Roth vs. Traditional Retirement Accounts: Why Roths are Not Always the Clear Winner

Amongst Gen X and Gen Y, there now seems to be an overwhelming belief that Roths are the better alternative when compared to Traditional retirement accounts.

When I talk to the fine folks I work with and on this blog about why they choose a Roth 401K or Roth IRA versus their Traditional counterparts, the response is something like this:

Roths allow earnings to accrue tax free, I’ll comparatively save more money for retirement, and I won’t pay taxes on withdrawals in retirement.

Each of those assertions is true – and I think that is why Roths have rapidly risen in popularity and usage percentage. But, one thing those facts typically overlook is a very important individual variable: your actual income and tax bracket now vs. your expected income and tax bracket in retirement.

Roth vs Traditional account

Why Tax Brackets are Key in the Roth vs. Traditional Retirement Account Debate

Remember that Roth 401K and Roth IRA contributions are post tax – meaning that your contributions are taxed in the year that you make them (vs. tax free until withdrawal for Traditional 401K and IRA contributions).

My guess is that most readers of this blog max out in either the 25% or 28% tax bracket (22% and 24% post tax-reform). As the U.S. tax brackets are progressively laddered, you pay the tax rate on income that falls into that bracket. The result is that many of us are paying an effective tax rate on Roth 401K or Roth IRA contributions of 24% on the portion of our income over the 24% ladder. At the lowest, many of us would be paying 22% on those contributions.

I don’t know what you expect your tax rate to be in retirement, but that’s a pretty high rate the IRS is locking in. And in order for the Roth to be a better alternative, you have to be fairly optimistic that you’ll fall in to higher tax brackets in retirement.

That probably will not be the case for most. Consider that:

  1. Pensions are somewhere between critically endangered to extinct, so very few of us will ever receive a dollar of pension payouts to boost our retirement income.
  2. Social Security is meant to be a supplement, not a primary source of income, and its future ability to pay out in full has been threatened.
  3. 75% of those nearing retirement (age 50-64), have less than $30,000 in their retirement accounts to begin with. $30,000 or less isn’t exactly going to be pushing anyone into higher tax brackets.
  4. The retirement deficit between what Americans have actually saved for retirement and what they should have saved for retirement is already $7.1 trillion. That’s $7.1 trillion of future income that isn’t there to be taxed.
  5. The trend of tax rates has been downward. When looked at historically, tax rates are near the lowest they’ve been since 1931. It seems unlikely that tax rates would go significantly higher from here given the political climate.

Opting for a Roth goes in the face of all of that.

A Reality Check

In order to make more income in retirement than you are making today (to push you in to higher tax brackets), think of what has to happen:

  • You have to consistently save at high enough percentages to be able to fully replace your income, and then some, which requires you to save at significant levels right from the beginning and for many years.
  • You’ll have to significantly outpace inflation on your earnings, achieving something close to historical market returns.
  • You’ll have to not withdraw funds early.
  • You’ll have to stay 100% invested most of the way to reap those returns.

In light of all of that, when you consider that the tax paid now for Roth contributions is a guaranteed rate (for most of us at 22% or 24%) vs. uncertain future tax rates, it should really make you question whether Roths are the smarter option for you.

As Roth 401Ks and IRAs were approved and joined the retirement account party after their Traditional relatives, perhaps the IRS crunched the #’s and realized that they’d be making more tax revenue off of the population, as a whole, with Roths. If the IRS is good at anything, it’s crunching numbers. Why else would they give us the option to avoid paying future taxes?

I’m not saying that Roths don’t make a lot of sense for a lot of people. I personally maintain a Roth IRA and for those who consistently save at very high levels for retirement and invest it wisely, Roths can be a tax-safe haven in retirement. Additionally, if your income is above the Roth IRA and Traditional IRA income limits, a Backdoor Roth IRA could be a wise move (if you follow proper precautions).

There’s no reason you can’t do both, either.

However, before you go all in with Roths vs Traditional retirement accounts, you should give your present and future income, tax rates, and goals some serious thought.

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