IRA, 401(k), Roth account?

Is A Traditional or Roth Retirement Account Better?

Saving in a retirement account is a great way to prepare for your future. Especially, when you take into consideration the tax-advantages retirement accounts like the TSP, 401(k)s, and IRAs provide. There are generally two ways to save: traditional and Roth accounts. While both have their advantages and disadvantages, choosing between them is a decision that should be made based on your personal financial goals and circumstances. In this article, we’ll share the pros and cons of each option and help you understand which one makes the most sense for you.

TRADITIONAL vs. ROTH RETIREMENT ACCOUNTS: AN OVERVIEW

A traditional retirement account is tax-deferred. It allows you to contribute pre-tax dollars and reduce your taxable income for the year you make the contribution. Your contributions, as well as any gains, are then taxed when you withdraw the money during retirement. On the other hand, a Roth retirement account allows you to contribute after-tax dollars. This means your contributions will not be tax-deductible from your income. The flip side to this is that you will not pay taxes on withdrawals during your retirement.

The contribution limits for retirement accounts are updated frequently. For TSP, 401(k), and 403(b) participants, the 2024 contribution limit is $23,000. If you’re over age 50, you can make an additional $7,500 catch-up contribution for the year. But a big difference between traditional and Roth accounts is that traditional accounts may require minimum distributions at age 73 whereas Roth accounts do not have this requirement.

The decision on which account type to choose depends on your own circumstances. Let’s dive deeper into the situations that would make a traditional retirement account preferable over a Roth, and vice versa.

WHY CHOOSE A TRADITIONAL ACCOUNT?

Generally, many people will be in a lower tax bracket when they retire. In this case, it may make the most sense to contribute to a traditional retirement account. For instance, imagine you currently earn $150,000 as a federal employee. This puts you in the 24% marginal tax bracket. Now imagine that your income drops to $75,000 in retirement, putting you in the 22% tax bracket. Would you rather pay a higher rate now, or receive a tax deduction for the current year? In this example, it makes sense to take the deduction now and pay a lower rate in retirement. So, most would opt for the current year’s tax deduction and contribute to the traditional account.

Traditional accounts make sense if your income is higher and you want to reduce your tax liability. This approach is common for federal government employees at higher NAF or GS levels, or on the SES pay scale, and with many years of service.

But the truth is, analyzing the tax benefits of a traditional versus Roth retirement account isn’t as simple as this example may imply. That’s because you have to pay tax on both contributions AND earnings in retirement when you contribute to a traditional account. The benefit of the traditional account is more valuable in the long run IF you invest the tax savings you earn from the deduction. Doing this will help make up for the tax payments in retirement. Many people think they will invest the extra funds, but don’t actually stick to the plan. So, make sure you have a plan and think through your strategy.

WHY CHOOSE A ROTH ACCOUNT?

If you believe you’ll be in a similar or higher tax bracket in retirement, a Roth account may be a better option. Roth accounts also make sense if you believe that taxes generally will be higher by the time you retire. For instance, some people believe it’s only a matter of time before Congress raises taxes again. They would rather pay based on today’s rates rather than the unknown rate in the future. Essentially, utilizing a Roth account can be viewed as pre-paying your future tax liability. Some people prefer the idea of their taxes are already paid.

Additionally, if you have a particularly low-income year, it can make sense to contribute to a Roth or utilize a Roth conversion. It’s appealing because you’re in a lower tax bracket for the year. By paying taxes on the contributions now, you can avoid paying taxes on the withdrawals (both contributions AND earnings) in retirement.

WHY NOT BOTH TRADITIONAL AND ROTH?

Sometimes the traditional versus Roth comparison overlooks the idea that you don’t have to choose one or the other! It might be best to have a combination of both pre-tax and after-tax retirement savings.

THE LAW OF COMPOUNDING INTEREST

One last consideration is the law of compounding interest. Compare each retirement accounts tax advantages through the lens of compounding interest. Simply put, the larger the amount you save early in the compounding process, all things being equal, the larger your account will be in the future.

HOW WE CAN HELP?

Choosing the right combination of after-tax and pre-tax retirement funding options is an important decision that depends on many personal factors. At Sentinel Financial Planning, we’re here to help federal employees, service members, and business owners navigate retirement planning and make well-informed financial decisions.

Schedule a no-obligation consultation, and together let’s find out if we’re the right people for you to depend upon during your journey, to and through, a happy retirement. Contact us at (443) 906-1565 or mark@sentinelfp.com today!

ABOUT MARK

Mark Humphries, CFP® is the owner and financial advisor at Sentinel Financial Planning, a boutique, veteran-owned and operated investment management and financial planning firm. Mark focuses on helping federal government employees, military members, and business owners manage their investments and plan for retirement. As a former military service member and federal employee with over 10 years in the financial industry, he is familiar with the Federal Employee Retirement System (FERS) and the Thrift Savings Plan (TSP) and is uniquely qualified to serve his clientele.