Should You Contribute to a Roth or Traditional Retirement Account?

You’re saving for retirement diligently. Every month your account is growing, and by the time you retire, you will have saved $1 million to your 401(k). You’re a millionaire, right? Well, maybe not. Depending on how you saved it, that $1 million nest egg could be worth hundreds of thousands of dollars less. Why? If you saved into a pre-tax account, the tax man will want his cut when you withdraw the money.

But that’s not always a bad thing. Traditional retirement accounts, like a 401(k) or IRA, let you save money without paying tax on it today, and your earnings grow tax free. That means you can save more now (and let all that money grow over time). But you’ll pay taxes eventually.

This is where the Roth account comes in. When contributing to a Roth IRA or Roth 401(k), you put in money that has already been taxed. The money then grows tax free and you don’t pay any tax when you withdraw the money in retirement.

So now you’re probably wondering, “Should I make my retirement contributions on a pre- or post-tax basis?” Everyone’s situation is different, but in most cases, it’s a good idea to have a mix of both.

How it works: The basics of Roth and traditional accounts

Under our tax system, how much you owe in taxes depends on how much you earn. Individuals earning less money fall into lower tax brackets, and are subject to lower tax rates; individuals earning more money fall into higher tax rates, and are subject to higher tax rates. In other words, you don’t pay much in taxes until you start to earn more money.

Tax efficiency is all about managing your marginal tax rate, or the tax rate incurred on each additional dollar of income. As you earn more, a greater portion of your income falls into higher tax brackets—all the way up to a rate of 37 percent on every dollar of income over $578,126 (for single filers).

If you are just getting started in the workforce, your top tax bracket may be lower than where you’ll land later in your career—or in retirement, when you likely won’t be working and will be living off of your savings and investments.

That’s the thinking behind Roth accounts: If you think your current tax bracket is the same or lower than your expected tax bracket in retirement, it may make sense to contribute to a Roth. That way, you’ll pay taxes upfront at your current lower rate, but you’ll withdraw those funds tax free when you’re presumably in a higher tax bracket later on in retirement.

But if your current tax bracket is higher than your anticipated bracket in retirement, just flip the logic around. Rather than pay a higher tax rate today, you can contribute on a pre-tax basis and postpone the income tax bill until you retire into a more favorable tax bracket.

Using both gives you flexibility

Contributing to both traditional and Roth accounts offers you flexibility—today, while you’re saving for retirement, and in the future when you’re living off of those savings. As you save for retirement, altering your mix of pre- and post-tax contributions lets you control your income tax obligations today. This can be especially powerful for individuals whose income rises and falls from tax year to tax year. If, for example, your income fluctuates due to high commissions or big bonuses, your marginal tax rate may also fluctuate dramatically. The same can be said for business owners or freelancers, who may have a really strong year followed by a weaker one.

During a stellar year, you may be better off contributing to a traditional account on a pre-tax basis, deferring those taxes and paying a lower rate later. But during a weak year, if you fall into a tax bracket that is lower than you’d expect during retirement, having access to a Roth account can help you take advantage of that fact. Knowing when to contribute to one account vs the other can go far in helping your retirement plan become as tax efficient as possible.

And once you get to retirement, having a mix of pre- and post-tax savings can allow you to be tax efficient with your savings—again, due to our marginal tax system.

It also gives you diversity

In deciding whether to allocate your money to a traditional or Roth account, you must necessarily make a number of assumptions about what your tax situation is going to be in the future. However well you plan, there’s always the possibility that you might be wrong.

“The truth is, no one can predict with 100 percent certainty where tax brackets are going to go, or what a person’s tax situation is going to be 40 years from now,” says Andrew Weber, senior director of planning philosophy, research and guidance at Northwestern Mutual. “If tax brackets change in a way that you perhaps didn’t anticipate, your retirement account could end up being less tax efficient than you’d hoped.”

Weber says leveraging both traditional and Roth accounts as a kind of diversification, because saving in both pre- and post-tax accounts allows you to hedge for a variety of situations which may or may not come to pass. This helps you control for a variety of known and unknown risks.

“You diversify your investment portfolio for different returns in different market environments,” he says. “Why not do the same thing for your retirement income streams?”

There are some rules to consider

Income maximums: Your ability to contribute to a Roth IRA starts to phase out if you earn more than $138,000 as a single filer and $218,000 for married couples filing jointly. Once you earn more than $153,000 as a single filer, or $228,000 filing jointly, you aren’t eligible to open a Roth IRA. However, there are no income restrictions on contributions to a Roth 401(k) through your employer.

“Another option for those over the contribution limit is a Roth conversion,” Weber says. “"If you are over the contribution limits for Roth IRAs, a Roth conversion allows you to pay taxes on the money on traditional IRA dollars and move them into a Roth account."

Required Minimum Distributions: The IRS mandates required minimum distributions (RMDs) from 401(k) plans, Roth 401(k) plans, traditional IRAs and several other retirement savings vehicles once you reach age 70-1/2. Basically, the IRS wants to get its cut from all that tax-advantaged growth. These mandatory distributions will serve as the floor for your income level and could impact your marginal tax rate.

However, Roth IRAs are not subject to RMDs.

It doesn’t need to be either/or

The question of whether you should invest through a traditional or Roth retirement account may seem like it should have a single answer, but the truth is much more nuanced. Ultimately, the best decision for you will depend on your personal financial situation and retirement goals.

Generally speaking, however, most individuals can benefit by saving through both types of accounts when it makes sense to do so throughout their careers. Doing so empowers you to take advantage of the maximum tax benefit possible, while providing you with flexibility and diversification in retirement.

If you’re still unsure whether it makes sense to have both types of accounts, a Northwestern Mutual financial professional can help you weigh your options and build a financial plan that takes tax efficiency before and during retirement into consideration.

CFP disclosure:  

Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™ and CFP® (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements. 

Tax disclosure: 

This article is not intended as legal or tax advice. Northwestern Mutual and its financial representatives do not give legal or tax advice. Taxpayers should seek advice regarding their particular circumstances from an independent legal, accounting or tax adviser.