Have you ever heard or read anything negative about Roth IRAs?
I doubt it. The people in charge of Roth’s public relations must have the highest regard of their industry for building their reputation as something every retirement saver must have.
In reality, the Roth is just another tax strategy with pros and cons like all others. If you choose to save your retirement dollars in a Roth IRA or Roth 401(k) instead of a traditional IRA or 401(k), you’ll give up some tax breaks. It may also turn out that a traditional IRA or 401(k) would have been a better option for you.
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Before reading any further, though, let me be clear: I love Roth IRAs — and I think the ultimate financial goal in retirement should be to have as much money in a Roth IRA as makes sense for you.
Why? Because I think all kinds of taxes are going to increase. way up. When that happens, you’ll need every tax break you can get — and the Roth IRA is a great one. However, that doesn’t mean you should blindly save in a Roth and underestimate the benefits of a traditional tax-deferred retirement account.
What are the differences between a traditional IRA, or 401(k), and a Roth IRA, or Roth 401(k)?
Different tax treatment of Roth and traditional accounts
Both are what I like to refer to as “tax wrappers”. Your choice of whether to go with a traditional or Roth account, or both, will have nothing to do with the actual investment in the account. You can put almost anything available in the investment world into one (although your workplace plan may have limited investment options). The difference is in the tax treatment you receive depending on the type of account — or “wrapper” — you choose.
Want to save on taxes today? When you contribute new money to a traditional IRA or 401(k), you get a tax deduction in that tax year, and the money becomes tax-deferred until you withdraw it in the future.
So, for example, if you earned $100,000 in a tax year and decided to contribute $15,000 to a traditional 401(k), you would only pay income tax on the remaining $85,000 that year, not the full $100,000. This is the advance income tax advantage of a traditional IRA or 401(k). You won’t pay any taxes on your money for years as it grows and compounds.
However, the tax man will eventually come calling – when you decide to get your money back. Your entire account balance is taxable, and each withdrawal will be taxed as ordinary income in the tax year. There is no avoiding this reality. You can put it off for several years if you like, but when you turn 73 (or 75 if you were born in 1960 or later), the IRS mandates that you take taxable withdrawals. This is called the required minimum distribution (RMD).
The taxes won’t go away even if you die. Your beneficiaries will have to pay them, and possibly at a much higher rate than what you would pay.
A Roth account shifts tax breaks. No upfront tax deduction is allowed on Roth contributions, so unlike traditional IRAs, there is no tax benefit on day one. Instead, there’s a bigger advantage with a Roth when you decide to take the money out. All of your profits have the potential for withdrawal free of any federal income tax.
There’s a five-year waiting period on this benefit, so if you haven’t yet opened your first Roth account, it may make sense to open one now (if you’re eligible) with a small amount to start your clock. .
Another plus: There’s no RMD over your lifetime on the Roth. Because it’s not taxable, the government doesn’t care if you ever withdraw the money. And, upon your death, the entire Roth is passed to your beneficiaries free of federal income tax.
Digging a Little Deeper into the Roth IRA
So, Roth sounds great, doesn’t it? Well, it is… but let’s look a little deeper.
Although Roths are often labeled as “tax-free,” I disagree with that description. When you save money in a Roth, you’re contributing after tax Wealth. You are not expected to pay taxes on your withdrawals because you have already paid taxes on those dollars. I don’t call it “tax-free”.
What comes out tax-free later is the profit you made. And this is a huge advantage. But I believe a better description for Roths would be “partially tax-exempt”.
Here’s something else to think about. What if it turns out you didn’t owe taxes on your traditional IRA withdrawal? If it were possible, and you had saved 100% of your money in the Roth over the years, you would have missed out on all the tax deductions you would have received on your contributions.
And it may be possible, these days, by using the large standard deduction that all Americans get on their tax returns. The 2023 standard deduction is $15,350 for single filers over 65, and $30,700 for married couples filing jointly. This means that the first $15,350 or $30,700 of income is tax-free on your tax return. Even for a retiree facing RMDs, the standard deduction can wipe out any tax due.
Now, of course there are other factors to consider, such as taxable income coming from pensions, Social Security, interest and dividends, and other sources. Those are the elements that may be why you really need that Roth account. In addition, taxes may need to be paid if your beneficiaries inherit your account, which also needs to be considered.
This is where retirement planning can come in handy. A CPA or financial advisor with tax expertise can help you estimate what your potential retirement income and tax situation will be and help you figure out what would be the best move for you and your family.
You don’t need to wait until you’re on the threshold of retirement to run the numbers and make a decision. In fact, the sooner you make this decision, the better it is for you.
Kim Franke-Folstead contributed to this article.
Appearances at Kiplinger were achieved through a public relations program. The columnist received assistance from a public relations firm in preparing this piece for submission to Kiplinger.com. Kiplinger was not given any kind of compensation.
This article represents the views of our assistant advisor and was not written by Kiplinger’s editorial staff. You can view advisor records with the SEC (Opens in new tab) or FINRA (Opens in new tab).
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