Should You Use Traditional or Roth Retirement Accounts?

This is a classic personal finance question. Should you contribute to a Traditional IRA or a Roth IRA? Utilize a traditional 401(k) or a Roth 401(k)?

Well, before answering the question, let’s start with a brief walkthrough of how each of these accounts work.

A “traditional” 401(k) or IRA is funded with pre-tax money.

For example, let’s say you earn $100 which you directly contribute to your IRA. You don’t pay income taxes on your contribution. Over the next 30 years that $100 grows by 4x to $400. In retirement, you withdraw that $400 but now owe income taxes on that amount. Let’s assume you have to pay 25% in taxes so you end up with $300.

A Roth 401(k) or IRA is funded with after-tax money.

In this example, you earn $100 and have to pay your 25% taxes before contributing to your Roth IRA. So you contribute $75 and over the next 30 years it grows by 4x to $300. In retirement, you can withdraw the full amount without having to pay any taxes.

In both scenarios you end up with $300 because the contributions are the same, the investment growth is the same, and the tax rates are the same over time. This makes sense because when you multiply a bunch of numbers together the order doesn’t matter.

The only difference between the two types of accounts is when you pay your taxes. If your tax rate doesn’t change between your working years and retirement, then it doesn’t matter which type of account you choose.

So, since the timing of when you choose to pay your taxes is the most important factor in this decision, the question you need to ask yourself is fairly simple:

Will your income tax rate be higher now while you’re working or later in retirement?

All else being equal, if you think your taxes will be higher right now, then contribute to a traditional account. If you think they’ll be lower, then contribute to a Roth.

The obvious problem with this question is no one has a clue what future tax rates will look like, especially if you’re still a few decades from retirement. The fact that we can’t predict the future makes this an impossible decision to make with exact certainty.

The majority of people favor traditional accounts over Roths. According to the IRS, at the end of 2017, there were twice as many traditional IRAs as Roth IRAs and they held nine times as much money. Typically, taxable income does decrease in retirement which lowers your tax rate. That expectation combined with the immediate tax benefit on contributions makes pre-tax accounts desirable and effective for a lot of people.

However, here’s where I’d like to give my pitch for why I tend to prefer Roth accounts, particularly if you still have some years left until retirement.

A few years ago, a Harvard Business Review article found that people who switched from a traditional 401(k) to a Roth 401(k) when their employer offered the option, saved at exactly the same rate. So, as opposed to the example I gave above where the initial Roth contribution was less because of taxes, in real life most people contribute the same amount to their 401(k) or IRA regardless of the taxes they’ll pay that year. Roth accounts provide an awesome behavioral hack in that those who contribute to them actually save more.

If you could choose today to be gifted $100,000 in a traditional IRA or $100,000 in a Roth IRA, which would you choose? You would pick the Roth because it’s worth more due to the fact no taxes are due on that money. Why not give your future self that same gift?

Also, if you have a long time horizon, hopefully, the growth in your account will be significantly larger than your contributions. I would prefer to pay taxes, even if it’s at a decently high rate, on small contributions rather than on the total ending balance after decades of compounded growth.

Here’s the thing, it doesn’t have to be all or nothing. You can, and probably should, take advantage of both types of accounts.

You can use a Roth early in your career when income is generally the lowest and you have the longest time to compound and then switch to more pre-tax savings when your earnings are at their highest and you’re closest to retirement. Or you can take advantage of your company’s traditional 401(k) and contribute to your own Roth IRA as well.

Sometimes I feel like we can get lost in the minutia on questions like this. I do think it’s a worthwhile discussion and does make a difference, but over the course of your life, the tax benefits of these accounts are found on the margins.

Consistently saving into an IRA or 401(k) is far more important than which account you choose.

Thanks for reading!