Traditional versus Roth

It is a common investment decision whether to use a traditional or Roth account. You must make this decision if your employer offers both a Traditional and Roth 401(k), or when you can invest in either your Roth IRA or your employer's Traditional 401(k), or when you consider a Roth IRA conversion.

In a traditional retirement account such as a deductible Traditional IRA or Traditional 401(k), your contributions are deductible, and you pay tax on withdrawals. In a Roth retirement account such as a Roth IRA or Roth 401(k), your contributions are not deductible, but you can usually withdraw the entire account tax-free in retirement  Either one may be a better investment choice; here are some of the considerations.

General guidelines
The following guidelines are relevant for most investors, e.g., they assume a marginal withdrawal tax rate of 15% or more. See below for explanations, and remember to check your own situation.

Non-tax considerations (Traditional 401(k) vs. Roth IRA):
 * If your employer matches 401(k) contributions, put enough to get the maximum match in the 401(k) before contributing to any IRA.
 * If you have inferior options in the 401(k), prefer an IRA to unmatched 401(k) contributions.

Tax considerations:
 * If your current marginal tax rate is 15% or less, prefer a Roth.
 * If you expect to have higher marginal rates than your current marginal rate for most of your career, prefer a Roth.
 * If you will have a traditional account or a pension large enough to meet your expected retirement expenses (and you expect to take that pension shortly after retiring), prefer a Roth.
 * Otherwise, prefer a traditional account.

Taxes
The main reason to prefer one type of account over the other is the comparison of marginal tax rates. If your marginal tax rate now is higher than your estimated marginal tax rate at retirement, then the traditional account is better; if it is lower, then the Roth account is better.

For example, if your marginal tax rate is 25%, you can contribute $3000 to a Roth account, or $4000 to a traditional account for the same $3000 out of pocket. If the account doubles in value, then you could have $6000 in the Roth account, or $8000 in the traditional account. Thus, if you retire at a 25% marginal tax rate, you will pay $2000 in tax when you withdraw the $8000 and wind up with the same $6000. If you retire at a 15% marginal tax rate, you will pay only $1200 in tax when you withdraw the $8000 and wind up with $6800.

Note: If you can maximize your IRA contribution, see below.

Marginal tax rates
The reason to use marginal tax rates in this decision is that you can make the decision separately for every dollar you invest. If the next dollar you invest will be taxed at 25% now and 25% when you retire, then the tax situation is break-even. However, if you put a lot into the Roth account, you may increase your taxable income to the 28% tax bracket this year, or reduce your retirement income so that you retire in the 15% bracket, making the Roth less attractive.

This is why a Roth is attractive for young workers who expect to be in higher tax brackets later. You can contribute to a Roth account while you are in a 15% bracket in your first few working years, then entirely to a Traditional 401(k) when you move up to the 25% and 28% brackets later, and retire in a 25% bracket because most of your retirement income will come from your mid-career contributions.

Your marginal tax rate is not necessarily your tax bracket, because of phase-ins and phase-outs of tax benefits; see Marginal tax rate for a more detailed explanation.

A common misunderstanding about traditional accounts is "contributions are taken from the top while withdrawals come from the bottom": in other words, that one saves a marginal rate when contributing but pays only an average rate (starting at 0% for the first dollar withdrawn) when withdrawing. That is true in a limited sense - limited, that is, to the very first traditional contribution one makes. After that, subsequent contributions will be withdrawn on top of the withdrawals due to previous contributions. One must therefore calculate the marginal withdrawal tax rate due to those subsequent contributions.

For example, assume a couple already has enough in traditional accounts to withdraw $42,000/yr (giving a taxable income of $21,300), currently earn $90,000/yr (taxable income of $69,300) and expect to earn that amount for the foreseeable future. They are looking at an $18K 401k contribution and expect it to grow at 5% for 15 years, at which time they will withdraw 4%/yr from what that $18K has grown to, or ~$1,500/yr.

For this couple, the contribution tax rate is 15% (marginal tax rate stays at 15% as the taxable income drops from $69,300 to $51,300), and the withdrawal tax rate is also 15% (marginal tax rate stays at 15% as the taxable income increases from $21,300 to $22,800 and tax goes from $2,268 to $2,493). It would be incorrect to compare a 15% contribution rate to the average withdrawal tax rate of $2,493/$43,500 = 5.7%.

Child tax credit
One of the most important phase-outs is the child tax credit. The credit is up to a $1,000 per child if modified adjusted gross income is $110,000 for married filing jointly, $75,000 for single, head of household, or qualifying widow(er), and $55,000 for married filing separately. The credit is reduced by $50 for each $1,000 of income above these threshold amounts. Given that traditional contributions lower MAGI, investors with qualifying children may have an advantage with traditional contributions if doing reduces their adjusted gross income and makes them eligible for the credit, or for a larger credit. Since the phase-out rate is 5%, your marginal tax rate is 5% higher than your tax bracket if your MAGI is in the phase-out range.

Many of the education tax credits also phase out for middle-income taxpayers, so you might prefer traditional contributions when you expect to take those credits.

Saver's Credit
Saver's Credit is effectively a match from the IRS on your retirement contributions if you have a relatively low income. The credit is given for contributions to either traditional or Roth accounts. However, there are two advantages which may make traditional contributions more attractive. If you cannot afford to contribute $2000 to a Roth account, then you can contribute more to a traditional account for the same out-of-pocket cost to get a larger match. In addition, the credit is based on your adjusted gross income; contributions to a Traditional IRA or 401(k) reduce your adjusted gross income and may make you eligible for the credit, or for a larger credit.

The saver's credit is one reason that someone in a low tax bracket might have a high marginal savings rate and thus prefer using a traditional account.

College aid
While the Expected Family Contribution for college financial aid is not a tax, it works the same way as a tax, as it is calculated based on a percentage of your income from the year before you file the form. But it counts after-tax income, including retirement contributions, and thus creates an advantage for the Roth as long as the Roth contribution does not cause education tax credits to phase out. For example, if you are in a 25% tax bracket and contribute $10,000 to a Traditional 401(k), the $10,000 is not subtracted from your income, and the $2500 tax savings is added to your income, so your EFC for the next year is increased by $1175 if you are subject to the 47% marginal rate. If you instead contribute $7500 to a Roth 401(k) for the same out-of-pocket cost, your EFC is not increased.

Do not convert a Traditional IRA to a Roth while you have children in college; the amount of the conversion is counted in your income for both EFC and tax purposes, so it will increase your EFC as well as possibly causing education benefits to phase out.

Lower taxes in retirement
Most retirees have the same or lower marginal tax rate than when they were working, and thus should prefer a traditional account to a Roth if the options are comparable.

When you retire, you will only pay tax on income earned outside a retirement account, and on the money you actually withdraw for spending. In addition, if any of your retirement spending comes from Roth accounts, it will not be taxed, and if it comes from taxable capital gains or qualified dividends, it will be taxed at a lower rate than your marginal tax rate. Therefore, you can spend the same amount but have less taxable income. This is why many investors should prefer traditional accounts, particularly if they already have Roth IRAs.

One important exception is the phase-in of taxation of Social Security benefits. If you are in the phase-in range, you may retire in a 15% tax bracket with a 27.75% marginal tax rate. Therefore, if you are in a 15% tax bracket now, and have a 15% marginal tax rate because you are not in any tax phase-out ranges, you will probably retire in a 15% tax bracket unless most of your retirement money is in Roths. You should not invest entirely in Roths for your whole career, as you would then retire in a 0% bracket, but you should generally prefer Roths, using traditional accounts for those years you happen to be in higher tax brackets, or for years later in your career if you have too much in Roths.

The opportunity to convert later
If you contribute to a traditional IRA, you can convert to a Roth IRA in a later year. If you contribute to a traditional 401(k) and leave your employer, you can roll the 401(k) into a traditional IRA and then convert it later, or roll it directly to a Roth IRA. In either case, you may come out ahead if you can convert in a lower tax bracket, because you pay the taxes in the year of conversion instead of the year of contribution.

This increases the benefit from using traditional accounts when you retire in a low tax bracket. If you retire in a 15% tax bracket before taking Social Security, and don't need the whole 15% tax bracket for living expenses, you can convert part of your Traditional IRA to a Roth at 15%, reducing the amount you will have in the IRA when you start taking Social Security.

But if you expect to retire in the same tax bracket, this is not a significant extra advantage for the traditional accounts. If you are usually in a 25% tax bracket and retire in a 25% tax bracket but happen to have some years in a 15% bracket (large deductions, unemployed part of the year, one spouse takes off from work or works part-time to care for children), you can convert up to the top of the 15% bracket in those years, and you can make those conversions from any traditional accounts you have, whether or not you have Roth accounts.

State taxes
Consider state taxes as well as federal taxes in your tax rate comparisons, both for the state you live in and for the state you expect to retire in.

Some states do not allow deductions for traditional account contributions, or only allow them for some types of contributions (New Jersey, for example, allows deductions for 401(k) but not 403(b) or IRA contributions); if you live in such a state, the Roth has an advantage. If your state allows a deduction but you might retire in a state which has no tax or will not tax your Traditional IRA withdrawals, then the Traditional IRA has a potential advantage; conversely, if your state has no income tax but you might retire in a state which taxes Traditional IRA withdrawals, the Roth has a potential advantage.

Tax risk
If all else is equal (that is, you expect to retire in the same bracket, and never to have the opportunity to convert in a lower bracket), the Roth account has a slight advantage because there is less tax risk. You might not retire with the same marginal tax rate that you expect, either because tax rates change or because your taxable income is higher or lower.

If you will have a lot of money in retirement, it is desirable to have some Roth money because of Required Minimum Distibutions. If all of your retirement money is in traditional accounts, you will have to take the RMDs even if that is more than you need to live on, and thus pay tax prematurely. If you have Roth accounts which you do not need in your own retirement, you can leave them for your heirs.

Investment options
You may have different investment options in traditional and Roth accounts. If your employer offers a Traditional 401(k) but not a Roth 401(k), then you must use traditional accounts if you invest in the 401(k). If you are over the income limit for a deductible Traditional IRA, then you must use a Roth account if you invest in an IRA (a non-deductible IRA cannot be better than either a deductible or Roth account). The choice of account, or benefits within the account, may be more important than the different tax treatment of traditional and Roth accounts.

Employer match
If your employer matches 401(k) contributions, this is by far the best investment you can make, as it has an immediate return equal to the match rate. Therefore, regardless of the quality of your employer's plan, you should get the maximum match before investing anywhere else.

If your employer offers both traditional and Roth accounts, any match goes to a traditional account. Therefore, if you cannot contribute enough to a Roth to get the maximum match, you should prefer the traditional account. For example, if you are in a 15% tax bracket and your employer will match 100% of your contribitions up to $4000, then you can contribute $3400 out of pocket to a Roth 401(k) and get a $3400 match in the Traditional 401(k), or $4000 to a Traditional 401(k) (with $600 in tax savings) and get a $4000 match.

Investment quality
Many 401(k) plans, and even more retirement plans of other types such as 403(b) plans, have inferior investment options. If you invest in high-cost funds in a 401(k), you will usually lose more to the high costs than you can gain from any tax difference between the 401(k) and IRA. Some plans have only high-cost options; in such a plan it is better to max out your IRA (Traditional or Roth) before making unmatched contributions to the 401(k). Other plans have some low-cost options, but have no options or high-cost options in some asset classes; in such a plan, you should prefer to invest enough in an IRA (Traditional or Roth) to cover the asset classes with no good option in the 401(k). Once your IRA is maxed out, it is usually worth contributing even to a bad 401(k).

Conversely, some retirement plans, such as the Thrift Savings Plan, have better options than are available to retail investors in IRAs. If you have such a plan, you may prefer that plan to an IRA, even at a tax cost.

Examples of investment choices and conversion
For the purpose of these examples, we assume that every $1 in your tax-deferred or tax-free account will grow to $5 when you retire (and then be taxed if not in a Roth), and $1 in a taxable investment will grow to only $4 after tax (including the tax on capital gains when you sell it). One set of conditions that would provide those results:
 * Tax rate on dividends and capital gains: 20%
 * Years invested: 20
 * Annual dividend yield: 2.91%
 * Annual growth rate (excluding dividends): 5.47%

Not maxing out your retirement accounts
These examples are based on contributing $7200 to a Roth account when you are in a 28% tax bracket. Thus, if you are not maxing out your traditional account, you could contribute $10,000 to a traditional account for the same out-of-pocket cost.

The numbers are exactly the same if you are considering converting a $7200 Traditional IRA to a Roth IRA and paying the $2016 tax instead of contributing $2800 to a Traditional IRA or 401(k), or converting a $10,000 Traditional IRA to a $7200 Roth IRA and paying the $2800 tax with the rest of the IRA. Either way, the conversion causes you to have $7200 in Roth accounts rather than $10,000 in Traditional accounts.

If you contribute to the Roth, you will have $36,000 in the Roth to spend in retirement.

If you contribute to the traditional account, you will have $50,000 in that account, which will become $42,500 after tax if you retire in a 15% bracket, $37,500 if you retire in a 25% bracket, $36,000 if you retire in a 28% bracket, and $33,500 if you retire in a 33% bracket. Thus it is break-even to contribute to the Roth if you retire in a 28% bracket and the Roth is just as good as the traditional account.

If you have the choice between contributing to a Roth IRA and an inferior 401(k), then you should prefer the Roth IRA even if you will retire in the 25% bracket. You would have $37,500 using the 401(k) and retiring in a 25% bracket if the 401(k) were just as good as the Roth. If it loses 3% to higher expenses (say 0.3% a year for ten years) before you can roll it into an IRA, it will only be worth $36,000, and the expenses wipe out the tax advantage.

The 401(k) would have to be fairly bad, and you would have to be stuck with it for a long time, to make it better than a Roth if you retire in a 15% bracket; even a 15% cost on the $42,500 would leave you with $36,125.

Likewise, if you are considering converting and you retire in a 25% bracket, the conversion is not a good idea unless you have a fairly bad 401(k). The choice is between $7200 in the Roth worth $36,000 at retirement, or $7200 in the traditional IRA worth $27,000 after-tax at retirement and $2800 in the 401(k) worth $14,000 pre-tax and $10,500 after-tax at retirement. Unless your 401(k) expenses consume more than 16% of the $10,500, you will have more than $36,000 at retirement.

Maxing out your retirement accounts
The IRS sets a maximum contribution to retirement accounts; if you have reached this maximum, anything else you contribute must be in a taxable account, which will lose much more to taxes than either a traditional or Roth account. The IRS limits do not distinguish between traditional and Roth accounts. If you contribute the maximum to a traditional account, you will pay less in taxes, but you will have to invest any tax savings in a taxable account. Therefore, if you can hit the IRS limit, a Roth account has an advantage because it effectively lets you tax-defer more money.

The benefit of effectively tax-deferring more money is reduced by any difference in tax rates, and by extra fees you pay in a retirement account. The extra fees won't apply to IRA accounts (because one can hold the same fund for the same fees at one brokerage for traditional, Roth or taxable accounts) but may apply to 401k, 403b, etc.

If you will have mostly taxable income in retirement (because of a pension or a large traditional IRA or 401(k)), then it is likely that you will retire in a tax bracket equal to or only slightly lower than your current tax bracket, and you should prefer a Roth. If you will have mostly non-taxable income in retirement (because you have a large Roth account) or income taxed at a lower rate (because you have a large taxable account), you might retire at a much lower marginal tax rate; it isn't worth tax-deferring a bit more in a Roth if you have to pay 33% now to avoid paying 25% later.

The effect of taxes on your taxable account is more pronounced the further you are from retirement, and the effect of extra fees in your retirement account is more pronounced the longer you stay with that employer.

For example, consider contributing the IRS maximum of $18,000 to a Roth 401(k), or contributing the same $18,000 to a Traditional 401(k) and investing the $5040 tax savings (28% bracket) in a taxable account.

The equivalent conversion decision would be to convert a $18,000 Traditional IRA to a Roth IRA, paying the $5040 tax with money that would otherwise have been invested in a taxable account.

If you use the Roth 401(k), you will have $90,000 in retirement. If you use the Traditional 401(k), you will have $20,160 to spend in your taxable account, and your Traditional 401(k) balance will be $90,000.

If you retire in a 15% tax bracket, your 401(k) will be worth $76,500, for a total of $96,660. If you retire in a 25% tax bracket, your 401(k) will be worth $67,500, for a total of $87,660. If you retire in a 28% tax bracket, your 401(k) will be worth $65,400, for a total of $85,560. If you retire in a 33% tax bracket, your 401(k) will be worth $60,300, for a total of $80,460. Thus it is better to use the Roth even if you are in the 28% bracket now and will retire in the slightly lower 25% bracket.

Here is a spreadsheet that allows you to plug in your own numbers:
 * Traditional versus Roth (401(k) or IRA)

Resources

 * Bogleheads' Guide to Retirement Planning, Chapter 10
 * Roth vs Traditional 401K on Bogleheads.org forum, 5 March 2008.
 * Why the Roth IRA bias? on Bogleheads.org forum, 14 October 2010.