Choosing Between Roth and Traditional Accounts for Your Retirement Savings

When it comes to deciding between a Roth account and a Traditional account for your retirement savings, the general guideline is simple: go Roth when your tax rates are low and opt for Traditional when your tax rates are high.

However, real-life scenarios are rarely that straightforward. The answer often becomes crystal clear only in extreme cases. If you find yourself in either of the two lowest tax brackets or the two highest tax brackets, the choice is evident, provided you won't remain in those brackets when you start withdrawing funds from your account.

But what if you fall in between?

The truth is, if your current tax bracket matches the one you'll be in when you withdraw your money, the choice between Roth and Traditional accounts becomes inconsequential. This concept is known as the principle of Tax Equivalency. Whether you pay 24% in taxes on that money now or 24% on that money when you withdraw it, as long as you earn the same return, you'll owe the same amount of tax to the federal government. This realization can help alleviate some of the anxiety associated with deciding which account to utilize.

Moreover, you have the flexibility to convert Traditional funds into Roth funds down the road if you believe you made the wrong initial choice. This process is referred to as a Roth Conversion and can prove highly beneficial if executed strategically.

Why Roth Conversions Matter

Roth conversions are advantageous because we know that funds in Traditional accounts will eventually be taxed. With this knowledge, we can make a conscious decision to pay taxes during years when our income is low, and our tax brackets are at their lowest. This might be during retirement before starting to collect Social Security benefits, in a year when your business can show a tax loss, or in a year when you've taken a sabbatical or are working for a startup with minimal salary.

Keep in mind that Roth conversions are an option. However, if you have substantial balances in your tax-deferred retirement accounts and are nearing retirement, it's essential to consult with a financial professional about Roth conversions. At our firm, we help clients in such situations each year, reviewing their circumstances for potential Roth conversions every December to prevent hefty taxes due to Required Minimum Distributions (RMDs) in the future.

In the worst-case scenario, neglecting Roth conversions could lead to a situation where you have over $1 million in traditional accounts, and your RMDs push you into a higher tax bracket, resulting in increased taxes.

The decision between Roth and Traditional accounts is not always straightforward, but understanding the principle of Tax Equivalency and the potential benefits of Roth conversions can provide clarity and flexibility in your retirement savings strategy.

If you have substantial balances in your tax-deferred accounts and retirement is on the horizon, we recommend seeking professional guidance to optimize your financial future.

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Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.

Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal.  Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.

A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.

Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.