To Roth, or not to Roth? That is the question.
One of the most frequent questions that I get in my practice is about Roth IRAs, and more recently Roth 401Ks. Roth accounts can be a very important part of a retirement portfolio, but I find that most investors don’t fully understand how they work. So, to clear up the confusion, let’s go through the key differences between Roth accounts and traditional retirement accounts.
The General Idea
Contributions to traditional retirement accounts are generally tax-deductible upfront, investment gains build up tax-deferred, and then withdrawals in the future are typically fully taxable at ordinary income tax rates. With Roth accounts, contributions are not tax-deductible but investment gains grow tax-free as there are no taxes incurred upon withdrawal. In other words, traditional accounts give you a tax break now, and defer taxes until retirement when you may have lower income and a lower tax bracket. Conversely, Roth accounts don’t help you with your taxes now but build up a tax-free pot of savings so you don’t have to worry about taxes later on.
Roth Contribution Limits
For 2022, the maximum an investor can contribute to a Roth IRA is $6,000, unless they are age 50 or older, in which case they can contribute another $1,000 for a total of $7,000 per year. However, to be eligible for the maximum contribution, your modified adjusted gross income must be less than $129,000 if single or $204,000 if married and filing jointly.
If you have a 401K that allows Roth contributions, your contribution limits are much higher than they are for Roth IRAs. The maximum contribution for 2022 is $20,500, or $27,000 if you are age 50 or older. Roth 401Ks have the additional advantage of not having any income limits like Roth IRAs do.
Are Roth Accounts Better?
I’m often asked which type of retirement account is better but there is no absolute answer to this question. The analysis of whether Roth accounts make sense for you would have to factor in what tax bracket you are in today (i.e. how big of a deduction you would get for a traditional retirement contribution) and what tax bracket you think you will be in after retirement. Of course, this means having to predict what you think will happen with tax rates many years into the future which is tricky. I find that most people believe they already pay too much in taxes now so they want to maximize their deductions today which points them to traditional accounts, but many others are more concerned about what taxes could be in the future which would push them toward Roth accounts. Personally, I like the idea of balance where an investor has a mix of both traditional and Roth accounts; you could consider this another form of diversification within your portfolio.
Disclosure: 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.
Neil Manning, CFP, AIF, CDFA, FSA
I am a reformed actuary turned financial advisor, helping my clients with everything from investments to retirement projections to LTC insurance since 2014. Unlike most normal people, I love numbers and finance – I’m currently reading a book about game theory which my wife and two teenage daughters think is unbelievably boring (they are wrong). For more details about my background, check out my website below.