The decision of whether to contribute to a Roth or a traditional (pre-tax) retirement account basically boils down to timing: do I pay taxes now or later? While both types of retirement accounts are powerful tools for building wealth, this seemingly simple binary can produce some unique planning opportunities with meaningful tax savings for many individuals. But how do you know which one is best for your situation?

What’s the difference between Traditional and Roth Retirement Savings?

Traditional (Tax-Deferred):

Tax-deductible contributions to an IRA or deferrals to a workplace 401(k)/403(b)/457 plan are made with pre-tax dollars, effectively reducing the income tax you owe in the year you make the contributions. While there are income limits for IRA contributions, there are no income phaseouts for employer-sponsored plans. Investments you make within these accounts grow tax-free, meaning that you don’t owe income tax on interest and dividends that you receive or pay capital gains taxes when you sell investments within these accounts. However, a portion of your account essentially belongs to the government: you’ll owe tax on both your original contributions and any earning when you eventually make distributions from your account. In fact, the government compels you to start taking distributions in the year you reach age 73 (changing to 75 in 2033) in the form of RMDs. The tax man want’s his share, and he’ll get it eventually!

Roth (Post-Tax):

Contributions to a Roth IRA or Roth 401(k)/403(b)/457 employer-sponsored plan are made with dollars that have already been taxed, so you don’t get any tax benefit in the current year. Like traditional IRAs, there are income phaseouts for contributions to a Roth IRA, but no income limits for contributions to employer-sponsored Roth plans. Like traditional retirement accounts, all earnings in a Roth account are tax-deferred; however, the superpower of Roth accounts is that all qualified distributions are tax-free. Once money goes into a Roth account, it will never be taxed again as long as you follow the rules.

Should I make a Roth or Tax-Deferred Contribution This Year?

The question basically boils down to whether you want to pay taxes now or later (i.e. whether you expect to be in a higher or lower tax bracket now vs. when you retire). There are some important nuances, but here are some basic rules of thumb that will get you started:

• Who benefits most from Roth?

  When you’re young, or if you fall into one of the lower marginal tax brackets (say 12% or lower, up to $117k of AGI or less in 2023 for MFJ), or if you’re in a middle or higher tax bracket but expect to be in a higher bracket later in life, you will likely benefit the most from making a Roth contribution.

• Who benefits most from Tax-deferred?

  If you fall into one of the higher marginal tax brackets (32%- 37%, AGI above $367k in 2023 for MFJ), or if you have a windfall in a given year that puts you temporarily into a higher tax bracket, or if you expect to be in a lower tax bracket in the future, you will likely benefit more from making Traditional (pre-tax) contributions this year.

• What if I’m in a middle tax bracket?

  If you fall in the middle brackets (22-24%, 2023 AGI between $117k-$367k for MFJ) and expect to remain in those brackets, your best course of action may be to do some of each: 50% in pre-tax, and 50% in Roth and plan to do some strategic Roth conversions in the future if it looks like your RMDs will put you into a higher tax bracket.

• What if my income goes up and down?

  There’s no rule against changing back and forth between Roth and Traditional contributions from year to year. Make Roth contributions in lean years, and tax-deferred contributions in high-income years. You should also make strategic Roth conversions in years in which your income is down. Yes, you’ll pay more taxes in those down years compared to your income, but the money you stuff into the Roth will not be taxed again! By filling up a certain tax bracket with Roth contributions and conversions in lower-income years, and making pre-tax contributions in higher-income years, you’ll smooth out your income and improve your overall after-tax outcome.

There are many other considerations and caveats, that may lead to the general advice above not giving the optimal solution (though, you’ll likely still get a very good result). I recommend consulting with a financial planner who has deep experience with tax planning opportunities around retirement accounts.

But, whatever you do, don’t let “analysis paralysis” or feeling like you don’t understand this stuff stop you from taking advantage of the opportunities that both types of plans provide to build your wealth and save for retirement.

The most important thing is that you pick a strategy and get started saving regularly.

Other Considerations (and Opportunities):

An (over)Simplified Case

Consider a simple comparison of two people who make the same lifetime earnings and make the same annual retirement plan contributions. The first (Ms. Traditional) saves via a traditional (pre-tax) retirement account (investing the money she saves by not paying tax on her contributions in a regular brokerage account, which will essentially grow and offset the taxes due later). The second (Mr. Roth) saves via a Roth (post-tax) account, paying income tax along the way.

Assuming their income needs in retirement don’t change and a flat tax rate, they’ll both end up in roughly the same spot. Their account balances and distributions in retirement will be exactly the same; however, Ms. Traditional, who benefited from tax savings along the way, will end up owing more in taxes later when she takes distributions since the account grew. This will be roughly offset by the monies she invested outside her retirement plan along the way. Mr. Roth will have the benefit of not paying any taxes in retirement because he had to pay taxes on all his contributions.

In this simple example, it doesn’t matter much which route you go.

Reality is more complicated but with greater benefits. Here are things to consider

• How much will your income needs really change in retirement?

Many people expect their income needs to be lower in retirement once certain expenses like mortgage payments and commuting are a thing of the past (which would favor making tax-deferred savings now), but the reality is that most people’s lifestyles don’t change as much as they might think. Odds are you’ll be in the same tax bracket in retirement that you are in now because certain expenses like travel, healthcare, and hobbies will increase, not to mention RMDs (see below).

• What matters most is your marginal tax rate now vs. your effective tax rate on distributions:

We don’t have a flat tax system. Our income taxes are progressive, meaning higher earners typically pay a greater overall percentage of their income. Not only that but the tax rate is graduated, such that the rate you pay on your first dollar of earnings is going to be lower than the rate you pay on your last dollar (i.e. your marginal tax rate). Therefore, the real crux of the decision is not whether your marginal tax bracket now is lower or higher than your marginal tax bracket in retirement.  Instead, what matters is your marginal tax bracket now versus your effective tax rate in retirement, (i.e. average tax rate you pay, or total tax divided by total taxable income.) When you make a pre-tax contribution to a traditional retirement account, you receive a tax deduction based on your higher marginal tax rate, whereas when you take distributions in retirement, you’ll be paying tax on those funds at a blended effective tax rate, which will, by definition, always be lower than your marginal tax rate. For this reason, most people benefit by having some pre-tax savings if they’re in a middle to high-tax bracket. However, saving too much in a pre-tax account could result in needing to take larger RMDs that put you in a higher marginal bracket later on.

• Most people’s earnings trajectories are not flat:

  People tend to earn more as they advance through their careers. Others, like business owners or folks who change jobs a few times, will see income vary with the economy and their career path. When your income is lower, you will benefit more from stashing money in a Roth or doing Roth conversions: (you pay the tax now at a lower marginal rate and get the benefit tax-free distributions later when your effective rate could be higher). Conversely, in years when you fall into one of the higher tax brackets, you’ll tend to get more benefit from the tax relief now by contributing to a traditional plan.

• Money invested in a regular brokerage account gets taxed:

  In the oversimplified example above, we assumed that Ms. Traditional could invest the savings she had from her tax deduction in a regular brokerage account so that it could grow and offset the future taxes she would owe when she takes a distribution from her retirement account in the future. But… she’ll end up paying tax on any capital gains or dividends she earns along the way at rates up to 23.8% depending on income level.

• How will you be impacted by RMDs?

  When you turn 73 (or 75 if after 2033), you’ll have to start taking annual distributions from your Traditional IRAs and employer plans whether you want to or not, based on a set percentage of your account according to your age. If you’re lucky enough to have built up sizeable pre-tax savings, your required minimum distributions may put you in a higher tax bracket than you were in when you were working! There are no RMDs from Roth accounts.

• Structural differences between Roth and Traditional accounts and between IRAs vs Employer Plans:

  Roth accounts offer the greatest flexibility because of the ability to withdraw contributions at any time for any reason without tax or penalty prior to age 59.5 (keep in mind there are other requirements to withdraw conversion amounts and investment earnings). There are even special provisions to allow for a onetime withdrawal for the purchase of your first home or pay for education without tax or penalty that are only available with a Roth IRA account. Employer plans offer greater creditor protection, as those funds are protected from lawsuits and sheltered from bankruptcy in some situations, and many plans offer the ability to borrow from the plan. Clearly, one would hope to never need those features!

• Tax laws will change:

  Tax brackets have changed over time and will continue to change in the future. The current brackets established by the Tax Cuts and Jobs Act will sunset beginning in 2026. The rules can change also. While there are not currently serious discussions in Washington about changing the rules for Roth accounts, this is something that could become an issue if the political winds change and there’s interest in curbing some of these benefits, especially for higher earners.

The bottom line:

The amount of money you could save in taxes by optimizing Roth contributions and conversions can be significant. Over a lifetime, depending on your situation, the savings could amount to many hundreds of thousands of dollars or even into the millions for higher earners.

While tax planning can be a significant value add, it cannot make up for lack of savings and prudent investing.