When we meet clients to review their tax information, there often is a frequent question. “Which retirement option is better, the Roth option of my employer’s retirement plan or the traditional option?”
Roth accounts started in 1998. The key concept of a Roth accounts is sacrifice a current year deduction for a guarantee the distributions taken when you retire are tax free.
From 1998 until 2005, Roth accounts were only available in the form of an IRA account. A lot of middle-income and high-income taxpayers could not contribute to a Roth IRA, because their incomes exceeded the relatively modest limit based on their filing status. (The Roth IRA limit for 2012 is $125k for single individuals and $183k for married couples.)
Our elected representatives liked the public giving up a current year tax breaks by opting to go with a Roth IRA instead of to a Traditional IRA. In 2005, politicians decided to expand this opportunity to employer plans.
What’s the difference between the Traditional and Roth versions? Traditional employer plans permit the salary deferrals to reduce your taxable income and grow tax deferred. Income taxes are paid on distributions taken from these accounts when you retire.
Let’s say you earn $200,000, and you max out your salary deferrals for $17,000 during the year. In this case, your W-2 will report taxable wages of $183k in Box 1. Assuming you are in the 33% federal tax bracket, the $17k you contribute saves you $6,667 in federal income taxes. That’s a pretty good tax break.
What happens if you instead decide defer into a Roth version? When you contribute money to a Roth account, you forego a current year tax-break. Your W-2, therefore, will report the full $200k as taxable wages in Box 1, instead of $183k that would be reported had you gone with the Traditional version. The benefit of giving up this tax break is the tax-free treatment of the compounded growth on the $17k of salary deferrals. In other words, you won’t owe any federal income taxes on the distributions taken from this account when you retire.
The Max Benefit Factor:
From a general tax perspective, the Roth IRA is the better choice if your tax rate during retirement will be the same or higher than your current tax rate, as the Roth IRA allows you to pay the taxes now, and receive tax-free distributions when your income tax rate is higher. If your tax rate will be lower during retirement, then the traditional IRA may be the better choice if you are eligible to receive a tax deduction now when your tax rate is higher.
Since the savings you accumulate in traditional employer plans will eventually be taxed at ordinary income rates when you withdrawal, high tax rates during retirement could dramatically reduce the after-tax value of those savings.
As a general rule the Roth accounts are better for savers in their 20s and 30s. This is when the option of paying taxes on your contribution now is generally a better deal than getting a tax break today. When people are in a lower tax bracket and should expect to be in the same or higher tax bracket when they retire.
The core to financial planning is saving. Saving will start to make you a Money Hero. On the way to becoming a hero there will be others to like us, to help improve your financial well-being.