Using both Roth and Traditional 401K / IRA accounts

IRA retirement balanceWhen it comes to retirement planning, it is often that you will come across phrases such as Roth Vs. Traditional, or which is better Roth or traditional. Finance celebrities like Suze Orman and Dave Ramsey pitch the Roth and Ric Edelman favors traditional accounts. While these accounts have vastly different tax considerations, I strongly believe that a mixture of the two is imperative to successful retirement planning.

With a traditional account, money is put in tax deferred today (no taxes paid on it), grows without taxation, and on the back end during retirement, income taxes are owed. The conventional wisdom favoring these accounts contests that getting the tax break NOW is the way to go. For someone in the 25% tax bracket every dollar saved in these accounts gives the investor a 25 cent deduction today. The long term bet is of course that tax rates will be lower in the future, or that tax law will change in such a way that having already taken the deduction will be the most advantageous. Let’s say that the income tax is abolished (extremely unlikely), Then people using a Roth will have not received any benefit, while those using traditionals will have already gotten a tax deduction.

Roth IRAs and Roth 401Ks operate in a different manner than traditionals. Taxes are paid today, and like a traditional account the growth is tax free, The major advantage in the Roth is that in retirement, all withdrawals are tax free. There are two other major advantageous of the Roth as well. Contributions can be withdrawn at any time, with no penalty. Although it is RARELY advisable to withdrawal money from retirement accounts, this is a substantial advantage. For someone with only traditional accounts, an early withdrawal triggers 10% penalty and taxes owed on any amount withdrawn. The other advantage is that minimum distributions do not apply to Roth accounts. For traditional accounts at age 70, there is a required percentage that needs to be withdrawn from the accounts every year (based on life expectancy), which increases every year. Failure to take these distributions results in large penalties.

There are some situations where it makes sense to go 100% Roth. IF someone is in the 10% tax bracket, or has no federal income tax liability, it would be foolish to use a traditional account (except to get an employer match). Since no income tax, or very little income tax would be owed, the deduction today does no good. In this scenario 100% Roth is the way to go. The other time it make sense to go 100% Roth is for high earners, who can afford to save more than the maximum allowed for 401K and IRA contributions. For 2013 the 401K limit is $17,500 and the IRA limit is $5,500. In the event that more than $23,000 can be saved in a tax deferred plan, switching to 100% Roth may be advisable, since it is effectively saving more total dollars in tax advantaged plans. ($23,000 with taxes never being owed is worth much more than $23,000 with taxes being owed in the future)

Other than those two scenarios, a mix is needed, and there is no perfect formula for determining the proper mix, because there are several variables involved, most notably marital status and tax bracket. Since we have no idea what the tax rates will be in 3 years, let alone 3 decades, we have to make rational guesses as to what they will be like. Using our current tax code as a starting point, between standard deductions and exemptions for a married couple, the first approx. $20,000 of earnings per year is tax free, meaning that money is in the 0% bracket. The next $17,400 is in the 10% bracket, and then the next $53,300 is taxed at 15%, and then into the 25% bracket. At a MINIMUM it makes sense to have the first $20,000 per year in retirement come from traditional accounts. We get a tax deduction on it today, and in retirement that $20,000 will be tax free if the tax code stays roughly the same. Using a 5% withdrawal rate in retirement, the goal would be to have $400,000 amassed in traditional accounts. Use a financial calculator to plug in your variables of time, expected rate of return, and monthly contribution to see what it takes to make that first $20,000 happen. As an example, with 30 years to save and an 8% return (stock mutual funds) THEN it would take approx $275 per month to reach this goal. Funding beyond that should be put in a Roth, making sure that traditional contributions don’t dip into that 0% or 10% tax bracket today.

The main thing to remember is that it isn’t a contest between which is better, both types of accounts have substantial advantageous and are both important in an investing strategy.

John C. started Action Economics in 2013 as a way to gain more knowledge on personal financial planning and to share that knowledge with others. Action Economics focuses on paying off the house, reducing taxes, and building wealth. John is the author of the book For My Children's Children: A Practical Guide For Building Generational Wealth.

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