Should You Make Roth or Traditional Retirement Plan Contributions? It Depends

Key Takeaways

• A traditional IRA provides deductions for deposits, it grows tax-deferred, and withdrawn funds are fully taxable as ordinary income. A Roth IRA does not provide deductions for deposits, but your money grows tax-deferred.
• Income limits on IRAs could restrict which type of account you can use.
• For the individual investor, the question of Roth versus traditional IRA may hinge on your personal preference: A tax deduction today or tax-free income in the future.
• Diversification in IRAs should be based on what makes sense for you and your retirement goals.

Christine Benz: Hi, I’m Christine Benz for Morningstar. Roth IRAs and 401(k)s allow for tax-free withdrawals, which is a major selling point. But Baird’s Director of Advanced Planning, Tim Steffen, argues that Roth contributions aren’t always the right call. He’s here to share some tips on decision-making.

Tim, thank you so much for being here.

Tim Steffen: Great to be here, Christine.

How Are Roth IRAs and Traditional IRAs Different?

Benz: It’s great to have you. Let’s start with a bit of stage-setting to discuss the tax treatment of traditional tax-deferred and Roth accounts. How are they different?

Steffen: Yeah, they’re kind of mirror images of each other. A traditional account that’s pretty basic in most cases, you get a deduction for whatever you put into it. It grows on a tax-deferred basis, and when the time comes to take the money out, it’s going to be fully taxable as ordinary income.

Roth works the opposite. There’s no deduction for putting anything in there, so it’s considered an aftertax contribution, but once it goes in there, it grows tax-deferred. If you meet some pretty basic rules, when it comes out, it’s fully tax-free. There are some other differences in terms of required minimum distribution rules and what happens to beneficiaries of inherited accounts.

At its essence, it’s about deductible contributions going in and taxable income coming out, compared with nondeductible contributions versus tax-free income coming out. Which one’s more important to you?

How Do Income Limits Affect Your IRA Options?

Benz: OK. I want to delve into that in a second, but first, with IRAs, income limits come into play, and it seems like your decision might be made for you in a way, if you’re a higher-income earner, that your only option might be to do a Roth account or maybe even a backdoor Roth account. Can you discuss that?

Steffen: From a traditional account standpoint, an IRA, the question is, can I deduct what I’m putting in there? On an IRA side, there’s a variety of rules that come into play, but generally, as your income exceeds certain thresholds, you lose the ability to deduct your contribution, and the money goes in on what we call an aftertax basis. There’s exceptions to that for people who don’t have an employer plan and that kind of thing, but generally that’s the rule.

On the Roth side, Roth contributions are only available for people with income up to a threshold. For married couples this year, $242,000 is the threshold where you start to lose the ability to contribute to a Roth. As your income gets much higher, you not only can’t do a Roth, you also can’t do a deductible IRA; you’re really kind of locked into one method, and that’s the nondeductible IRA.

There’s a band of income that’s a little lower than that where the Roth contribution makes sense. As you get to lower levels of income, you’ve got options. You can do the deductible traditional, or you can do the Roth. You’re able to do both. You’ve just got to decide which one makes more sense. That’s the IRA side.

The employer plan side? Much different, totally wide open. Anybody’s able to do a deductible or Roth as long as the plan offers it. It’s a much, much bigger decision on the employer plan side than on the IRA side, frankly.

Key Things to Consider When Deciding on Roth vs. Traditional IRA Contributions

Benz: OK. As you just said, Tim, investors are apt to have more discretion over the Roth versus traditional decision because their income doesn’t come into play. Can you discuss the key things?

Say I’m a 401(k) or other company retirement plan participant. What should I be thinking about when I’m confronted with that decision about whether I want my contributions to go in on a traditional tax-deferred basis or whether I want to make Roth contributions?

Steffen: Yeah. While on the IRA side, as you said before, your decisions are kind of locked in for you based on your income level with employer plans, 401(k), 403(b), you’ve got total flexibility as long as the plan allows a Roth option, which most of them do these days. It kind of comes down to this issue of what’s more important to you, having a tax deduction today or having tax-free income in the future.

The deduction today comes from putting money into the traditional account, and that would be: You’re putting money in, you get a deduction for it, but when it comes out later, it’s going to be fully taxable. Again, with the Roth, no deduction for the contribution today, but all the growth and everything that comes out of it in the future is going to be fully tax-free. That’s going to be your primary decision.

As we said earlier, there are other things to think about, RMD rules, beneficiary rules, et cetera, but that deduction today versus tax-free income in the future, that’s the big one.

Tax Rates and IRAs, Now and in the Future

Benz: People have likely heard that to make that decision, it depends on evaluating your tax rate today and trying to hop into the future machine and figure out what it will be in the future. If there are many years from retirement, that can be really hard to get your arms around what sort of tax rate you’ll be paying.

Do you have any guidance for people?

Steffen: Yeah, let’s be honest, we don’t know what the tax rates could be next year, or five years, or 10, 20, or 30 years. They can change at any time. What we try to tell people is, first of all, if you look historically, rates really don’t change that much. It’s not the laws that change. They do, but rates kind of stay within a band, deductions change, credits change, that all kind of work together to keep people at, as long as your income stays the same, kind of a consistent tax rate in many cases, or reasonably close.

What changes is your income level. Rather than focusing on what you think tax rates might be in the future, we tell people, “Focus on your income level.” If you’re at peak earning years right now and you know that at some point you’re going to retire and your income’s going to fall off, while we don’t know for certain, it’s very likely you’re going to be at a lower tax rate when that happens just because you have less income or the nature of your income has changed from wages to dividends and capital gains, which are taxed much differently.

Again, yes, generally you want to do a Roth contribution when your tax rate is lower and a traditional when it’s higher, but you don’t always know what the rates are going to be. Think about: Where am I at on an income basis? Am I at a low income level or a high income level, and what’s going to happen when it changes, and how might I change my saving strategy then?

When Is a Roth IRA the Better Choice?

Benz: Yeah, that’s helpful guidance. What do you think of the tax diversification argument that if you’ve been saving for retirement primarily with traditional tax-deferred contributions, accounts, and that’s the case for a lot of baby boomers or Gen Xers, it could make sense to prioritize Roth for these future contributions. Do you agree with that line of thinking?

Steffen: Kind of. Roth accounts have been around for about 30 years or so now. We’re coming up on the 30th anniversary of Roth accounts soon. Most people who are working have had the opportunity to do a Roth or a traditional. If you were somebody who’s only got their dollars in traditional accounts, I wouldn’t say, “Oh, you should start putting everything in Roth just so you’ve got Roth and traditional. You’ve got to split.” If it would’ve been more right to do the Roth years ago, but that ship has sailed, that doesn’t mean you should do it now. If you missed the opportunity to do it when it was right back then, don’t compound that by doing it now when maybe it’s not the right time.

Again, if you’re at your later working years, you’re in your 50s, approaching 60s maybe, and you’re nearing retirement, you’re probably at some of your highest earnings years. In those years, your traditional contribution may actually be a better option for you than the Roth. Unfortunately, that’s when people really start thinking about Roths, and they tend to throw Roth money in when they’re at those later working years.

Diversification is great. We want to have options when we get into retirement, but don’t create Roth accounts simply because you don’t have any, and therefore, you think you need them. Conversions may be another way to get there. That’s something you can do after retirement. Again, when income falls, you’ve got more flexibility on the tax side. From a contribution standpoint, don’t just say, “Well, I need Roth because I don’t have Roth.” You should do Roth because it makes sense from a tax and planning standpoint overall.

Benz: That makes sense. What are some instances when a person should favor the Roth contributions? I often think that it applies to maybe young people just starting out in their careers, who aren’t yet earning much, and they have lower incomes. What’s your take on that?

Steffen: Yeah, absolutely. I mean, the ideal Roth candidate is somebody who’s at a lower income level, lower tax rate—but again, we don’t always know what tax rates are going to be—lower income level than they might be later. People who are just starting in the workforce, or the early working years, high school kids with that summer job they get, they’re great candidates for Roth. Why is that? Because their tax rate is so low, the value of a deduction is not that valuable. You’re in a 10% or 12% rate, so that savings, that deductible contribution, isn’t saving you a lot. As income goes up, maybe there comes a point when you start to shift your savings away from Roth into the traditional side.

When Should You Opt for a Traditional IRA?

Benz: OK. You mentioned that situation, the older worker’s peak earnings years, that, even though they might want more Roth assets, actually taking advantage of the tax break and the year of contribution is often the better strategy. Are there any other situations that would point someone in the direction toward those traditional tax-deferred accounts and away from Roth?

Steffen: Again, it’s a function of tax rates and timing. There’s things you can do with IRAs. Perhaps you can always do conversions. So, if you really want Roth dollars, put it in the traditional IRA, get your deduction when you’re at a high rate. When you retire, and you’re in that, what we call the trough period, before RMDs start and your tax rate has fallen, then you do your conversions, then you get your money into the Roth when it costs you less to do so.

There comes a tipping point where a traditional IRA makes more sense than a Roth, or vice versa. There’s always legislative changes. We’ve seen things proposed that would say, cap the value of Roth accounts. That’s usually a very high number. Most people aren’t going to be concerned about that. If that was ever to come to fruition, then maybe we’d steer more money into traditional, so you avoid some of those things. Generally, it comes down to that tax rate issue.

Benz: OK, Tim, this is a perennially hot topic, and we are so glad you’re here to walk us through it today. Thank you so much for being here.

Steffen: Thanks, Christine.

Benz: I’m Christine Benz from Morningstar. Thanks for tuning in.

Watch How to Build the Bond Core of Your Portfolio for more from Christine Benz.