Traditional, Roth, and Taxable, Oh My!
In casual conversation, it’s not uncommon that the topic turns to retirement plans. As I reflect on these conversations, it occurs to me that there may not be a clear understanding of the differences between types of accounts.
For simplicity sake, we are going to limit our discussion to traditional and Roth 401(k) and IRA plans, as well as taxable accounts. Consider each of these as baskets that hold investments in them.
A main difference between these accounts is their tax treatment.
The traditional plan.
Traditional 401(k) plans and IRAs have beneficial tax characteristics. What I mean by this is that contributions are made on a pre-tax basis. These pre-tax contributions have the effect of reducing your taxable income in the current year. Likewise, if you invest the contributions (which you should), these will grow without tax year over year. When you ultimately take out the money, the distributions will be taxed at your ordinary income tax rate.
So the money in your traditional 401(k) or IRA doesn't all belong to you. In effect, the government is allowing you to defer taxation, so part of the money in your traditional plan belongs to Uncle Sam.
These plans are designed for retirement in mind. Therefore, in most cases distributions taken out before age 59 ½ will be subject to ordinary income tax, as well as an additional 10% tax. There are a few exceptions, including one under § 72(t) of the Internal Revenue Code that allows one to avoid the additional 10% early withdrawal tax if distributions are taken out in the form of a series of substantially equal periodic payments. But these exceptions are a topic for another article.
By means of this additional tax, the government incentivizes you to refrain from withdrawing from your traditional accounts prior to age 59 ½. Additionally, the taxpayer is generally required to take what are known as Required Minimum Distributions (RMDs) to begin by April 1st of the calendar year after the calendar year the taxpayer turns 70 ½.
In 2019 traditional 401(k) plans limit employee contributions to $19,000. For those over 50, an additional $6,000 is allowed to be contributed, bringing the total limit to $25,000. For traditional IRA plans, contributions are limited to $6,000 for those under 50, and $7,000 for those age 50 or older. The deductibility of IRA contributions is subject to your filing status, adjusted gross income, and whether or not you or your spouse are covered by an employer retirement plan.
More and more employers are offering Roth 401(k) plans. For Roth accounts, contributions are made on an after-tax basis. In other words, unlike the traditional plans, Roth plans offer you no tax deduction in the current tax year. Growth in the account is tax free, and distributions are tax free as well, so long as they are taken after 59 ½. There are some nuances for the 59 ½ rule for Roth IRAs that we won’t review in this article.
As your income increases, direct contributions to Roth IRAs may not be possible, and you may need to employ the use of what is commonly known as the “Back Door” Roth IRA. For example, in 2019, taxpayers who are married filing jointly begin to be phased out of their ability to contribute directly to Roth IRA plans when their modified adjusted gross income reaches $193,000. They are completely phased out from making direct Roth IRA contributions once this amount reaches $203,000.
Unlike the Roth IRA, Roth 401(k) plans do not have an adjusted gross income phase out.
Another difference between the Roth 401(k) and Roth IRA plans is that the Roth 401(k) plan is subject to the Required Minimum Distribution rules. In contrast, the Roth IRA has no RMD requirement.
The contribution limits for Roth 401(k) and Roth IRA plans are the same as their corresponding traditional 401(k) and IRA plans.
A taxable account does not have the favorable tax treatment of traditional and Roth plans. There is no deduction for contributions, any income or gains realized will be taxed as the account grows, and when assets are sold and money is distributed you are taxed at short or long term capital gains tax rates.
However, a taxable account does not have contribution limits, nor does it have income-limit rules. You don’t have to wait until you’re 59 ½ in order to take distributions, nor are you compelled to take distributions at age 70 ½.
Because taxable accounts are not designated as retirement accounts, you lose the favorable tax characteristics of retirement accounts, but gain a bit more flexibility in terms of when the money is used.
What types of accounts should you use?
As always, this will be unique to your situation. You will need to consider your current tax bracket and whether or not you believe it will be higher or lower than your tax bracket in retirement. You will also need to consider the time horizon for when you will need the money.
Let’s consider a few scenarios. Imagine that you find yourself in peak earning years. In this case, it is likely to your advantage to contribute to traditional retirement plans in order to reduce taxable income today, and ideally withdraw the funds at a lower tax rate in retirement.
Alternatively, if you find yourself in a lower tax bracket relative to what you believe your rate will be in retirement, there’s an argument to contribute to a Roth plan.
And if your time horizon requires the use of the investment proceeds before age 59 ½, the best option may be a taxable account so that you can access the funds without having to deal with the 59 ½ rule and the additional 10% tax.
Given the uncertainty of the future, I believe it makes sense to diversify your situation from a tax perspective. Meaning that it may be favorable to have all of the options we’ve discussed. By doing so, you can make strategic decisions depending on the current tax environment you find yourself in both now, and in the future.
Unless you will need the money prior to age 59 ½, it likely makes sense to fill the retirement buckets first, and then once you’ve hit your contribution limits to begin making contributions to the taxable bucket.
Your unique situation will dictate the path you should take forward.
The content you just read is for informational purposes only. Yes, I’m a financial advisor, but this article really isn’t intended as advice for you specifically. Your unique situation needs to be taken into account, and the ideas presented here may not apply.
So, please make sure you do your due diligence BEFORE implementing anything. Due diligence may include hiring a qualified professional who understands your situation completely and can offer you personalized advice.