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Deciding between traditional retirement plan contributions and Roth retirement plan contributions

Whether or not to make investments into “traditional” tax-advantaged employer accounts and IRAs versus investing in “Roth” tax-advantaged employer accounts and personal IRAs is not always a straightforward decision. The decision on the trade offs happens to be one of the most complex aspects of lifetime personal financial planning.

A broad array of factors can influence whether a traditional retirement plan account contribution or a Roth retirement account contribution decision would be optimal. Given the significant importance of this decision on your lifetime financial plan and the build-up of your retirement savings, it would be worth taking a closer look at this decision. For most people’s lifetime circumstances, making deposits in traditional accounts is the preferred decision, when those contributions would be deductible against current income taxes.

Factors favoring Roth plan contributions over traditional plan contributions

Many people struggle with the traditional versus Roth contribution decision for their personal financial and investment planning. The trade-offs over a lifetime are very complex. Rules-of-thumb, back-of-the-envelope calculations, and simple retirement planning spreadsheets cannot model all the important personal financial factors.

The decision is not simply about present versus future tax rates and whether rates might be higher or lower. Instead, the decision requires a personalized and comprehensive projection and valuation of an investor’s lifetime income, expenses, debts, net assets, and taxes. (Look here for a sophisticated Roth IRA and Roth 401k calculator tool that fully automates the traditional versus Roth analysis.)

Also, be clear in noting that this discussion focuses ONLY on situations where an investor has the choice of making a CURRENTLY TAX-DEDUCTIBLE traditional IRA, 401k, etc. contribution VERSUS a CURRENTLY NON-TAX DEDUCTIBLE Roth IRA, 401k, etc. contribution. For most people, this is often they case, because they have not maxed-out their current opportunities to make tax-deductible traditional retirement plan account contributions.

If under the U.S.’s incredibly complex tax-advantaged retirement account rules, an investor does NOT have any further opportunities to make currently tax-deductible retirement account contributions, then a Roth contribution is the choice to make. Since an investor cannot take a current tax-deduction and since Roth account contributions avoid future taxation of asset appreciation in retirement, that is why such Roth contribution would be preferred over traditional retirement account contributions, under these limited circumstances of non-deductibility.

Whether or not a person or family will save enough and invest efficiently across a lifetime dominates the Roth retirement plan versus currently deductible traditional retirement plan contribution decision.

If an investor does not earn sufficiently high income, does not save aggressively, does not control investment costs, and/or does not grow a sufficiently substantial investment asset portfolio retirement nest egg, then that investor will not have to worry about being in high tax brackets in retirement — whether or not state and federal income tax brackets had moved up or down in the interim. If an investor will not have substantial assets and income in retirement, then the current tax savings an investor could get from contributing to a traditional tax-advantaged retirement savings plan will tend to be much more economically advantageous over a lifetime.

For an investor to justify making current Roth contributions in lieu of currently deductible “traditional” contributions, here are eight personal circumstances, taken together, that might reverse the average person’s preference for traditional tax-advantaged plan contributions.

Roth retirement plan contributions might be more advantageous over currently deductible traditional retirement plan contributions, when a retirement investor:

1. has a long time for her assets to appreciate before and during retirement.
2. is likely to earn high enough taxable income over her working lifetime to have a realistic chance of amassing enough assets to cover her retirement expenses easily and still build up financial assets.
3. is more likely to have increasing earned income that is expected to continue to rise in real dollar terms across a working life cycle, enhancing that investor’s ability to feed her investment program through increasing savings.
4. saves at sufficiently high percentage rates across her working lifetime. (This means consistently saving at rates that are well in excess of 10% of gross earned income.)
5. will fully fund either traditional and/or Roth tax-advantaged accounts up to maximum annual contribution limits.
6. may have proportionately higher front-loaded itemized deductions (e.g. mortgage interest and real estate taxes) and lower earned income that effectively lowers an investor’s nearer term federal, state, and local marginal ordinary income tax rates compared to her more distant retirement years.
7. will adopt a very low-cost investment strategy to improve her chances of capturing higher asset appreciation rates.
8. will maintain an investment asset allocation that is skewed heavily toward equities, and when her financial assets continue to grow at rates that are similar to long-term historical rates of return on equities.

Given all these factors, an investor may find that her assets in traditional tax-advantaged accounts would grow to be so substantial that when they are distributed under the mandatory distribution rules after age 70 and 1/2, she is pushed into much higher marginal tax brackets. If her traditional tax-deferred assets are sufficiently large, then ordinary income taxes on these mandatory distributions COULD wipe out the value of the tax shield assets that an investor gained by making traditional account contributions that reduced her taxable earned income in earlier years. This is the crossover point where Roth contributions become more desirable on a present value basis compared with currently deductible traditional retirement new investments. Again, the majority of those saving for retirement are less likely to be in this position and should therefore prefer reducing their currently taxable income through traditional retirement plan contributions.

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