Pay now or later

Withdrawals from a Roth account are tax-free (provided you opened the account at least five years ago and have reached age 59½), but contributions are nondeductible. In contrast, withdrawals from traditional accounts are taxable, but contributions are deductible if you meet certain requirements.

The right type of account, therefore, depends on whether it’s best to pay the tax now or later. An oft-cited rule of thumb says that, if you expect your tax rate to be higher in retirement, a Roth account is more desirable. But if you expect your tax rate to go down, a traditional account is the best choice. As the following example demonstrates, however, in some situations a Roth account is preferable, even if you expect your tax rate to drop.

Anna, age 50, wants to defer $24,000 of income (the current maximum for someone 50 or older) to her employer’s 401(k) plan. The plan allows her to choose between a traditional account and a Roth account. Anna is in the 33% tax bracket and expects to be in the 28% bracket when she retires in 15 years. She opts for a Roth account, which earns a return of 6% per year. At retirement, the account has grown to $57,517, which Anna withdraws tax-free.

If, instead, she chooses a traditional 401(k) account earning the same 6% return, she’ll still end up with $57,517. But when she withdraws the funds, she’ll owe $16,105 in taxes (at 28%), leaving her with $41,412 after taxes. That’s not the end of the story, though. Anna’s contribution is deductible, which generates tax savings of $7,920 ($24,000 × 33%). If she invests the savings in a taxable portfolio that also earns 6%, for an after-tax return of about 4%, the funds will grow to $14,263 after taxes at retirement. Combining this amount with the after-tax 401(k) withdrawal results in total retirement income of $55,675 — $1,842 less than the Roth account.

Contrary to the rule of thumb, Anna is slightly better off with a Roth 401(k), even though her tax rate is lower in retirement. The outcome changes, however, if we change the assumptions. For example, if Anna’s tax rate drops to 25% in retirement, traditional and Roth accounts would yield nearly identical results. If we increase the rate of return or the number of years until retirement, the Roth account’s advantage increases.

Another factor to consider is whether you plan to max out your contributions. Suppose, going back to our example, that Anna defers $16,000 rather than the $24,000 maximum. In that case, she’s better off with a traditional 401(k) account. Why? Because, instead of investing her tax savings in a separate taxable account, she can simply increase her 401(k) contribution to the pretax equivalent — in this case, $23,881 (at 33%). In other words, a $23,881 pretax contribution to a traditional 401(k) is equivalent to a $16,000 after-tax contribution to a Roth 401(k).

Consider your retirement needs

Our example assumes that the funds are withdrawn in a lump sum at retirement. But what if you withdraw them gradually over time? The longer you leave the funds in the account, the greater the Roth account’s advantages. Unlike a traditional IRA or 401(k), which mandate distributions starting at age 70½, a Roth account’s funds can continue growing tax-free for as long as you want. If you don’t need the money, you can leave it in the account for the rest of your life, and after your death, it can provide a source of tax-free wealth for your children or other heirs.

Hedge your bets

To determine which type of account is best for you, ask your tax advisor to run some numbers using various pre- and postretirement tax rates, rates of return, distribution schedules and other assumptions. Keep in mind, though, that there’s always a possibility that Congress will change tax rates or limit the benefits of Roth accounts in the future. To hedge your bets, consider diversifying your retirement funds by setting aside some of your money in a Roth account, if you qualify, and some in a traditional account.

Sidebar: Will lawmakers close the door on “backdoor” Roth IRAs?

The ability to contribute to a Roth IRA is phased out once your income reaches certain levels. For 2015, contributions for single filers are phased out beginning at modified adjusted gross income (MAGI) of $116,000 and eliminated when MAGI reaches $131,000. The phaseout range for joint filers is $183,000 to $193,000. To get around these limits, many high-income taxpayers use “backdoor” Roth IRAs — that is, they contribute to a nondeductible traditional IRA and then convert it to a Roth IRA. (There’s no income limit on conversions.)

The president’s fiscal-year 2016 budget contains a proposal to eliminate the benefits of backdoor IRAs. It’s uncertain whether the proposal will become law, but, if you’re considering this strategy, it may be best to act sooner rather than later.

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