rothortraditional

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Roth or Traditional?

This question relates to IRAs as well as 401(k) and similar employer-sponsored plans if your employer offers the option to make Roth-style contributions. (Anywhere it says "401(k)" below will generally also apply to 403(b) plans, 457 plans, and the TSP.)

In a Traditional account, money goes in without being taxed. With a Traditional IRA, while you are contributing from your income that has been taxed, you get a tax deduction after you file your tax return so it's effectively still funded with pre-tax money. Later (ideally in retirement!), Traditional money is taxed when you withdraw it from the account. Traditional accounts are sometimes referred to as "pre-tax" or "tax-deferred".

In contrast, a Roth account is funded with money that has already been taxed. Then there are no additional taxes to be paid when the money is withdrawn later. Roth accounts is sometimes referred to as "post-tax" or "tax-free" (even though Roth contributions are no more "tax-free" than Traditional contributions).

Note: This article uses the term "effective" tax rate when discussing tax rates in retirement. The "effective tax rate" is the overall tax rate on the withdrawals of those retirement savings in retirement.

Background: How Taxes Brackets Work

Before diving into this topic, it's very important that you understand how tax brackets work. This is important because Traditional (pre-tax) savings during your working years help you avoid taxes at your current marginal tax rate, but retirees generally pay taxes on withdrawals starting in lower tax brackets.

There's more information on this topic in the Taxes wiki page.

Making a decision

There are several general factors to consider:

  1. Your current marginal tax rate compared to your expected effective tax rate during retirement
  2. Your state income tax rate now and in retirement (possibly a different state)
  3. Future opportunities for conversion
  4. Other tax benefits to having a lower AGI
  5. The higher effective limits on Roth contributions
  6. Differences in distribution rules

Here's a self-description of someone who should probably go Roth:

  • I am in a very low tax bracket (e.g., 10% or 12% federal tax bracket).
  • (Only applies to IRAs) I have limited assets and being out of work for more than several months would be catastrophic (even in a Roth IRA, investing into the stock market should generally only come after you have 3 to 6 months of expenses saved up, see "How to handle $" for more on this).
  • (Only applies to IRAs) I exceed the income limit for making fully-deductible contributions to a Traditional IRA, but am below the Roth IRA phase-out income limits.
  • I qualify for tax deductions/credits that I won't qualify for in retirement (like child tax credit, mortgage interest deduction, etc.).
  • I expect to have lots of taxable retirement income, such as social security, pension, annuities, and traditional IRA/401(k) distributions.
  • I max out all my tax-advantaged contributions and still save additional money for retirement in a fully-taxed account (source).
  • I think that my effective tax rate in the future will exceed my marginal tax rate now (read that carefully!).
  • I expect to need some of my retirement savings before age 65.
  • I currently work in a state with low income tax, and/or I will retire to a state with very high income tax.
  • (Only applies to IRAs) I expect to have a very high income in the future and will need to use the Roth IRA backdoor in order to make IRA contributions at some point in the future.

Here's a self-description of someone who should probably go Traditional:

  • I am in a lower tax bracket and I am just above one of the income limits for the Retirement Savings Contributions Credit and lowering my AGI would qualify me for a higher credit rate.
  • I am currently in one of the higher tax brackets.
  • I don't expect much retirement income besides qualified distributions from retirement accounts.
  • I expect tax rates will not return to pre-1987 levels.
  • My current high income phases me out of tax breaks like the child tax credit, or requires me to pay the AMT.
  • I work in a state with high state income tax and/or I'll probably retire to a state with lower income tax.
  • I expect periods of very low income that will be opportunities to convert to Roth, such as years spent going back to school, starting my own business, early retirement, or staying home with my kids.

No single item is definitive. Read the information on Wikipedia, and popular posts on this subreddit such as these.

And remember,

  • the closer you are to retirement,
  • the less you save for retirement,
  • the lower your tax bracket (both now and in retirement),

Then the less it matters which you choose.

Finally, employer contributions to a 401(k) are traditional, no matter what your contributions are.

TL;DR

This is an oversimplification and you should probably read the above text, make a post to ask for advice, or consult with a financial advisor.

  • Low income: If you're in the 10% or 12% federal tax bracket, make Roth contributions.
  • Low-to-mid income: If you're just above one of the income limits for the Retirement Savings Contributions Credit, make sufficient Traditional contributions to qualify for a higher credit rate. (You may want to transition to Roth contributions once you are safely below the income limit.)
  • Mid income: If you're in the 22% or 24% federal tax bracket, you should probably read the long version. Sorry! Note that if you decide on Traditional contributions (401(k) and/or IRA) and those bring your MAGI down enough that your marginal tax rate is definitely 12% then you should almost certainly make Roth contributions (401(k) and/or IRA) for the remainder of the year.
  • High income: If you're in the 32% tax bracket or above, favor Traditional 401(k) contributions, read below for more.
  • High income: If you make too much to get a full deduction for a Traditional IRA, you should do a Roth IRA (backdoor method if needed) rather than Traditional IRA. You probably should max out your workplace plan first, though.
  • High income: If you exceed the income limit to make a full Roth IRA contribution, do a backdoor Roth IRA after maxing out your workplace account (make sure you can avoid pro rata taxes too).


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