Should You Fund a Roth or Traditional IRA/401k?

Should you be funding a Roth 401(k) or a traditional 401(k) or a Roth IRA?

There are differences between traditional and Roth accounts.A Roth account allows you to pay the tax now before you fund it so it’s tax free in retirement.

A traditional IRA or 401k works the exact opposite. You get a tax deduction now.

Roth IRAs are tremendous vehicles, however, in my opinion, they are in fact over sold in our marketplace. The only way a Roth IRA wins is if your taxes are higher when you take them out than when you put them in. In the end run, if taxes are the same as when you put the money in as when you take them out, there is no economic benefit to a Roth IRA. You end up with the same amount of money. The Roth makes sense if your tax rate in the future is higher than what it is now when you put the money in.

A traditional 401k or IRA is better if your tax rate is higher today than it will be tomorrow. One of the problems is we don’t know what our taxes will be tomorrow. But most people in the marketplace retire in a lower tax bracket than they work in.

I do think taxes are going to go up in the future. I think our taxes 20, 30, 40 years from now will be much higher than they are now, but it is still a moving target. A critical component of planning for younger people is tax diversification, where you do some of both. You can get some into a Roth and some into a traditional, then you’re playing both ends of the fence.

If you’re already near retirement, your taxable income when you retire is probably going to drop a reasonable amount and your tax bracket is probably going to go down not up, so a traditional 401k/IRA may make a lot of sense. However, if you have a large 401(k) or IRA balance when you are 70 and a half years old, you have mandatory distributions that may cause your tax rate to go way up. In other words, you may have this window in your 60’s when you retire where your tax rate is lower than when you are in your 70’s and you have to start taking that mandatory minimum distribution. That’s when a Roth can really make a lot of sense.

Some ask, “Would you rather pay tax on the seed or would you rather pay tax on the harvest?” The reality is it’s not that simple. What are taxes today? What might taxes be tomorrow? And how can you have a plan to address that in a very smart way?