June 24, 2019 Written by John Brimhall, Client Advisor, CFA, CPA, CFP®
My daughter Olivia will be three years old in a few months. Currently, she’s in the dreaded, “why?” stage and it’s as every bit annoying as I thought it would be. You can’t resent a child for being inquisitive. Well, you can, but you shouldn’t. When I was a child and asked my parents a question, I always hated when they’d answer with, “well it depends.” My little mind at the time just couldn’t comprehend why that was an appropriate response. “What do you mean it depends,” I’d say angrily while shaking my fists in the air. I wanted absolute certainty. Now I get it. “It depends” is a perfectly acceptable answer in the grown-up world.
Speaking of the grown-up world, saving for retirement, you’ve likely been presented with a choice: traditional or Roth contributions. This article does not intend to make the case that one contribution type is always better than the other. To the contrary, and frustratingly so for some – my young daughter included, the contribution type most appropriate for you “depends” on your situation and investment goals. However, there is one often overlooked element of Roth contributions worth highlighting.
Roth Provides Certainty
Roth contributions provide a desirable element of tax certainty. Your contributions are after tax, and the amount of taxes paid today are based on your current tax bracket. This is certain. At normal distribution, the amount of taxes you’ll owe on contributions and earnings is zero. This is certain. Obviously, your ending portfolio value is not known and is dependent on a variety of economic and market factors. However, by making Roth contributions to either a 401(k) or an individual retirement account (IRA), you’ve removed a key piece of uncertainty regarding taxes.
As mentioned, choosing between traditional and Roth contributions can be a complicated endeavor. It is important to create a roadmap for the future and to consider the following:
Current vs Expected Tax Rates
Will your tax rate rise in the future? There’s no way to know for certain, but if you believe your tax rate will increase as a result of your rising income or changes in the US tax system, Roth contributions may make sense. When you expect your tax rate to increase, a Roth will allow you to pay taxes now and avoid paying taxes ever again. Generally speaking, the younger you are, the higher the likelihood that income earned and taxes paid will increase in the future. The graphic below shows the best choice based on current and expected tax rates.
Diversification is a concept mostly associated with investing and portfolio allocation. However, it is just as important when it comes to taxes. Roth contributions could help you better manage the overall income tax liability during retirement. For example, it’s possible to take distributions from a traditional IRA until your taxable income reaches the top of a tax bracket, and then switch to a Roth IRA to avoid crossing the tax threshold. The Roth IRA also provides a hedge against future tax hikes. You don’t know what tax rates will be during retirement, so proper tax diversification can help navigate the unknown.
Hedge Your Bets
In some cases, you have the flexibility to make both traditional and Roth contributions. For example, let’s assume Lisa has just started her career and desires to contribute 10% of her income to her 401(k) plan. She can split her 10% total contributions between Roth and traditional. Initially, the bulk of her contributions, say 8% may be made as Roth contributions while the remaining 2% are traditional contributions. Over time, as she progresses in her career and her income rises, she can gradually adjust the mix between Roth and traditional contributions.
Now that you’re ready to make distributions for retirement expenses, how do you choose the right account? While your specific situation may differ, generally distributions should be taken from taxable accounts first, followed by tax-deferred and tax-exempt as shown below:
Withdrawals from taxable accounts first allow traditional and Roth IRAs to grow while taking advantage of the deferred tax. Also, traditional IRAs have required minimum distributions (RMDs) that force you to make distributions after a specific age. RMDs are calculated and withdrawn each year based on the IRS schedule located here: https://www.irs.gov/pub/irs-tege/uniform_rmd_wksht.pdf. On the other hand, Roth IRAs are not subject to RMDs for the original owner. This allows the account to continue to grow throughout retirement.
Taking Full Advantage of a Roth
You must be willing to invest Roth contribution more aggressively for two reasons: upfront taxes and time horizon. Think about it; to deposit money inside a Roth you are required to pay taxes on the funds, which lowers the value compared to a contribution to a traditional IRA or 401(k). In order to cover the lost ground, assets in a Roth should be invested in securities that have the highest long-term growth potential. Some examples include emerging markets, actively managed equity, and REITs. These high returning assets are also appropriate due to the time horizon of a Roth. The Roth account should be your last source of retirement funds, which allows for you to become more aggressive and accept more risk to obtain higher returns.
As we’ve discussed, whether you should make traditional or Roth contributions or both, it depends on your specific situation. In my own case, after many conversations, I believe Olivia is starting to understand that Roth contributions provide a desirable level of certainty. Furthermore, we’ve assessed her situation and the various planning considerations. I’m confident she’s well on her way to adopting a successful retirement savings strategy. Now, if I could only articulate why she can’t have cookie dough ice cream for breakfast….
 This article assumes a general understanding of the differences between traditional (pre-tax) and Roth (after-tax) contributions to either an individual retirement account (IRA) or a defined contribution plan (such as a 403(b) or 401(k)). For a good refresher, check out this article https://www.thesimpledollar.com/investing/roth-vs-traditional-ira/.
 Income limits, participation in an employer-sponsored plan, and tax filing status may reduce or prevent your ability to make tax-deductible traditional IRA contributions or Roth IRA contributions.