As we’ve discussed here before, the question of whether you should use Roth savings (i.e., a Roth 401(k) or Roth IRA) as opposed to tax-deferred savings (such as a regular 401(k) or traditional IRA) is primarily a function of tax brackets:
- If you expect your tax bracket to be higher when you’re withdrawing the money than it is when you’re contributing the money, a Roth is a better choice.
- If you expect your tax bracket to be lower when you’re withdrawing the money than it is when you’re contributing the money, tax-deferred savings are a better choice.
- If you have no idea, it’s probably wise to do some of both.
There are exceptions of course. But the above breakdown is generally true.
What if Tax Rates Are Going Up?
One of the most common arguments I see in favor of choosing Roth accounts is that tax rates are likely to rise in the future as a result of our country’s enormous deficit.
Leaving aside any qualms about that assumption, there’s a big hole in this line of thinking: It overlooks the fact that most people have meaningfully less taxable income during retirement than they had when working. (This is pretty intuitive; for most people, when they leave their jobs, their taxable income goes down.)
Where Will Your Income Come From?
When making the Roth vs. tax-deferred decision, rather than basing it entirely on the direction in which you expect legislative tax rates to move, it’s important to also ask what types income you’ll have in retirement.
For example, how much of your income will be from fully taxable sources such as:
- A pension,
- Part-time job income,
- Tax-deferred savings, or
- Rental property?
And how much of your income will be from sources that are only partially taxable (or fully taxable, but at lower rates) — things like:
And how much of your expenses will be satisfied with money that’s entirely tax-free, such as:
- Roth IRA savings,
- Roth 401(k) savings, or
- Taxable holdings where your cost basis is equal to (or greater than) the market value?
The less of your income that you expect to come from the first (fully taxable) category, the lower your tax bracket in retirement is likely to be (even if legislative tax rates do rise), and the less sense Roth savings make relative to tax-deferred savings.