Is your first instinct to spend a bonus, tax refund, or other windfall on an expensive vacation or the latest smartphone, or do you put it right into savings? The answer to that question may help you make another important decision: where to save for your future—aka retirement.
If you work for a large employer, you may be able choose to contribute to either a traditional or Roth 401(k) or 403(b). If you are self-employed or if a 401(k) isn’t offered where you work, the choice might be a traditional or Roth IRA.
While a 401(k), 403(b), and IRA are different types of accounts, the basic principles of a traditional or Roth type apply to the different accounts. So, how should you choose between a traditional or Roth account?
“There are two things to keep in mind when choosing between a traditional and a Roth retirement account,” say Matt Kenigsberg, vice president of financial solutions at Fidelity. “Tax rates and how you manage your money.”
Let’s dive into each.
Tax rates: higher now or later?
One key difference between a traditional and Roth account relates to tax rates. With a traditional account, your contributions are pretax—they generally reduce your taxable income and, in turn, lower your tax bill in the year you make them. But your money doesn’t avoid taxes entirely; you’ll pay income taxes on any money you withdraw from your traditional 401(k) in retirement. A Roth account is exactly the opposite. Contributions are made after tax, with money that has already been taxed, and you generally don’t have to pay taxes when you withdraw from your account.1
So essentially, you need to choose between taking a tax deduction today or taking it in retirement. The key is to get the tax deduction when you think your tax rates are going to be the highest. In general:
- If you think your tax rate will be significantly higher when you retire than it is now, a Roth account may make sense, because qualified withdrawals are tax free.
- If you think your tax rate will be significantly lower in retirement than it is now, a traditional account may be more appropriate, because you will pay a lower tax on your withdrawals.
While some people may have good reason to think that their tax rates will be a lot higher or lower in retirement than they are now, for many it is pretty much a guess. A lot can change, including tax rates, where you live, and your income, for instance. That’s where the way you manage money comes in.
Spender or saver?
Do you live paycheck to paycheck or make saving some of it a priority? Your answers can help you choose which type of account may make sense for you.
Traditional 401(k) and IRA contributions leave money in your pocket because they, generally, lower your current taxable income. But these tax savings can help you reach your retirement goal only if you invest them. If you get a tax refund and spend it, it’s not going to help you when you retire.
On the other hand, a similar contribution amount to a Roth account reduces the amount of money left in your pocket, because you pay taxes on your contributions up front. But, if you’re like the many people who tend to spend what they take home, taking home less might be a good thing when it comes to your retirement savings. You’ve already paid your taxes, so you get to take your money out tax free,1 which could leave you more to spend in retirement.
“In a sense,” says Kenigsberg, “a Roth account can force you to save more for later by leaving less in your pocket now.”
Meet three hypothetical investors—Sara, Brian, and Sam. Each is 45, married, and would like to retire at age 65. But, when it comes to money, they are very different.
Sara is frugal and a relentless saver and investor. She tracks every penny, and if she has some money left over at the end of the month, she invests it. Same goes for any windfalls. She contributes to a traditional 401(k) every paycheck, and she always invests her tax refund into a taxable brokerage account.
Brian spends his money. When he gets a tax refund or has money left over from his paycheck, he doesn’t save it. Instead, he goes out to dinner, buys things, and takes weekend trips and vacations. He also contributes to a traditional 401(k).
Sam has a lot in common with Brian. He’ll spend his money if it is available on his debit card, but he contributes to a Roth 401(k) at work. He likes the idea of not having to pay taxes on the money when he begins to use it in retirement.
Time to run some numbers
Each contributes $5,000 to a 401(k) at age 45 and plans to keep it in the account until age 75, or about 10 years after he or she retires. That’s a 30-year time horizon, and we’ll assume they’ll earn a 7% annual return over that time. Brian and Sara both receive a $1,400 tax refund, because they made traditional 401(k) contributions and are in the 28% tax bracket. Sam doesn’t receive a refund, because his Roth 401(k) contribution doesn’t reduce his taxable income. (Note that the $1,400 could also take the form of extra take-home pay, or some combination of extra take-home pay and a tax refund, depending on withholdings and other assumptions.)
How much would they each have after 30 years, after paying taxes, based on the type of 401(k) account they chose, and whether they saved or spent their tax refund? Take a look:
As you can see, Brian has the lowest balance after 30 years, because he chose the pretax 401(k) and spent his entire tax refund. His account grows to $38,061, just like Sam’s Roth 401(k), but he then has to pay more than $10,657 (or 28%) in taxes when he withdraws the money in retirement, so he ends up with $27,404, or $10,657 less than Sam.
Sara ends up with more than Brian. After paying taxes in retirement, she ends up with the same $27,404 from her 401(k) that Brian does, but she comes out ahead because she invests her $1,400 tax refund in a brokerage account earning 6% after taxes. Sara will have $8,041 in her taxable account after 30 years, so she’ll have a total of $35,445.
Sam ends up with the most. His Roth 401(k) grows to $38,061, like Brian's, but he doesn’t have to pay any tax when he withdraws the money. The Roth 401(k) gives Sam two advantages that account for the difference: First, the Roth captured all Sam's tax savings—safe from his temptation to spend it before retirement—and second, all his savings were able to grow tax free in the retirement account. Hence, he achieves a higher after-tax rate of return than Sara in this hypothetical example. Of course, Sam, and Sara too, will have less to spend before retirement than Brian, but Sam will end up ahead of both in retirement.
Our example shows how a Roth 401(k) might actually be an easier way to reach your savings goals, because for those who are tempted to spend—like Brian—it removes temptation. And even for those who are not tempted to spend—like Sara—it can lead to higher after-tax returns. “Given that most people tend to spend what they have,” says Kenigsberg, “perhaps having less in your pocket now leads to more later.”
Our example is a good starting point for thinking about traditional vs. Roth accounts, but there is more to the story. It doesn’t take into account possible changes in Sara, Brian, and Sam’s future tax rates. If any one of them winds up with tax rates in retirement that are much lower than they are now, that would tilt the scales in favor of a traditional 401(k). (For middle-aged and older investors with incomes at or near the lifetime peak, that is often the case.) Conversely, if they end up with tax rates that are much higher than today, that would favor a Roth 401(k). (This is fairly common among younger investors, particularly if they expect to see their incomes grow rapidly over the coming decades.)
Those who have the time and interest may want to “gross up.” Grossing up is finding the amount of a traditional contribution that would leave you in the same position as a Roth contribution. In simple scenarios, this can be done by dividing the Roth contribution by one minus the marginal tax rate, although it can be more complicated than that. For example, if Sara had contributed $6,944 ($5,000 divided by 1 – 0.28) to her traditional 401(k), and spent the $1,944 in tax savings that would have resulted, she would have wound up in the same position as Sam both before and after retirement. But that’s a big if: Sara's 401(k) plan may not let her adjust her contribution level so precisely, and if she were contributing to an IRA vs. a 401(k), the contribution limits would not allow a contribution of more than $5,500. That’s why grossing up may be tricky for most savers.
What about both?
It may be appropriate to contribute to both a traditional and a Roth account if you can. That can give you taxable and tax-free withdrawal options when it comes time to take withdrawals in retirement.
Financial planners call a strategy of using both types of contributions tax diversification. It can make sense for those who aren’t sure about their future tax picture. Plus, it gives you the ability to manage your tax brackets in retirement.
It’s important to note that if you get an employee match or profit sharing contribution from your employer, those contributions are typically to a traditional 401(k)—even if you are making only Roth contributions. So you may already be contributing to both types of accounts. Check with your employer to be sure.
So the message is this: It’s important to know the numbers and think about your current and future tax rates when planning for retirement. It’s important to know yourself and the way you handle money, too.
Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917