The difference between Roth vs Traditional plans for retirement is primarily about tax rates. Other differences relate to when you can or must withdraw your savings. With one exception, the same withdrawal rules apply to both 401(k)s and Individual Retirement Accounts (IRAs), so I’ll refer to both 401(k)s and IRAs collectively as Roth and Traditional plans. In this post, I will:

Describe the four different combinations of tax-advantaged retirement savings plans in the US.
Provide information about contribution limits.
Talk about the major differences between Roth vs Traditional plans.
Give you the nuts and bolts of the tax considerations so you can make an informed decision as to where to put your retirement savings.

Key Take-Aways – Roth vs Traditional Plans

While there are several differences between Roth vs Traditional plans, some of which may be important to some of you, the biggest difference has to do with when you pay taxes on the money you have saved. As will be explained below, you pay taxes before you put money in a Roth plan and you don’t pay taxes on Traditional plan money until you withdraw it.Characteristics that make a Roth plan a better option than a Traditional plan for you include:

Your salary and spending are likely to go up a lot before you retire.
You anticipate having a lot of taxable income in retirement, such as from a part-time job, a pension or savings not in a tax-sheltered retirement plan.
The expectation that tax rates will increase.

If none of these characteristics apply to your situation, a Traditional plan is likely to be better for your than a Roth plan.As you are thinking about saving for retirement, you'll want to think about not only where to save, but also a target for your retirement savings and how much you need to save each year.

Mechanics of Tax-Advantaged Retirement Savings Plans

In the US, there are two types of tax-advantaged retirement savings plans, each with two variations.

Types of Plans

The two types of plans are:

Individual Retirement Accounts (IRAs). An IRA is an account that you establish on your own at a bank, brokerage house or other financial institution that offers IRAs. You make contributions to your IRA and can select one of many different choices for investments. Allowed investment classes include stocks, bonds, real estate, mutual funds, ETFs, money market and other savings accounts and annuities, among other.
401(k)s. A 401(k) is usually an employer sponsored plan, though you can open an individual 401(k) if you are self-employed. You can contribute a portion of your salary to the 401(k). Many employers will match some or all of your contribution. In a 401(k), you are restricted to the investment options offered by your employer, usually mutual funds and ETFs.

Two Variations

The two variations of each of IRAs and 401(k)s are Roth and Traditional plans. When you set up an IRA, you have the choice of designating it as a Roth vs a Traditional IRA. Your employer (or you if you have an individual 401(k)) determines whether to offer a Roth vs a Traditional plan. For information about the types of investments that are best held in each type of account, check out these posts for the US and Canada.

Maximum Contributions

For 2019, the maximum combined contribution to all of your IRAs combined is $6,000, plus another $1,000 if you are 50 or older. The maximum combined contribution to your 401(k) plan is $19,000 ($25,000 if you are 50 or older). The 401(k) contribution limits apply to money you deposit in your 401(k) and excludes any funds contributed by your employer.

Major Differences between Roth vs Traditional Plans

There are four major differences between Roth vs Traditional plans.

Roth contributions are restricted if your income is high, as discussed below.
You pay a penalty on any withdrawals you make from Traditional plans before the year in which you turn 59.5.
There are required minimum distributions on all plans except Roth IRAs.
The timing of paying taxes on the money in Roth and Traditional plans is different.

Restrictions on Roth Contributions

If your modified adjusted gross income is more than a certain threshold ($137,000 for single taxpayers in 2019, $193,000 for taxpayers who are married filing jointly), the tax law does not allow you to put as much in a Roth IRA and, if your income is high enough, do not allow you to directly contribute to a Roth IRA. However, you can contribute to a Traditional IRA and then very quickly transfer the money to a Roth IRA. This transfer is called a “roll over.” If you fall in this category, I suggest talking to your tax advisor or broker to make sure the process follows the IRS rules.

Early Withdrawal Penalty on Traditional Plans

If you withdraw money from your Traditional retirement plan before the year in which you turn 59.5, you will have to pay income taxes on the withdrawal (see below for more) and you will have to pay a tax penalty equal to 10% of your withdrawal amount. With a Roth plan, you can make withdrawals at any time without paying a penalty, as long as you are either at least 59.5 or you made contributions in each of the previous five years. If you are younger than 59.5, you can withdraw your contributions without paying any tax, but will pay taxes on any investment earnings (interest, dividends or appreciation) on your contributions. I’ve read in some places that the every withdrawal is assumed to be a mix of your contributions and earnings, but I read the IRS web site as saying that you are assumed to withdraw your contributions first and then any earnings. If you want to make withdrawals before you are 59.5, I suggest talking to a tax advisor to make sure you understand the tax consequences.

Required Minimum Distributions

All tax-advantaged retirement accounts, except Roth IRAs, have minimum distribution requirements. By April 1 of the year in which you turn 70.5, you need to start withdrawing money from these accounts.

The amount you need to withdraw is the balance at the beginning of the year divided by your life expectancy, as calculated by the IRS. The same life expectancy is used for everyone, based on their age, except people whose sole beneficiary is their spouse and their spouse is more than 10 years younger. For most people, your life expectancy, according to Table 1 at the bottom of the page on this IRS web site, in the year you turn 70.5 is 18.8 years. So, if you have $50,000 at the beginning of that year in a Traditional IRA or any 401(k), the minimum withdrawal would be $2,660. The penalty for not making the minimum withdrawal is very steep – 50% of the amount that you were required to withdraw but didn’t!

Even though I am retired and able to start withdrawing from my retirement savings, this minimum distribution requirement difference between a Roth IRA and the other accounts has not seemed important to me, as I assume I will need to withdraw money from my other retirement plans to support my expenses. I may change my mind as I get older and have to start making withdrawals, as these withdrawals may increase my taxes more than necessary if I have other funds available to cover expenses.

Dollars and Cents of Taxes

The biggest difference between Roth vs Traditional retirement plans is the way they are taxed.

Taxes on Contributions

Briefly, Roth contributions are made with after-tax money, while Traditional contributions are made with pre-tax money. After-tax money means that you have already paid income taxes on the money you contribute. Pre-tax money means that you do not pay income taxes on the money when you contribute it.In practice, you can deduct the amount of any contributions to Traditional plans from your income on your tax return, but you don’t get to deduct Roth contributions. The amount of your wages reported by your employer on your W-2 has usually already been reduced for contributions you have made to a Traditional 401(k). There is a specific line on your tax return for Traditional IRA contributions.

Taxes on Withdrawals

You do not pay any taxes on withdrawals from Roth plans, but you do on Traditional plans. Just the opposite of when you contribute the money.

Comparison

If the tax rate applicable to your contributions and withdrawals (a lot more on that in a minute) were the same, it wouldn’t matter whether you put your money in a Traditional vs Roth plan! For a Traditional plan, you contribute the amount you have available, earn a return and withdraw it after paying taxes. That is:

Money in Traditional plan = Contribution x (1 + compound investment return) x (1 – tax rate)[1]

For a Roth plan, you start with the amount you have available, pay taxes on it, contribute what you have left, earn a return and withdraw it. That is:

Money in Roth plan = Contribution x (1 – tax rate) x (1 + compound investment return)

Because you can change the order of the terms when multiplying (the associate property for math geeks like me), these two amounts are equal as long as the applicable tax rate when you make your contribution is the same as when you make your withdrawal.

What You Need to Know About Taxes

The Federal government and most states tax your income. There is a small handful of states with no income tax. Because state income taxes vary so widely, I will focus only on Federal income taxes. If you want more information about your state income taxes (and you’ll want to know at least a bit about them for your decision-making process), I suggest visiting your state’s web site or contacting your tax advisor.

The Federal income tax system is very complicated. In this post, I will focus on aspects of the calculation that impact your choice between Traditional vs Roth retirement plans. As with state income taxes, if you have questions about your specific situation, I suggest you contact a qualified tax advisor.There are two steps in calculating your Federal income tax.

Calculate your taxable income.
Determine the taxes that apply to your taxable income.

Taxable Income

Your taxable income is the sum of all sources of income minus your deductions.

Income

The most common sources of income include:

Wages
Interest and dividends, other than those from US Government bonds
Capital gains and losses
Pension income and withdrawals from retirement plans, other than Roth plans
A portion of your social security benefits, as discussed in this post
Self-employment income
Alimony

Reductions and Deductions

These amounts are reduced by a number of items, including the following:

Contributions to Traditional retirement plans
Contributions to Health Savings Accounts
Alimony paid
Some student loan interest

The total of your income excluding this amounts is called your Adjusted Gross Income.You can then choose to either itemize your deductions or use the standard deduction. The standard deduction is $12,000 if you file individually and $24,000 if you file jointly with your spouse. (There are also separate thresholds for most aspects of the tax calculation for married filing separately and head of household. I will not provide the specifics for these filing statuses. You can find more information at www.irs.gov.)

Itemizing your deductions is quite complicated. Briefly, here are the most common deductions:

Medical expenses, but only the portion that exceeds 7.5% of your adjusted gross income
State and local income and property taxes, up to $10,000
Some or all of your mortgage interest
Charitable donations

People usually use the standard deduction unless their itemized deductions are higher than the standard deduction in which case they use their itemized deductions.Taxable income is adjusted gross income minus deductions.

Calculating Your Taxes

For most people, the regular tax rates are applied to your taxable income. People with high incomes and especially those with a large amount of deductions have to calculate a second tax called alternative minimum tax. According to the Tax Policy Center, a very small percentage of people with income between $200,000 and $1 million and about 10% - 15% of people with income more than $1 million will pay the alternative minimum tax. I am going to assume that most of you are not subject to the alternative minimum tax, so will not discuss it here.If you do not have any dividend income or capital gains, you can calculate your taxes from tables provided by the IRS.

Tax Table for Single Taxpayers

Here is the table for single taxpayers for tax year 2018.

Tax Table for Taxpayers Who Are Married Filing Jointly

Here is the table for taxpayers who are married filing jointly for tax year 2018.

How to Use Tax Tables

To calculate your taxes from these tables, you:

Determine the range in which your taxable income falls.
Take your taxable income and subtract the value in the last column.
Multiply the difference by the percentage in the second-to-last column.
Add the amount in the middle column.

For example, if you are single and your taxable income is $50,000, your tax is($50,000 - $38,700) x .22 + $4,453.50 = $7,093.50If you have dividend and capital gain income, the calculations are a bit more complicated as those types of income are sometimes taxed at different rates.

Key Points about Taxes as They Relate to Contributions

Let’s look at a couple of examples to see how Roth and Traditional retirement plans affect your taxes today.

John's Contributions

In the first example, John’s sole source of income is wages of $60,000. He doesn’t have a lot of expenses to itemize, so takes the standard deduction of $12,000. The table below compare the taxes he will pay if he makes contributions of $5,000 to either a Roth and a Traditional retirement plan.

If we take the tax difference and divide by the difference in taxable income, i.e., $1,100/$5,000 = 22%, we get what is known as the marginal tax rate on your IRA contribution. A “marginal” rate is the amount by which the result changes if you make an addition or subtraction to one value in the calculation. It differs from the average tax rate which would be the total tax divided by taxable income. For the Roth column, the average tax rate is 13.5%. It is the weighted average of the 10%, 12% and 22% tax rates that are combined to determine your taxes if your taxable income is between $38,700 and $82,500. The marginal tax rate will be important because it is the tax rate we need to evaluate whether you are better off making a contribution to a Roth or Traditional plan.

Jane's Contributions

Let’s look at another example. Jane’s situation is similar to John’s except she makes $90,000. She also takes the standard deduction and has no other income.

Her marginal tax rate is also 22% (=1,100/5,000), calculated using the differences in the table above.

Key Points about Taxes as They Relate to Withdrawals

The key focus of the Roth vs. Traditional decision is how the marginal tax rate compares at the time contributions are made with the marginal tax rate at the time withdrawals are made. So, now we will look at what John’s and Jane’s situations might look like if they were retired and making withdrawals. For this part of the illustration, we will assume that there hasn’t been any inflation or changes in tax rates between now and the time they retire.We will assume John’s Social Security benefit is $2,000 per month and he has expenses (including income taxes) of $60,000 a year in retirement. His Social Security totals $24,000, so he needs an additional $36,000 from his retirement accounts to cover his expenses. (He will actually need to withdraw more from a Traditional account to cover the taxes on his Social Security benefits and withdrawals, but I will ignore those for now as they add a lot of complication without having much impact on the conclusion.)

John's Withdrawals

Let’s look at John’s tax calculation in his retirement. As a reminder, a portion of your Social Security benefits become taxable if the value in the Test Sum row is greater than $25,000. For more details on this calculation, see my post on Social Security benefits.

John’s marginal tax rate in retirement is 12% (=$4,828/$40,400). He is better off if he contributes to a Traditional retirement plan, as he would reduce his taxes at a 22% marginal rate when he makes his contributions with the Traditional plans as compared to reducing his taxes at a 12% marginal rate when taking his withdrawals with the Roth plans. That is, a Traditional plan is better if the marginal tax rate when you withdraw the money is less than the marginal rate when you contribute it.

Jane's Withdrawals

Now we will look at Jane’s situation in retirement. In her profession, most people she knows get significant raises between her age and retirement. She anticipates that her salary will be more than $150,000 (before inflation) when she retires. With her higher income, her monthly Social Security benefit will be $3,000 or $36,000 a year. Jane expects to have gotten accustomed to her higher salary so has estimated that she will have $120,000 a year in expenses. She plans to save some money in taxable accounts (i.e., not in tax-advantaged retirement accounts) and will get a pension from her employer. These two amounts contribute $44,000 a year to her retirement income. She will need to withdraw $40,000 from her retirement savings accounts to cover her expenses. Her tax calculation in retirement is as follows:

Her marginal tax rate in retirement is 23% (=$10,698/$46,800). In her case, her marginal tax rate in retirement is higher than when she makes her contributions, so she is better off putting her contributions in a Roth retirement plan. That is, it is better for to pay the taxes at the lower rate before she contributes money to a Roth plan than to pay the taxes at a higher rate on Traditional plan withdrawals in retirement.

How John's and Jane's Situations Differ

Jane's situation differs from John’s in two ways:

Her retirement expenses are expected to be much higher than her current salary, pushing her into a higher tax bracket in retirement than she is in today.
She is funding some of her retirement expenses with other sources of income that are taxable which causes the marginal tax rate on her Traditional withdrawals to be higher than if all of her non-Social Security income were from her retirement plans.

How Taxes Have Changed

It is pretty clear that your spending when you retire would have to be much higher than your current income before a Roth retirement plan would be preferred under the current tax structure. However, the tax structure changes frequently so it is impossible to know your marginal tax rate in retirement. To shed some light on how much tax rates might change, I’ve compiled information from this site on historical tax rates.

Marginal Tax Rates Over Time

The graph below shows the marginal tax rate for four different taxable income levels: $40,000; $60,000; $100,000 and $200,000. I adjusted these four amounts for inflation from 2018 back to each year shown in the chart. For example, the Social Security wage adjustment from 2000 to 2018 is 1.565. I therefore looked up the marginal tax rate in 2000 for $25,559 (=$40,000/1.565) when creating the $40,000 line in this chart.

Tax rates prior to 1985 were much higher than they are today. They were fairly constant from 1985 to 2014 with a few ups and down primarily at the higher income levels. In 2015, the marginal tax rates for all but the $60,000 level in the chart increased. The increase for the $40,000 level brought the tax rate for people at that income to its highest level ever. In 2018, all of the tax rates decreased.

For people with taxable income in the $60,000 to $100,000 range, current tax rates are about as low as they have been in the past 35 years. There is also a common sentiment that those with higher incomes should pay even higher taxes than they currently do. Given the current financial condition of the Federal government, it seems more likely than not that tax rates will go up, making Roth plans more attractive. One possible exception is people with lower incomes, e.g., at or below the $40,000 threshold in the graph, as their tax rates are high by historical standards.

How to Decide

Here are some guidelines you can use to decide whether a Roth or a Traditional plan is better for you. Characteristics that make a Roth plan better include:

Your salary and spending are likely to go up a lot before you retire.
You anticipate having a lot of taxable income in retirement, such as from a part-time job, a pension or savings not in a tax-sheltered retirement plan.
An expectation that tax rates will increase.

One suggestion I have seen that is interesting is to put some of your retirement savings in each of a Roth and a Traditional plan which you can do as long as the total doesn’t exceed the limit on contributions. In this way, a portion of your retirement savings is protected from large increases in tax rates, but you still have the benefit of reducing your taxes now. This approach is similar to what I did. All of my 401(k) savings is in Traditional plans, while my IRA savings is all in a Roth plan.

[1] Here is a quick explanation of the (1 – tax rate) term in these formulas. The pre-tax value is Contribution x (1 + compounded investment return) which can be thought of as Contribution x (1 + compounded investment return) x 1. The tax on that amount is equal to Contribution x (1 + compounded investment return) x tax rate. To get the after-tax return, we subtract the tax from the pre-tax value. When we pull out the common term and group them (i.e., apply the distributive property of multiplication over subtraction for you math geeks), we get Contribution x (1 + compounded investment return) x (1 – tax rate).

Mar 12 Traditional vs Roth Retirement Plans