If there’s a question I’ve seen a thousand times, it’s “should I invest in a Traditional or Roth retirement account?”
A lot of people feel very passionately about this topic. If I had to pick which one I see recommended more, it’d be Roth. But there are plenty of reasons to like Traditional accounts, too.
In my opinion, there is no “right” answer for choosing between Traditional and Roth accounts…at least not one you can know ahead of time. My crystal ball remains stubbornly broken, so I am going to give you considerations for each type. You should choose your Traditional and/or Roth contributions based on what you think is more likely or what your personal situation dictates.
Note: This post only covers the differences between Traditional and Roth tax treatments. It does not cover the differences between TSP/401k/403b/etc and IRAs. We’ll get there…
Oh, this also assumes you will follow all the normal withdrawal rules for any account. The tax situation may change if you don’t, not to mention the possibility of copious early withdrawal penalties.
What is a “Traditional” Retirement Account?
- If the retirement account is “Traditional,” that means taxes are deferred. So your taxable income is reduced dollar-for-dollar by the amount you put into the Traditional account.
- You can invest in a Traditional account through the TSP/401k or an IRA (or other methods, depending on your employment status).
- There are no income eligibility limitations for a Traditional IRA or TSP.
What is a “Roth” Retirement Account?
- If the retirement account is “Roth,” you pay taxes now but all future withdrawals, including earnings, are tax free.
- You can invest in a Roth account through the TSP or an IRA (or other methods, depending on your employment status and the available options).
- There are income eligibility limits for a Roth IRA, but not for a Roth TSP.
Should you choose Traditional?
- If you are set on investing for your retirement but it is absolutely vital that you keep every penny possible in your paycheck to keep from accumulating debt, a Traditional account might be the best choice because your taxes will be lowered, keeping more money in your paycheck. Or, maybe the money you save on taxes could be used to up your contributions!
- If you think your taxes are high right now and will be lower when you reach retirement, a Traditional account may be right for you.
Should you choose Roth?
- If you aren’t paying much in taxes (early in your career, low pay, or you have tax-free income) a Roth might be right for you.
- If you think overall that tax rates are low right now and will be higher by the time you retire, a Roth account might be right for you.
So…what does that all mean?
The arguments for both types of accounts come down to one question: Will your tax rate after retirement be higher or lower than it is today?
Remember that (as of April 2017) Long Term Capital Gains taxes are generally lower than income taxes, so if investment withdrawals are your primary means of income in retirement your taxes might be lower than while you are working. Many people also have lower total income and thus, lower tax rates, in retirement. However, for some lucky people it may be different. For instance, a military pension + Social Security + withdrawals from retirement accounts could mean you have higher income in retirement (not the worst problem ever…).
You should also keep in mind that tax rates can always change! The President announced his plan for a drastically different tax structure just this week. Will it pass as is? Probably not. Congress will undoubtedly put their own spin on it, if they end up pursuing any tax changes at all. But the point is taxes could change at any time, and since you are (hopefully) investing in these accounts for decades, there is no way to know for sure what the tax situation will be when you start taking withdrawals.
I can’t make up my mind! What should I do?
If you still can’t make up your mind whether to choose Traditional or Roth, consider contributing to both. If you meet the requirements for both Traditional and Roth accounts, nothing says you can’t split your contributions to hedge your bets.
Personally, I contribute to a Roth IRA. It’s actually the first investment I ever opened, and I’ve been maxing it out since then. I also split my TSP contributions between Traditional and Roth. This way, I have the tax-deferred benefits of a Traditional account and the tax-free growth of a Roth account!