money gives you money that will generally be taxable when you take it out. Roth money gives you money that can potentially be withdrawn tax-free. Having both gives you options. Maybe one year in retirement, it makes sense to take more from your traditional accounts. Another year, taking money from your Roth might make more sense.

Of course, if we knew exactly what tax rates were going to be 20 or 30 years from now, this decision would be a lot easier. We don't.

So, I don't think most people need to plant their flag firmly in either the Roth or traditional camp. There are certainly situations where one makes more sense than the other, but for many people, contributing to both gives them something that can be pretty valuable in retirement: options.