This is one of the most common questions that the average retirement saver has. If you’re not a finance person, not knowing the answer to this question alone could keep you from investing at all, and you would be missing out on years of tax-free growth on that money. If you never want to read another thing about it, then please know that they are both wonderful accounts, so don’t worry about it and just pick one and start contributing. If you would like to truly optimize, then continue to read.
The Main Difference — Tax Now or Tax Later
The main difference when choosing whether to invest inside a Roth or Traditional retirement account is simply: when do you want to pay income taxes?
Traditional retirement accounts are tax-deferred. This means that you are electing to defer (put off) the income taxes on that money until later. You will pay no income tax on that money now, it will grow without capital gains taxes in a retirement account, and then any money that you withdraw upon retirement will be subject to income tax when you remove it from the account.
Roth retirement accounts are funded with post-tax dollars. This is money that you already possess from your regular income, and therefore money that has been income taxed for the year in which you earned it. The money will be put in the Roth account, and no money in the Roth account is ever taxed again. Technically, the earnings in a Roth 401(k) is subject to income tax, but you can roll that money over to a Roth IRA in retirement and that solves the problem.
Neither account is subject to capital gains tax (a tax on what you earn on your investments), and that is the main advantage of a retirement account.
To put it simply:
Roth: pay income tax now. Traditional: pay income tax later.
As mentioned in my last post about the Roth versus Traditional Myth, if the income tax rate you pay is the same, then there will be no difference in how the income tax affects the money in your account regardless of whether you pay now or pay later.
If it’s the same whether you pay now or later, then why does it matter?
The answer, as you might imagine, is that the tax rates usually are not the same. An understanding of how marginal tax rates work is a requirement for this discussion. If you already understand that, great! Go ahead and keep reading. If you need marginal tax rates explained, follow this link, and I’ll see you back here in a bit.
When taking money from your income to invest, you should consider that you’re taking that money from the TOP of your income (illustrated below). Since that money is coming from the top, you will be paying your highest marginal tax rate on that money if you pay the income tax now. If you defer taxes by investing in a traditional account, then you are choosing not to pay your highest marginal tax rate at that point in time.
When withdrawing the money in retirement, your distributions (money you withdraw from the retirement account) are counted as your income, and it’s taxed as regular income based on the marginal brackets. Assuming you have no other income in retirement, that means that you took the money you invested from the top marginal bracket, and it’s now starting at the bottom marginal rate. The goal is to get your “effective” tax rate (the average of all your taxes — calculated: "taxes paid" divided by "gross earnings") lower than your top marginal rate (which is what you would have paid on that money if you didn’t defer).
For an illustrated example: consider a single man with an income of $95,000 taking the standard deduction of $12,400. This makes his taxable income $82,600 — well within the 22% bracket. He lives on $40,000 per year, so he wants to defer taxes on $40,000 by contributing to Traditional accounts (an unusually high amount of tax-deferred space, but not impossible — it fits with my example). When he defers the tax on the left side during his earning years, he avoids the highest marginal tax rate. On the right side, when he withdraws that money in retirement when he has no other income, it starts at the bottom (even $12,400 below $0 due to the standard deduction). This gives him a wonderful 7.86% effective tax rate on that money in lieu of the 22% he would have paid had he not deferred — saving more than $5,600 in taxes!
Illustrated are the marginal federal tax rates for a single filer in 2020. Colored areas are earned income; the pink area below $0 accounts for the 2020 standard deduction.
You can see that the chances that you pay a lower rate later are pretty good, especially if you are in the 32% bracket or above.
Now to the actual choice
You would choose a Roth if you think your highest marginal rate is a good deal — lock in that rate by paying it now. You would choose a Traditional if you think your marginal rate is a bad deal, and you could get a better rate later.
How do you know if it’s a good deal? Here’s a general rule of thumb:
The 12% bracket and below is a good deal, and the 22% bracket and above is a bad deal.
Here are the 2020 federal tax brackets (if you’re reading in a future year, they’re probably different):
Why is 12% the cutoff? For one, 12 to 22 percent is a 10% jump. In the end it comes down to how much money you’ll be living on in retirement and a consideration of required minimum distributions.
Distributions from your tax-deferred accounts will be counted as income for that year, and you will pay income tax on that money. For a married couple taking the standard deduction, you would need to have an income of approximately $122,650 in order to pay an effective tax rate of 10%. In order to get to the 12% effective tax rate, you would need an income of about $147,100 in a year, and $458,000 for an effective 22%. These numbers include all income in retirement, including but not limited to social security, pensions, rental properties, and retirement account distributions. Since distributions are just what you take out, you have some control here over what your “income” is for that year, and therefore some control over what your income tax rate is.
If you understand everything so far, then you’re probably thinking: “Well I can live on much less than that. I’ll just do everything in tax deferred accounts in order to have a lower tax rate later.” This is a rational thought, but it is complicated by one thing: Required Minimum Distributions.
The RMD Complication
Required Minimum Distributions (RMDs) are exactly what they sound like: a minimum amount that is required for you to withdraw from your retirement accounts at a specific date. The important part here is that you have to pay taxes on the money that is withdrawn, so this is a forced taxable event. RMDs start when the account holder is 70.5 years old, and they’re the government’s way of saying that they’ve waited long enough for you to pay taxes on that money. (Update: this will change to 72 years old in 2021). The problem is that you could be forced to take so much out that it is enough to make the effective tax rate higher than the marginal rate you originally avoided when you deferred the taxes.
RMDs are required for your tax-deferred accounts, but not for the Roth accounts, since you already paid taxes. So this is a complication you only need to consider when deferring taxes in a traditional account.
Technically, RMDs are due on Roth 401(k)s and Roth 403(b)s, but you can just roll those balances over to your Roth IRA once you have terminated employment, and that solves the problem — no RMDs for your Roth accounts.
RMDs are calculated by taking your account balance and dividing it by the “life expectancy factor” that is determined by your age. Whatever the amount is after you divide, that’s how much you have to take out that year. Here’s the table as of 2020. (Starting in 2021, this table will be adjusted to fit a longer life expectancy for Americans, decreasing your RMDs.)
Assuming you have no other income in retirement, you would need to have an account balance of around $4 million the year you turn 70.5 for the RMDs to force you to pay an effective 12% (because it would force you to withdraw $147,100). To be forced to pay an effective 22%, your account balance would have to be approximately $12.5 million. Here is a table that extends this idea for later ages. Keep in mind that if both you and your spouse are required to take RMDs from your respective accounts, then these are totals.
Consider that two 401(k) accounts that were maxed out for 40 years at the current 2020 max of $19,500 and grew at 8% yearly now have a combined total of approximately $11.4 million. Since the tax brackets in 40 years will be adjusted upward for inflation, we’ll consider the “real value” (adjusted for inflation) of your portfolio to compare. Assuming 2% yearly inflation, the real value of your portfolio is a little under $6.5 million, and that’s the number we’ll use. You can see that when you get to an age requiring RMDs, an account balance of $6.5 million will fall between 12% and 22%, which means paying 22% was a bad deal, and paying 12% was a good deal. Most people don’t max out two 401(k)s for 40 years, so setting the rule of thumb between the 12 and 22 percent brackets is reasonable in my opinion.
The US government provides an RMD calculator that can help you with this planning; you can find that with this link.
Social Security, Pensions, and other Income
The numbers in the table above are based on if you have $0 of income in retirement. If you have other income from social security, a pension, rental income, or anything else, you will have to consider that along with your RMDs to fully count your income for that year, and then calculate the effective tax rate.
Working Example — What does it look like?
I want to give an example to hopefully drive this idea home so you can actually take some action. So let’s say we have the following scenario:
Scenario: Married couple is filing jointly, has a gross income of $120,000, and is taking the standard deduction. They want to invest $30,000 into retirement accounts this year.
Taxable income: Their total taxable income is their gross income minus the standard deduction, so $120,000 minus $24,800 is $95,200.
Invest $14,950 in Traditional: The 12% bracket in 2020 goes up to $80,250, so any dollar amount over $80,250 will be taxed at 22%. They would therefore contribute $14,950 in traditional accounts to defer the taxes on the money above $80,250 to avoid the 22% tax. (illustrated below in blue)
$95,650–14,950 = $80,250
Their top marginal bracket is now 12%, and that is a rate they are ok paying.
Invest the Rest in Roth: Now that they’ve deferred taxes on the top of their income to get themselves down to the 12% bracket, they will put the remaining $15,050 into Roth accounts to lock in the 12% tax rate. (illustrated below in purple)
Most married couples only have Roth IRAs ($12,000 in space), but others have Roth 401(k)s, 403(b)s, and/or 457(b)s, which offers a lot more space. Whatever the case, they will switch back to traditional accounts if they run out of Roth space.
They chose their tax rate: This way they have made the tax decision for themselves: “I don’t want to pay 22%, so I’ll defer those taxes. I’m ok paying the 12%, so I’ll pay those.”
Emergency Funding
Besides not having RMDs, a Roth account has other benefits that a traditional account does not. The main benefit is its ability to be used for emergency funding. Since you already paid income tax on your contributions, you are allowed to withdraw that money at any time, penalty free. Any other retirement account would charge a 10% penalty, except if your account allows for hardship deferrals (which may or may not be written into your specific 401k or equivalent plan). This exception only applies to your contributions (the money you put it) and not on any earnings that have accrued in the account.
There are nuances with the Roth 401(k) versus your Roth IRA, and if you care for more detail, you can read about it at this link.
As a disclaimer, you should not remove money from your retirement account until retirement unless it is absolutely necessary in an emergency. Retirement savings should be for retirement, and if you are dipping into your retirement accounts, you are negatively impacting your future. But if you’re someone who doesn’t invest because you think “what if I need that money?”, a Roth account can allow you to save for retirement while at the same time having a robust emergency fund.
In Conclusion
Your decision between Roth and Traditional is a decision to pay taxes now or later. You are comparing your top marginal rate today with your effective rate in retirement. Be sure to consider RMDs when comparing these tax rates. As a rule of thumb, invest pre-tax at marginal rate of 22% or above and post-tax at a marginal rate of 12% or below. Consider the emergency funding benefits of Roth accounts. Make a decision and go for it.
Remember, I have made assumptions with numbers throughout this post: most notably about your other income in retirement (Social Security, pensions, etc.) and your retirement account balance. Please be sure to consider your own individual situation to make the right choice for yourself, and contact a licensed financial planner to discuss your specific situation. I hope this has made the decision-making process more clear and that you can feel more confident going forward.
Answers to Common Pushback
What if I'll be in a higher tax bracket in the future? Answer in this post.
What if taxes go up in the future? Answer in this post.
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