Roth 401k and Roth IRA vs. traditional IRA and 401k: How to choose which one is right for you

A question I am often asked is “Should I contribute to a Roth IRA or Traditional IRA?”.  A similar discussion occurs during my 401k enrollment meetings when I discuss Traditional 401k and Roth 401k contributions.

Unfortunately, articles written on the topic are confusing and way too long. By the end, the reader is often more confused and doesn’t know what to do. I think the biggest difference between a Roth IRA and a traditional IRA is how and when you get a tax break.

  • Contributions to traditional IRAs are tax-deductible, but withdrawals in retirement are taxable.
  • Contributions to Roth IRAs are not tax-deductible, but qualified withdrawals in retirement are tax-free.

The BIG question you need to answer first when deciding Roth IRA vs. traditional IRA is… Do you think your tax rate will be higher or lower in the future?

Consider the Roth IRA vs. Traditional IRA. The bottom line is this:

  • If you expect to be in a higher tax bracket in retirement, consider choose a Roth IRA and its delayed tax benefit. If you expect lower rates in retirement, consider choosing a traditional IRA and its upfront tax advantage.

But Erick, how am I supposed to know what my tax rate is going to be?

It’s hard to anticipate what your tax rate will be in retirement, particularly if you’re decades away from leaving the workforce. Fortunately, there are other ways to determine whether a Roth or traditional IRA is best for you.

The IRS rules on IRA eligibility may make the Roth vs. Traditional IRA decision for you. Your income will determine how much of your contribution to a traditional IRA you can deduct from this year’s taxes. Traditional IRA deductibility is restricted if you or your spouse has access to a workplace savings plan like a 401(k).

But to make this more confusing, there are no income restrictions when investing in Roth 401k.

Worth noting: You can contribute to a traditional and Roth 401k during the same year just like you can contribute to traditional and a Roth IRA (as long as the total amount does not exceed the maximum allowable contribution limit: $6,000 in 2020 and 2021 ($7,000 if age 50 or older) during the same year.

When to Consider a Roth IRA

Here’s why it may be better to go with the Roth vs. traditional IRA for those who qualify.

  1. Early withdrawal rules are much more flexible with a Roth. Roth can allow you to withdraw contributions — money you put into the account; not earnings — at any time without having to pay income taxes or an early withdrawal penalty.

Keep in mind, if you withdraw from a traditional IRA or your 401k before retirement and you’ll likely face the dreaded 10% penalty from the IRS and owe taxes at your current income tax rate on the money you take out. That’s why I am so outspoken during my employee education workshops about early withdrawals and loans (which often lead to early withdrawals).

  1. The Roth has fewer restrictions for retirees. Traditional IRAs require you to start taking required minimum distributions (RMDs) at age 72.

Unless you inherit a Roth IRA, it has no required minimum distribution rules. What that means is you can let your savings stay invested to continue to grow tax-free as long as you live.

  1. In my experience, you’ll end up with more after-tax money in a Roth IRA simply based on human behavior. Yes, both types of IRAs offer a tax break but because your tax break doesn’t arrive till retirement (via tax-free withdrawals), you won’t be tempted to spend it before then. Since the tax benefit of a traditional IRA is received each calendar you invest, people usually spend that tax savings.
  2. Funding a Roth in conjunction with your 401(k) provides tax diversification. The classic 401(k) plan offered by most employers provides the same tax benefits as a traditional IRA. If you’re a participant in one of the 401k plans that I advise, you have access to both traditional and Roth. I make sure of that. Keep in mind, that is not typical across 401k plans in America. Many do not offer Roth contributions.

Note: If your company doesn’t offer Roth 401k, contact me today so I can help. As an alternative, consider a Roth IRA this year until we get that sorted out.

Making the call

Getting people to save for their retirement is my priority #1. After that, I want to get them to save 10% of their income so they won’t struggle in retirement. Then setting a goal of 15% so they can live a bit more comfortably.

Contributing to a traditional 401k or IRA gets you that upfront tax break. That’s a wonderful thing. I think it is the best tax deduction offered Americans today. But keep in mind you’ll owe taxes on all of it in retirement as you withdraw it over the years. With Roth IRAs, you pay taxes on contributions now and get tax-free withdrawals later.

Whether you think your annual income and tax bracket will be lower or higher in retirement is a key factor in determining which IRA to choose.

Still have questions? I understand. There are a lot of moving parts here. Want to discuss your traditional and Roth strategy, book a free consultation today.

Would you like a review of your current 401k Plan?

Discuss your retirement plan with a 401(k) specialist.

You should consult with your attorney or tax advisor for guidance on your specific situation.