2022 | Roth or Traditional: Choosing Your Retirement Savings Vehicle

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2022 | Roth or Traditional: Choosing Your Retirement Savings Vehicle

Deciding which type of deferral to make in your 401(k) or other employer retirement plan is usually positioned as a choice between lowering taxable income now (traditional) or assuming that your tax rate will be higher in the future so you should pay tax now (Roth). Traditional contributions are tax-deferred, so you avoid taxes now, but will incur a tax bill in retirement. Making Roth contributions means you contribute after-tax dollars and won’t have to pay taxes on that money when you take withdrawals in retirement.

While comparing current vs. future tax rates is a valid point, we think there is more to consider. Before we address this, it’s important to first understand what the tax-deferral feature of traditional accounts means and what tax liabilities may look like in the future. 

The Tax-Deferred Account

Lowering current income is attractive now, but how could it impact your future. Putting aside money tax-deferred means that both the contribution and the growth of that contribution will be taxed when withdrawn in retirement. You also will not have complete discretion over those withdrawals (required minimum distributions), so income planning to minimize taxes could be limited. 

The government mandates required minimum distributions (RMDs) to ensure that the taxes will ultimately be paid. In practice, this means you must distribute a portion of the account every year even though you might not need the money for living expenses. This impacts how much of your Social Security will be taxed, as well as Medicare Parts B and D premium surcharges.

The Roth Account

Roth contributions are funded with after-tax dollars. This means no further taxes are due. You’ve paid the taxes on the contribution, and all the growth is now tax-free when you take it out. Because you’ve already ponied up, there are no requirements for those future withdrawals. You can withdraw as much or as little as you want.

This puts you in complete control of your income stream in retirement, which can be a significant factor in creating tax efficiency. 

The Decision-Making Fulcrum

From a savings standpoint, and assuming the accounts are invested identically and for the same period, which option provides the greatest lifetime benefit? 

We’ve conducted analysis for many clients, and we have found the only time traditional deferrals are more advantageous than Roth is when the tax savings are put to work. If you’re using the money saved on taxes for anything other than funding an investment account, Roth is likely the better option for you. 

In other words, the tax-deferred account needs the boost of outside investments to equal the benefit of tax-free withdrawals in retirement from your Roth account. 

The Bottom Line

This is all theoretical until applied to your specific situation, with all the inputs that apply to your lifestyle, tax rates, and goals. When we model this out for clients, we focus our analysis on exactly how much additional savings will be required to equal the benefit of Roth savings. If your current financial situation does not allow for consistently making that investment, you’ll be better off paying the taxes now rather than later. 

Below is a sample illustration we provide clients when making this decision:

Sample chart showing Roth vs Traditional 401(k) contribution analysis

The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but is intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax, or financial advice. Please consult a legal, tax, or financial professional for information specific to your situation.

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This content was not reviewed by FINRA.

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