These are the biggest considerations when guiding a client between a Roth vs. Traditional retirement account
A question we often get asked from clients - should I be contributing to a Roth or Traditional retirement account? Like many conversations around personal finance, the answer tends to be “it depends.” The reason being is two fold. For one, every client's situation is different and the impact from a Roth vs. a Traditional 401(k) or IRA can vary based on the client's financial goals and unique personal situation. Secondly, when comparing the two strategies, there are many future variables that we can forecast, but we lack certainty on. Because of this, we can only give an estimate at best for which strategy leaves you coming out “ahead” at the end of the day.
What I find most important in these cases is to factor in what we can control. Even though future variables are a moving target, there are factors today we know for sure and can account for. We then do our best to balance the science of forecasting with the art of financial planning to determine the best approach for a client's personal & family situation. I’ll share below the framework that leads our discussions as clients try and make the decision that’s best for them.
Clients Age
Age is a big factor when determining the benefits of a Roth vs. traditional retirement contributions. Whether you are deciding on a contribution, or maybe even a Roth conversion, your age and time frame before needing to take distributions has a big impact as to which strategy will benefit you the most. Any time you contribute to a Roth, there is a “cost.” That cost is in the form of giving up any tax deduction you would get from a traditional IRA or 401(k) contribution, or the taxes incurred from a Roth conversion. We help clients map out the long-term impact of both. And as you can imagine, the younger you are, the longer you have for the Roth to grow and recoup, and further exceed, any of the upfront “costs.”
Tax Bracket
Understanding the client's current, and estimating their future tax brackets is how we can bring the science of planning into the conversation. This is one of the more accurate variables we can account for today, although the future is still a bit uncertain. For today, the lower an individual or family's tax bracket, the more enticing it is to make Roth contributions. If a client is in a higher tax bracket, it doesn’t mean a Roth isn’t a viable strategy. It does mean that there is a higher hurdle rate to clear the tax cost, and a deeper analysis is needed.
One strategy I often hear when it comes to tax brackets is that if you expect your tax bracket to be lower in retirement, then you should contribute to a traditional retirement account to get the tax break now. This analysis is a bit too simplified. It doesn’t take into account the length of time you have to grow the investment accounts. Just because you expect to be in a lower bracket in retirement, doesn’t necessarily mean you shouldn't still take advantage of a Roth. It’s also helpful to do a full blown planning analysis to understand if you truly will be in a lower tax bracket. Oftentimes clients can be surprised with how high their income ends up in retirement due to distribution needs, as well as RMD’s from a growing IRA.
Lastly when it comes to the tax bracket analysis, where we get the most in-depth with clients is working on Roth conversions. Having the software and expertise to do complex tax planning helps us come up with strategies for current year or on-going Roth conversion strategies while keeping clients within a particular tax bracket. This helps with the science of planning to forecast the lifetime tax savings impact of this type of strategy.
Flexibility
The 3rd piece of the framework has to do with flexibility. I always encourage retirement savings because of the current & future benefits it affords. Sometimes clients get really caught up in maximizing every last penny into some form of retirement savings. While this is good on the surface, it may take away from other opportunities. Doing everything you can to put money into a 401(k) plan is great, but if you have spending needs or looking for other opportunities to deploy capital prior to retirement, a taxable brokerage account works very well for investing. Having liquidity without paying the penalties IRA’s require is a huge benefit if you think you may need access to those funds. Having all of your money in an IRA or 401(k)’s can limit some of your options until you reach 59 ½ (with some exceptions for 401(k) plans or if you take advantage of the 72(t) rules).
If you are choosing between a Roth IRA vs. a Traditional IRA, typically if you still qualify for the Roth I would choose the Roth IRA. It means you are in a more favorable tax bracket, and it also gives you added flexibility. With a Roth, as long as it's opened for five years you can actually access the funds you put into the account without penalty. If however you take any gains, you may face additional penalties. Anytime you have liquidity and flexibility in your own personal financial situation it’s a huge advantage and something I advocate for with clients all the time.
Estate Planning
Recent legislative changes have impacted how we work with clients on their estate planning goals, and the potential for even further changes in the near future. It’s also brought some Roth contribution & conversion strategies to the forefront that weren’t considered in years past. Very rarely in years past would I encourage a retired or soon to be retired client to start considering Roth conversion strategies or Roth contributions. It didn’t make sense, mostly because of their age and years to recoup the cost of the taxes paid on the Roth conversion.
Today, there are other elements to consider. Non-spousal IRA beneficiaries are worse off now than ever before with inherited IRA rules. This means more money you helped save for and build to leave a lasting legacy will go to Uncle Sam. Roth IRA conversions help alleviate this. Also, with RMD dates being pushed back, there is more time for IRA’s to grow and be subject to higher taxes once they are required to be distributed. Looking at a well thought out conversion strategy can help increase your savings and minimize taxes for you and your family. This is an area of planning we help clients with often.
Further Considerations
The above framework is typically how I have these conversations with clients to determine their best strategy. There are many more nuances and considerations we discuss, but these are the major points in my mind when choosing between your retirement savings options. For certain situations, there are other considerations. I’ll touch upon them here, but they probably all deserve a longer write-up and explanation
High Earning W-2 Employee
If you’re a high earning W-2 employee, you may have other considerations and options to consider that go above and beyond just Roth vs. Traditional. Maybe your work offers a high deductible health insurance policy and you have the ability to contribute to an HSA. If so, this is one of the BEST places to contribute for the long-term if they offer investment options. HSA gives you triple-tax savings and is absolutely worth exploring.
The other offering within a 401(k) plan would be if you have the opportunity for after-tax contributions. If so, this could give you the chance for a “mega-roth” contribution. For those looking to maximize retirement savings, this is an amazing opportunity, while it lasts. I say that since congress has been trying to remove this loophole over the past few years, yet still haven’t gotten around to passing any legislation quite yet. So for now, I’d say its still a consideration to make.
Business Owner
Business owners have even more options to consider. Whether you're a sole proprietor, have employees or maybe work with your spouse, there are many options to pursue. Are you set up as an LLC or S-corp could affect your savings options. You’ll be able to choose from SEP IRA plans, 401(k)’s, and if you really want to maximize your savings, a Defined Benefit plan could be in play for you.
Recently Retired
This is where deciding whether or not a Roth conversion could be right for you comes into play with many of our clients. We analyze the type of tax bracket they are in, figure out any bigger impacts when it’s time to take RMD’s (potential increase in taxable income) and see if a Roth conversion makes sense from an estate planning perspective. Leveraging good tax planning software can help keep clients in particular tax brackets so we know the “cost” of each dollar of conversion and to best calculate what the potential long-term benefit may be. It’s a great way to maximize what you KEEP!
Conclusion
So if you find yourself trying to make a decision about your retirement savings for you or a family member, try this framework to help guide you. These are the considerations at the forefront of many of my conversations. In most cases, there aren’t necessarily bad or wrong choices to be made since everyone's situation is unique.If you feel you're having trouble making the right choice for you, or if you’d like some guidance along the way, we’re here to help.