Question: What's better: Roth after-tax account or pre-tax account?

How are you planning to retire?

What is the difference between pre-tax and Roth after-tax retirement accounts? Will I pay less in taxes in the long run if I put all my retirement savings into a Roth account? How should I decide which type of account is best for me?  - Clarissa, Minnesota

Response:

Contributions to a traditional IRA, 401(k), and similar retirement savings plan are made with pre-tax dollars. You get a nice upfront tax break which eases the financial burden of funding the retirement account. You will pay your ordinary income tax rate when you withdraw the savings in retirement. You also have to start making your Required Minimum Distribution starting at age 70.5. Many advisors favor pre-tax accounts if you think your tax bracket will be lower in retirement.

With a Roth-IRA, a Roth-401(K) and the like your contributions are made with after-tax dollars. The earnings on your contributions come out tax free at withdrawal. The tax-free withdrawal of money during retirement is especially valuable if you anticipate that your tax rate will be higher when you’re elderly than it is now.

Here’s one way to look at it: If you’re just starting out your career and money is tight the pre-tax option is much easier on your monthly cash flow. The Roth option is preferable if your cash flow is strained. (From now on I’ll just use the regular IRA and the Roth-IRA to illustrate the trade-offs. The details between various pretax and after-tax retirement savings plans differ. For example, there is no Required Minimum Distribution with a Roth-IRA, while there is one with the Roth-401(k). Go figure. The thought process of deciding between a pre-tax retirement account and an after-tax retirement account is essentially the same, however.)

Longer term, the question is more complicated. We don’t what tax brackets will be in 5 to 10 years, let alone 30 years. Many people reasonably expect taxes will be higher, largely to pay for Social Security, Medicare and government services. However, we could all be surprised and overall rates could be lowered if Washington embraces comprehensive tax reform. Whether it’s better to invest in a traditional IRA or the Roth-IRA also depends on whether your income will be higher or lower during retirement. Again, who knows? You can and should make an informed guess, but that’s all it is -- a guess.

That said, for many workers a Roth is a good choice. For one thing, the research I’ve looked at suggests that the tax free withdrawal of investment gains from the Roth is extremely attractive with time. The younger you are when you start making contributions the longer your money has to compound and (hopefully) the bigger the benefits from tax-free withdrawal.

For another, there’s the attraction of tax diversification with the Roth. Many workers find themselves with a grab-bag of retirement savings plans by the time their career winds down, say, a pre-tax employer-sponsored 401(k) and 403(b), a Roth-IRA, a SEP-IRA, and so on. Depending on your income needs you can withdraw money during retirement from the account that will best shelter your retirement income from taxes.

Fact is, you can’t go wrong choosing either a regular IRA or a Roth-IRA. You can only go wrong by not saving for retirement.

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