Would you rather invest in your future using “pre-tax” dollars or “after-tax” dollars? I recently had a friend ask me if I thought that he should be making Roth contributions to his retirement account or not. Roth IRA accounts have become incredibly popular investment vehicles and a lot of that is for good reason. However, it is important to understand the difference between Roth and “traditional” retirement accounts in order to know what the best decision for your financial future is.
What are Roth Contributions?
Roth contributions work the exact opposite way that traditional pre-tax contributions do. Traditionally, contributions to a qualified retirement account like an IRA, 401(k), 403(b), SEP, etc. are made with pre-tax dollars, meaning that you get a tax deduction the year you make the contribution equal to the amount you contribute. However, once you reach retirement age (59 ½) and you begin taking money out of the account your withdrawals are taxed as ordinary income.
Roth contributions are made with after-tax dollars and you receive no upfront tax deduction when you make the contribution, but your withdrawals are tax-free upon retirement (there are exceptions to this I will explain below).
Who Can Make Roth Contributions?
The most common way to make Roth contributions to a retirement account is by utilizing a Roth IRA. Just like Traditional IRA’s, Roth IRA accounts have a contribution limit that is equal to $6,000 in 2021 ($7,000 if you are over the age of 50). However, unlike Traditional IRA’s, which allow anyone with earned income to make contributions, Roth IRA’s have an income limit that prohibits some high-income earners from making direct contributions.
Income limits for Roth IRA’s are based on what is called Modified Adjusted Gross Income (MAGI), which is equal to the adjusted gross income on your tax return with deductions such as student loan interest, self-employment taxes, and education expenses added back in. The ability to make Roth IRA contributions starts to phase out at a MAGI of $125,000 for single filers ($198,000 for married filing jointly). At $140,000 of MAGI ($208,000 MFJ) direct Roth IRA contributions are entirely disallowed.
However, for those who are above the income limits for direct Roth IRA contributions, there is still a way to contribute using a strategy often referred to as a “backdoor Roth contribution.” This strategy involves making contributions to a Traditional IRA and then later converting those funds to a Roth IRA. While direct Roth IRA contributions are disallowed for those above the income limits, Roth conversions are still allowed. The key thing to remember is that all of the IRA money that gets converted to a Roth becomes immediately taxable the year of the conversion since the contributions were originally made with pre-tax dollars.
Additionally, it is becoming more common for employers to include the ability to make Roth contributions to their employer-sponsored plans such as 401(k)’s. 401(k)’s have much higher contribution limits ($19,500 for 2021) and there are no income limitations to contribute to a Roth 401(k).
What Else is Special About Roth IRA Accounts?
It’s important to remember that funds in a Roth IRA Account are split into two categories that each have their own rules and restrictions: earnings (interest) and contributions.
Unlike traditional retirement accounts that are funded entirely with pre-tax money, there is a large portion of your Roth account that you have already paid taxes on (your contributions) and therefore have fewer restrictions on. You can withdraw contributions you made to a Roth account at any time without penalty. However, the interest that is earned within your Roth IRA Account has not yet been taxed, so some additional rules must be adhered to to ensure you receive this money tax and penalty-free.
In addition to waiting until age 59 ½, there is also a 5-year waiting period that must be met from the time of your first Roth contribution for the earnings to be withdrawn tax and penalty-free. Keep in mind that BOTH requirements must be met. For example, if you make your first Roth contribution at age 57 you can only withdraw earnings tax and penalty-free beginning at age 62 once the 5-year waiting period has been met.
Should You Make Roth Contributions or Pre-Tax Contributions?
I will answer this question with the most common financial planning response there is: “it depends.” Everyone’s situation is unique and whether it is a question of taxes, access to funds, or even simplicity of personal accounting, people will have their own reasons for choosing to invest in retirement accounts on a pre-tax or after-tax (Roth) basis.
All else being equal, Roth IRA accounts get bonus points in my book due to the flexibility they provide. Not only do you have the ability to withdraw your contributions at any point tax and penalty-free, but there are also certain situations in which you can dip into the earnings in a Roth account without incurring an additional penalty, such as for a first-time home purchase or if the withdrawal is due to a disability. Keep in mind that you will still need to pay taxes on the earnings if you are younger than 59 ½ and/or have not met the 5-year window.
However, from a mathematical perspective, the answer is a bit clearer. If you are making more money now than you think you will at retirement age then you should make pre-tax contributions, and if you are making less money now than you think you will at retirement age then you should make after-tax, or Roth, contributions. The reason for this is that the deduction you receive is most valuable when you are in the higher tax bracket since every “next-dollar-earned” is taxed at a higher rate.
This rule of thumb usually gets spun into “young savers should use a Roth account and older savers should use a Traditional account,” but that doesn’t always tell the full story. There are plenty of cases where someone older can utilize the advantages of a Roth account.
Check out additional Roth IRA resources at our Roth IRA page.