Traditional or Roth? Which is the Best Tool for Saving for Retirement?

One of the questions I get asked the most is which type of retirement account is better, traditional or Roth? The answer varies for different situations, and the best choice for you might change over the course of your life, but I will provide some guidelines with a little help from Yogi.  

I am talking about Yogi Berra, the baseball legend who died in 2015. Yogi was a Hall of Fame player and successful manager but in spite of that he is best remembered, not for his on-the-field exploits, but for the things he said off the field. 

Yogi had a knack for saying funny things that at first don’t seem to make a lot of sense but on further reflection contain a nugget of truth. Speaking of Yogi’s quotes writer Peter Patau said, “[They] have the right blend of sense and nonsense, of meaning struggling to emerge from chaos…[They] sound quotably dumb while at the same time being pregnant with hidden meaning.” 

If nothing else Yogi’s sayings were memorable. I am sure you have heard some of them, and probably even repeated them.  Some of my favorites are:

  • “It ain’t over till it’s over.”
  • “It’s déjà vu all over again.”
  • “You can observe a lot by watching.” and,
  • “Always go to other people’s funerals; otherwise they won’t go to yours.”

What does any of this have to do with retirement accounts? While Yogi was not considered a financial genius he did say a couple of things that shed light on our current question, but before we get to that we need to make sure everyone knows the difference between the two types of retirement accounts. 

How Traditional and Roth Accounts Work

Traditional and Roth retirement accounts are both tax-advantaged accounts created by the government to encourage people to save for retirement. While they both have the same goal the tax incentives offered are different; in fact, in some respects they are opposites of each other. 

Retirement planning has three phases:

  • Contribution
  • Growth, and
  • Withdrawal

In a traditional IRA the money you contribute is exempt from taxes in the year of contribution.  In addition, growth in the account is exempt from taxes between contribution and withdrawal.  However, withdrawals during retirement are taxed at your tax rate when the money is withdrawn.  This type of plan is known as an EET plan because retirement savings are exempt from taxes during the first two phases but taxed upon withdrawal. 

The deferral of taxes allows the money to grow much faster than it would otherwise but the money is not all yours. Uncle Sam is your investment partner and the tax bill will eventually come due.  Furthermore, there is uncertainty about how much you will have to pay in taxes upon withdrawal since it is impossible for you to predict your personal tax rate during retirement. 

A Roth retirement account works in an opposite manner. There is no tax advantage during the year of contribution.  In other words, you contribute money that you have already paid taxes on.  However, both the growth of the account between contribution and retirement, and withdrawals from the account during retirement, are exempt from taxes.  A Roth account is known as a TEE plan because the money you contribute is taxed, but both growth and withdrawals are exempt.  Everything you have in a Roth account is yours, free from further taxation.

Which Type of Account is Better?

Which is better, a traditional or Roth account? It depends on your personal situation but here are some guidelines: 

  • If your personal marginal tax rate is the same when you withdraw the money as it was when you contributed the money, the tax effect will be the same with both types of accounts. There will be no advantage to either over the other one.
  • If your personal marginal tax rate is lower when you withdraw the money than when you contributed the money, a traditional account offers tax advantages over a Roth account. You will be paying less in taxes when you withdraw the money than you saved in taxes when you contributed the money.
  • If your personal marginal tax rate is higher when you withdraw the money than when you contributed the money, a Roth account offers tax advantages over a traditional account. You will be saving more in taxes when you withdraw the money than you paid when you contributed the money.

Personal Marginal Tax Rate

As you can tell by the explanation above, knowing your current personal marginal tax rate is vital in determining which type of account is better for you. Your personal marginal tax rate is the percentage you would pay in  taxes at the end of the current year on one additional dollar of income.  Generally speaking it is the federal tax bracket you fall in.  For the 2015 tax year the Federal tax scheme consists of the following tax brackets:

  • 10 Percent
  • 15 Percent
  • 25 Percent
  • 28 Percent
  • 33 Percent
  • 35 Percent
  • And 39.6 Percent.

Your homework assignment is to determine, based on your household income, exemptions, and filing status, what your current personal marginal tax rate is. This is an important number and you should know what it is each year.  Write it down and track it. 

Traditional or Roth?

In order to determine which type of account is better for you in the current year you would need to know both your current personal marginal tax rate and your personal marginal tax rate in the year in which you will withdraw the money you contribute this year. This is an impossible task because, as Yogi once said, “It’s tough to make predications, especially about the future.” 

Even if you knew the year you were going to withdraw the money you contribute this year, and what your taxable income would be that year, you still would have no idea what the tax rates will be in the future. That depends on things you have no control over. 

Since you cannot predict tax rates in the year you withdraw the money you need to make the most of the information you do have – your current marginal tax rate – and play the probabilities.

If you don’t owe any taxes this year, or are in the bottom two tax brackets (10% or 15%) it is highly likely that your tax rate will be higher when you withdraw the money than it is now. A Roth IRA is probably your best bet. 

If you are in the 25% or 28% tax brackets this year it’s a tossup as to whether your rates during retirement will be higher or lower than this. Hedge your bets and split your contributions between a traditional and a Roth account. 

If you are in one of the top three tax brackets (33%, 35%, or 39.6%) there is a decent chance you will be in a similar or lower tax bracket during retirement. Consider taking the tax break now by contributing to a traditional retirement account.

This assumes you need the tax savings now. If you can arrange your budget to meet your financial goals now without using the current tax breaks provided by a traditional IRA than a Roth is a great option.  With a Roth, in spite of Yogi’s wisdom about predictions, you truly can predict your future tax rate.  It will be zero and everything in the account will be yours to use.  

More Wisdom from Yogi

Yogi also reportedly said, “When you come to a fork in the road, take it.”

This is great advice for choosing a retirement account. The traditional/Roth question is not an all or nothing equation.  The answer on which type of account is best for you will likely change during the years and there are clear tax planning advantages to arriving in retirement with a significant amount of money in each type of account. 

Take the case of a young married couple with two kids. If they earn somewhere around the median household income of about $50,000 per year, with their child tax credits and exemptions for the children they are probably paying little or nothing in taxes.  It doesn’t make sense for them to contribute to a traditional account since the tax savings from doing so would be minimal.  The Roth is the better choice in this situation. 

As the couple grows older their income will hopefully rise. While this is happening the kids will also grow up and leave the nest, taking valuable tax breaks with them.  Over time they find themselves creeping up through the tax brackets.  This can be a painful process (I am currently experiencing it) and the couple might decide they need to shelter some of their increased income from taxes now.  Shifting some or all of their contributions to a traditional account during this phase of their lives makes sense.  

Following this process they would arrive in retirement with a significant amount of money in each type of retirement account. This situation would open up some beneficial tax planning options.  Each year during retirement they could withdraw enough from the traditional IRA to fill up the lower tax brackets and take the rest of the income they need from the Roth account. 

Although Yogi was a baseball man, not a financial planner, he did offer some great advice when it comes to retirement planning and the traditional/Roth decision:

  • “When you come to a fork in the road, take it.” At different points in your life each fork in the traditional/Roth road will make sense. Sometimes the best decision is to take both.   
  • “It’s tough to make predictions, especially about the future.” Don’t try to predict what future tax rates will be. Instead, use your current personal marginal tax rate to guide your decision about which type of account to use each year.  

Of course, take this advice for what it’s worth. Yogi also said, “I really didn’t say everything I said,” and congress could decide to change the entire tax system before you retire. 

Even if that were to happen I am confident that saving for retirement is infinitely better than not saving, and that saving in either a traditional or Roth account will continue to offer tax advantages over saving in a taxable account. You really can’t go wrong with either type of retirement account.  Happy saving!

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