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To "Roth" Or Not

December 1, 2011

"It Depends.”  My clients hate it when I say that in response to their question about whether or not to contribute to a Roth IRA or Roth 401(k).  While the Roth is a great tool, it is not a clear cut strategy suitable for everyone.  A number of factors must be evaluated to determine the best choice for each person. 

 

The Basics.  Whether you are talking about an IRA or 401(k), the “Roth” portion denotes that you are able to make contributions to the account on an after-tax basis and later down the road withdraw the funds (contributions and earnings) tax-free.  Tax-free sounds like a good thing!  But, remember, contributions to Traditional IRA and 401(k) accounts instead are made on a “pre-tax” basis, meaning you can deduct the contributions on your tax return and lower taxes now.  Of course, you will have to pay taxes later on the withdrawals, but today you are happy because you are spending less on taxes.

 

Tax Benefits.  One misconception is that one of the options must be clearly better than the other.  Again, that depends.  The math says that if you are in the same marginal income tax bracket when you make the contributions as when you take the withdrawals, there is no economic difference between the Roth and Traditional.  You are merely making a decision about the timing of when you pay your taxes.

 

The Roth option yields a higher economic benefit, if you will be in a higher marginal income tax bracket when you withdraw the funds than you are now when you contribute the funds.  Vice versa, Traditional accounts will yield a higher economic benefit, if your marginal income tax bracket is higher now when making contributions than in the future when you make withdrawals.

 

Considerations.  It stands to reason, the first issue that must be addressed is to compare your current marginal income tax bracket with your estimated marginal income tax bracket during retirement.  If you are just starting your career, it is possible you may be in a higher tax bracket when you retire because your salary and standard of living increase over the years.  So, a Roth option may make sense for you.  However, most likely your cash flow is tight and tax savings would be helpful now, not later.  

 

If you are in the peak of your career, most likely you will be in a lower tax bracket when you retire because you are probably earning and spending as much as you ever will in your life.  As a result, you will not need as much income during retirement to pay for your expenditures that typically go away such as a mortgage, children related expenses, payroll taxes, and saving for retirement.  So, the Roth option may not be the best choice for you right now.  However, you may have more cash flow power now and want to trade the tax benefits now for peace of mind knowing you will have tax-free income later.      

 

Sometimes, it is important to think about the incidental benefits of Roth accounts.  For instance, having the option to draw from tax-free investments during retirement can help with optimizing your overall tax situation.  And, unlike the Traditional IRA, Roth IRAs are not subject to the required minimum distribution rules at 70 1/2 years of age.  Another consideration is if you plan to pass along assets to your heirs.  In this case, subsequent future withdrawals from the Roth IRA by them will be income tax-free, unlike the Traditional IRA.  

 

This article has only begun to scratch the possibilities and as you can see “to Roth or not” can be complex.  We can help. Contact our office at 515-284-1011 to learn more about whether the Roth IRA or Roth 401(k) make sense for you.

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