Making the Call

Bryan Sudweeks

TRADITIONAL OR ROTH retirement accounts? Below are eight key questions to ask. Your decision should be based on your answers to these eight questions—including the importance you put on each.

  1. Do you want a tax break now? Assuming you qualify, a traditional IRA allows you to deduct your contributions, resulting in a lower taxable income for the year. Ditto for tax-deductible contributions to an employer’s 401(k) or 403(b) plan. But with Roth accounts, you don’t get this tax benefit. Rather, you pay taxes on your contributions—but, in return for losing that tax break, you don’t pay taxes when you take out the account’s earnings in retirement.
  2. Do you have money to pay the taxes owed on today’s earned income? If you choose the Roth, you’ll have to pay income taxes on the income used to fund your retirement plans. If you don’t have the money to pay those taxes, you would choose a tax-deductible account.
  3. Might you need your money back before retirement? With a traditional, tax-deductible IRA or 401(k), you must pay income taxes and a 10% penalty if you make a withdrawal before retirement. But if you choose a Roth IRA and need money, you can withdraw your original contributions at any time, with no taxes or penalties owed.
  4. Do you expect your tax rate to rise in retirement? If your tax rate is likely to climb, you would go with the Roth. If you expect your tax rate to be lower, you would favor traditional accounts.
  5. Do you want more after-tax money for retirement? With a Roth account, you’re saving more for retirement, because $100 coming out of a Roth will be tax-free, while $100 coming out of a traditional retirement account will trigger a tax bill—except in the unlikely scenario where your income is so low that you don’t owe taxes.
  6. Do you want to reduce required minimum distributions, or RMDs? These are distributions required by law on almost all retirement accounts beginning at age 70½. RMDs are required per person, not per couple. Each year, you must add up all your tax-deferred account savings—traditional IRA, 401(k), 403(b), SEP IRA and so on—and divide that amount by an IRS table that’s based on life expectancy. The result is the amount you must take out of your tax-deferred accounts in the next year. Failure to do so results in a 50% penalty that’s levied on the RMD amount you failed to withdraw. Want to avoid RMDs? Get money into Roth IRAs. Be warned: Money in a Roth 401(k) or Roth 403(b) is subject to RMDs—a reason to roll this money into a Roth IRA when you leave your employer and retire.
  7. Do you want to bequeath this money to your heirs, without triggering tax problems? Leaving traditional retirement accounts to heirs is more challenging, because income taxes are still owed. If you want to minimize tax problems for your heirs, choose Roth accounts.
  8. Do you want to better manage your tax rate during retirement? Think of your financial accounts in three buckets. There are tax-now accounts, such as mutual funds and individual stocks held in regular taxable accounts. There are tax-deferred accounts, like a traditional IRA, 401(k), SEP IRA and so on. And then there are tax-never accounts, including the Roth 401(k), Roth 403(b) and Roth IRA.

Ideally, you should aim to have a mixture of all three, so you can more easily target a particular tax rate once you retire. Each year, first take money out of your tax-deferred and tax-now accounts up to your targeted tax rate. Need additional funds? You might then turn to your Roth accounts, which are never taxed.

Bryan Sudweeks is an associate teaching professor at Brigham Young University’s Marriott School of Business and a Chartered Financial Analyst. He teaches personal finance and asset management, as well as advising the student-run investment fund. A California native, follow Bryan at the BYU Personal Finance website.

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