June 10, 2021
I recently read that less than 15% of people who have a workplace retirement plan with a Roth option do their saving in the Roth, rather than a traditional account.
If you are not saving for retirement in a Roth, I think there’s a good chance you are making a mistake. And if your reason is because your employer doesn’t offer a Roth option, I want you to double check. Over the past few years many retirement plans have added the Roth option. If you were told no a few years ago, I wouldn’t be surprised if they now give you the choice of whether to save in a Roth or a traditional account.
Okay, now here’s my pitch for why I want you to consider saving in a Roth account.
The big difference between a traditional account and a Roth account is when you pay the IRS tax.
With a traditional IRA, you contribute money that hasn’t been taxed yet (it is pulled from your pay before calculating the tax). With a Roth IRA you pay the tax right when you make a contribution, so the money you contribute has already been taxed (it is pulled from your paycheck after your tax withholding has been calculated).
I want to make sure you understand that everyone owes tax on their retirement savings. The question is when you pay the tax.
Here’s why I am a big believer in paying the tax now by saving in a Roth account-- because you pay the tax upfront, you will never owe any tax on that money in the future. In retirement, you can withdraw money and owe no tax.
Now let’s talk about what happens to money in a traditional account. Because you didn’t pay the tax when you contributed money to your account, you will owe tax in retirement. Every dollar you withdraw will be taxed at your ordinary income tax rate. And even if you don’t need to withdraw money from a traditional 401(k) or IRA, you must make annual withdrawals—known as required minimum distributions (RMDs)— once you turn 72. Simply because the government wants to collect some tax!
Unless you are sure your income tax rate will indeed be much lower in retirement, I think saving in a Roth is smart. And right now, it’s important to consider that federal tax rates are near historic lows. There’s no way to know what tax rates will be in 5 years, let alone 10 or 20, but given today’s low rates, it’s not out of the question that rates could move higher in the future.
That is not a prediction. Just something to consider.
For those of you who have been saving in a traditional 401(k) for years (or decades) I recommend you consider doing your future savings in a Roth if it is available. Contact your plan and tell them you want your new contributions to go into the Roth option. That way come retirement you will have a mix of taxable and tax-free savings. I think you will be so glad about the flexibility that will give you in retirement, to have some money you can tap without triggering more income tax.
And please note, I am not telling you to do an in-plan Roth conversion. That is an entirely different strategy, that will trigger a tax bill. An in-plan Roth conversion may be a smart move for you, but you should always consult a tax pro before considering such a move.
What I am suggesting is that you simply direct your future contributions into the Roth option. That’s a great start to building retirement savings that will be tax free.