The debate continues: what’s preferable, traditional retirement accounts or Roth retirement accounts?
Fortunately, there are plenty of shades of gray in this debate. There’s no “right” answer, but I do believe that there are good insights that can help individuals make the right planning decisions for themselves.
Traditional and Roth Retirement Basics
Before we dive into the traditional versus Roth debate, we should quickly survey the basics of these types of retirement accounts.
Traditional
Traditional retirement accounts feature a tax deduction on the way in (i.e., for contributions) and ordinary income tax on the way out (i.e., for withdrawals). At work these are known as traditional 401(k)s, 403(b), 457s, and occasionally have other names. At home these are known as traditional IRAs.
Additional twist: many working Americans do not qualify to deduct a traditional IRA contribution due to relatively low income limits on claiming a deduction.
Part of the appeal of traditional retirement accounts includes: (i) the notion that many will have lower taxable income (and thus lower income tax) in retirement than they did during their working years and (ii) the tax saved by contributing to traditional accounts can be invested, potentially creating more wealth for retirement.
Roth
Roth retirement accounts feature no tax deduction on the way in (i.e., for contributions) and tax free treatment on the way out (i.e., for withdrawals). At work these are known as Roth 401(k)s, 403(b), 457s, and (after SECURE 2.0 implementation) will occasionally have other names. At home these are known as Roth IRAs.
Additional twist: some working Americans do not qualify to make an annual Roth IRA contribution based on income limits, but many can get around this rule by implementing a Backdoor Roth IRA.
Part of the appeal of contributions to Roth retirement accounts is the notion that it is better for our younger, healthier selves to pay the tax associated with retirement savings when cash flow is good and the investor knows they can bear the cost.
The basics out of the way, we can get into 2023 insights on the debate between the two types of retirement accounts.
The Risk of Traditional Retirement Accounts is Vastly Overstated
We hear it time and again: be worried about all the tax lurking inside traditional retirement accounts such as 401(k)s and IRAs!
Here’s the thing: rarely do commentators offer any sort of mathematical analysis backing up that contention. I ran the math, and I repeatedly find that many retirees with traditional retirement accounts are likely to pay Uncle Sam a very manageable amount of income taxes in retirement.
You be the judge and jury. I believe a fair assessment of my posts and videos and the numbers behind them shows that most Americans do not face a high risk of crippling federal income taxes in retirement, even if the vast majority of their portfolio is in traditional 401(k)s and IRAs.
While I cannot give readers of this blog individualized advice, I can say that if one considers themselves to be an “Average Joe” it is difficult to see how having significant amounts in traditional retirement accounts is a problem.
The Needle Keeps Moving Towards Traditional
Picture it: United States, September 2017, six short years ago. You’re bright-eyed, bushy-tailed, and fear only one thing: incredibly high taxes on your traditional 401(k) and IRA in retirement.
Then a few things happened.
- December 2017: TCJA increased the standard deduction and lowered the 15% bracket to 12%
- December 2019: The SECURE Act (SECURE 1.0) delayed RMDs from age 70 ½ to 72
- March 2020: CARES Act cancels 2020 RMDs and allows taken RMDs to be rolled back in
- November 2020: IRS and Treasury issue a new Uniform Life Table, decreasing the amount of annual RMDs beginning in 2022
- December 2022: SECURE 2.0 delays RMDs from age 72 to 73, and all the way to age 75 for those born in 1960 and later
Tax cut after tax cut for traditional retirement accounts and retirees! In the traditional versus Roth debate, DC keeps putting a thumb on the scale for traditional.
Taxable Roth Conversions Going Away?
One reason I like traditional 401(k) contributions is that they do not close the door on Roths. Rather, traditional retirement account contributions at work are a springboard for years of Roth conversions in retirement for many in the FI community!
The idea is to take deductions at high marginal tax rates at work into a 401(k) and build up wealth for an early retirement. Then, in retirement, one’s tax rate is artificially low as they no longer have W-2 income to report. This opens up room for potentially very efficient Roth conversions (affirmatively moving money in traditional accounts to Roth accounts) taxed at the 10% or 12% federal income tax rate.
That’s a great plan, in theory. But couldn’t Congress take it away? Sure, they could, but I seriously doubt they will in an effective way. First, let’s look at recent history. In 2021 the Democratic Congress proposed, but did not pass, a provision to eliminate (starting a decade in the future) taxable Roth conversions for those north of $400K of annual income. Such a rule would have had no effect on most retirees, who will never have anything approaching $400K of income in retirement.
Second, why would Congress eliminate most taxable Roth conversions? They “budget” tax bills in a 10 year window. Taxable Roth conversions create tax revenue inside that budget window, making it that much less likely a Congress would eliminate most of them.
While there is not zero risk taxable Roth conversions will go away, I believe that the risk is negligible. The greater one believes Roth conversion repeal risk is, the more attractive Roth contributions during one’s working years look.
Special Years Favor Roths
I’ve written before about how workers in the early years of their careers may want to consider Roth 401(k) contributions prior to their income significantly increasing. Those in transition years, such as those starting a job after graduating college and those about to take a mini retirement may want to prioritize Roth 401(k) contributions over traditional 401(k) contributions.
Optimize for Known Trade-Offs
People want to know: what’s the optimal income for switching from traditional to Roth? What’s the optimal percentage to have each of traditional, Roth, and taxable accounts?
Here’s the thing: there are simply too many unknown future variables to come up with any precision in this regard. That said, I don’t believe we have to.
Why? Because in retirement planning, we can optimize for known trade-offs. Let me explain. At work, Americans under age 50 can contribute up to $22,500 (2023 number) to a 401(k). At most employers, that can be any combination of traditional or Roth contributions. Every dollar contributed to a Roth 401(k) is a dollar that cannot be contributed to a traditional deductible 401(k). That’s a known trade-off.
What about at home? For most working Americans covered by a 401(k), a dollar contributed to a Roth IRA is not a dollar that could have been contributed to a deductible traditional IRA. So a Roth IRA contribution is not subject to the trade-off downside that a Roth 401(k) contribution is.
Why not optimize for known trade-offs? Contribute to a traditional 401(k) at work and a Roth IRA (or Backdoor Roth IRA) at home. This approach optimizes for the known trade-offs and sets one up with both traditional and Roth assets heading into retirement.
Further, Roth IRA contributions and Backdoor Roth IRAs can serve as emergency funds, while traditional IRAs, traditional 401(k)s, and Roth 401(k)s do not serve well as emergency funds. Roth IRA contributions do not suffer from an adverse trade-off when it comes to emergency withdrawals, unlike Roth 401(k) contributions.
Roth Contributions End the Planning
Traditional retirement account contributions set up great optionality. A retiree may have years or decades of opportunity to strategically convert traditional accounts to Roth accounts. Or, a retiree might say, “thanks, but no thanks, on those Roth conversions, I’ll simply wait to withdraw for RMDs or living expenses later in retirement at a low tax rate.” Traditional retirement account contributions open the doors to several planning options.
Roth contributions end the planning. That’s it, the money is inside a Roth account. Considering the potential to have low tax years after the end of one’s working years, is that always a good thing?
Rothification Risks
Having all one’s retirement eggs in the Roth basket can create significant problems. This is an issue I do not believe receives sufficient attention. Previously I posited an example where an early retiree had almost all his wealth in Roth accounts (what I refer to as the Rothification Trap).
Risks of having all of one’s eggs inside the Roth basket going into retirement include:
- Missing out on standard deductions
- Inability to qualify for ACA premium tax credits
- Missing out on benefits of qualified charitable distributions (QCDs)
- Missing out on tax efficient Roth conversions in retirement
Sufficiency
Much of the traditional versus Roth debate misses the forest for the trees. Rarely do commentators state that long before one worries about taxation in retirement they have to worry about sufficiency in retirement!
Recent reports indicate that many if not most Americans struggle to afford a comfortable retirement. A quick review of average retirement account balances indicates that many Americans are not set up for what I’d call a comfortable retirement. Further, according to a recent report, the median American adult has a wealth around $108,000. That means the median adult has a significant sufficiency concern when it comes to retirement planning.
Most Americans will be lucky to have a tax problem in retirement! Most Americans need to build up retirement savings. The quickest, easiest way to do that is by making deductible traditional 401(k) contributions. That deduction makes the upfront sacrifice involved in retirement saving easier to stomach. Further, if one is not likely to have substantial retirement savings, they are not likely to be in a high marginal tax bracket in retirement.
If all the above is true, what is the problem with having taxable retirement accounts? The tax savings in retirement from having Roth accounts is not likely to be very high for many Americans.
Conclusion
Both traditional retirement accounts and Roth retirement accounts have significant benefits. When viewed over the spectrum of most Americans’ lifetimes, I believe that workplace retirement plan contributions should be biased toward traditional retirement accounts. For many Americans, either or both of the following will be true. First, there will be low tax years in retirement during which retirees can take advantage of low tax Roth conversions. Second, many Americans will be in a low tax bracket when taking retirement account withdrawals for living expenses and/or RMDs.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
Follow me on Twitter at @SeanMoneyandTax
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, investment, and tax matters. Please also refer to the Disclaimer & Warning section found here.