Explainer: Roth Vs. Traditional
Your retirement savings account gets special tax treatment.
Regular (non-qualified) investment accounts are taxed according to the tax rules that exist for dividends and interest as well as capital gains. Those accounts generate tax forms you’ll get at the end of the year like 1099-DIV, 1099-INT, and 1099-B.
Traditional Retirement Accounts
A retirement account like a traditional 401(k), 403(b), 457, IRA, or annuity enjoys special tax-deferred treatment. You don’t have to count contributions to these accounts as income for the year you contribute, which reduces your taxable income for that year.
The money also gets to grow tax-deferred. Which means you don’t pay any taxes on interest, dividends, or capital gains realized inside the account.
Once you take money out of a traditional you are taxed on those distributions as ordinary income. Any distribution from the account will increase your taxable income for the year.
Roth Retirement Accounts
Roth accounts are different. Instead of reducing your taxable income in the year you contribute to these accounts, you still have to count the income in the year you contribute. Roth contributions do not lower your taxable income for the year you contribute.
Roth accounts grow tax-deferred just like traditional accounts do. There are no taxes on interest, dividends, or realized capital gains in these accounts.
When you take distributions from a Roth account there is no reporting to the IRS. The money has already been taxed and won’t be taxed again (unless you’re taking an early withdrawal).
Why People (and Tax Preparers) Prefer Traditional
The tax break you can get in the current year for saving into a traditional retirement account is very appealing. It can reduce taxes in the current year, sometimes by a lot. Sometimes using a traditional account can drop your marginal tax rate.
It’s very tempting to kick the tax burden down the road each year.
Sometimes, especially when you’re earning a lot, the tax-deduction now seems like it will be more beneficial than it will be later (in retirement) when your income will most likely be lower.
This is true and it might be true for you too. But what about when retirement comes?
Retirement Tax Time-Bomb
Eventually, you’ll start taking money out of your retirement accounts. Either you’ll use the money to supplement your income in retirement, you’ll fund big purchases, or you’ll give charitably out of it. Maybe you’ll postpone taking any money out of the account until Uncle Sam forces you to take Required Minimum Distributions and you’ll give the leftovers to your heirs.
Eventually, that money is going to get taxed (unless you deplete the entire account through Qualified Charitable Distributions).
Big traditional accounts have big RMDs. Big distributions mean more taxable income and bigger taxes.
All of those years of avoiding taxes during your working years could be offset by paying excess taxes during your retirement years if you’re not careful. A big traditional retirement account is better than nothing at all, but I’ve seen distributions cause unnecessary tax increases, Medicare surcharges, social security reductions, etc.
Where A Roth Is Beneficial
Having a Roth can help mitigate the tax impacts of a large traditional account by being the place where you paid taxes on purpose on some money already so that you don’t have to have a plan when you want to take it out.
By strategically funding a Roth account and controlling marginal tax rates you can ensure that you’re paying as little in lifetime taxes as possible.
This adds the flexibility to be able to take large distributions from the Roth for things like vacations, home improvement projects, cars, and more without having to worry about the tax consequence in retirement years.
Leaving A Roth to your heirs is the best
If you want to leave a large blessing to your kids and grandkids when you pass away, a Roth is a great gift.
Since you’ve already paid the taxes on the money, they won’t have to worry about it.
I’ve helped many folks who inherit traditional retirement accounts from their parents and grandparents, and while it too is a blessing, the tax consequences are annoying.
Usually inheritors are working and any distribution from a traditional inherited retirement account is taxed to them as ordinary income on top of what they’re already earning. It’s not that way with a Roth.
How To Defuse the Bomb
With some good planning you can take advantage of that large traditional retirement account you’ve built. You are allowed to convert traditional accounts to Roth accounts, but it’s fraught with other tax landmines.
My favorite way to navigate this is to use the early retirement years combined with charitable giving strategies to lower taxable income to allow for the largest Roth conversions possible.
This type of planning is what excites me most. We can simultaneously reduce taxes, increase giving, leave a legacy, and enjoy retirement all at the same time! It just takes some work and thorough planning.