When Not to Open a Roth IRA

In the family of financial planning products, the Roth individual retirement account (IRA) sometimes looks like the cool younger brother of the traditional IRA. Indeed, the Roth version, first introduced in 1997, offers a number of attractive features that its standard sibling lacks: the absence of required minimum distributions (RMDs), plus the flexibility to withdraw money prior to retirement without penalties.

A Roth indeed makes sense at certain points in your life. At others, however, the traditional version of the IRA or 401(k) has a strong allure as well. Often, choosing between one or the other comes down to how much you’re making now and how much you expect to bring in once you stop working.

Different Accounts, Different Tax Treatments

Here’s a quick refresher on the respective major types of retirement accounts. Both offer distinct tax advantages for those squirreling away money for retirement. However, each works a little differently.

With a traditional IRA or 401(k), you invest with pretax dollars and pay income tax when you take money out in retirement. You then pay tax on both the original investments and on what they earned. A Roth does just the opposite. You invest money that’s already been taxed at your ordinary rate and withdraw it—and its earnings—tax-free in retirement whenever you want, provided you’ve had the account for at least five years.

Another benefit of a Roth is that you can withdraw the amount you contributed (though not your earnings) at any time—even before you retire—tax- and penalty-free.

In choosing between Roth and traditional IRAs, the key issue is whether your income tax rate will be greater or lesser than at present once you start tapping the account’s funds. Without the benefit of a crystal ball, that’s impossible to know for sure; essentially, you’re forced to make an educated guess.

For instance, Congress could make changes to the tax code during the intervening years. There’s also a time factor. If you’re opening the Roth late in life, you need to be sure you’ll be able to have it for five years before starting to take distributions in order to reap the tax benefits.

The Case for a Roth

For younger workers who have yet to realize their earning potential, Roth accounts have a definite edge. That’s because when you first enter the workforce, it’s quite possible that your effective tax rate, expressed as a percentage, will be in the low single digits. Your salary will likely increase over the years, resulting in greater income—and quite possibly a higher tax bracket—in retirement. Consequently, there’s an incentive to front-load your tax burden.

“We advise younger workers to go with the Roth because time is on their side,” says financial advisor Brock Williamson, CFP, with Promontory Financial Planning in Farmington, Utah. “Growth and compounding are one of the beautiful truths about investing, especially when the growth and compounding are tax-free in the Roth.”

Another reason is that if you’re young, your earnings have decades to compound, and with a Roth, you will owe zero taxes on all that money when you withdraw it at retirement. With a traditional IRA, you’ll pay taxes on those earnings.

On the other hand, if you choose a traditional IRA or 401(k), you have to divert less of your income to retirement in order to make the same monthly contributions to the account—because the Roth would essentially require you to pay both the contribution and the taxes you paid on that amount of income. That’s a plus for a traditional account, in the short term, at least.

Roth IRA vs Regular Investment Account

But now let’s look a little harder. Let’s say that after making the maximum contribution to your traditional retirement account, you then choose to invest all or part of the tax you saved into a regular (non-retirement) investment account—and compare that with investing in a Roth. Those non-retirement investments will not only be using post-tax dollars, but you’ll also be taxed on their earnings once you cash them out at the capital gains rate.

Because of those differences, you might end up paying more tax in the long run than if you put the entire sum you can afford to invest in a Roth account in the first place.

Forgoing the Roth Due to Taxes

The tax argument for contributing to a Roth can easily turn upside down if you happen to be in your peak earning years. If you’re now in one of the higher tax brackets, your tax rate in retirement may have nowhere to go but down. In this case, you’re probably better off postponing the tax hit by contributing to a traditional retirement account.

For the most affluent investors, the decision may be moot anyway, due to IRS income restrictions for Roth accounts. In 2021, individuals can’t contribute to a Roth if they earn $140,000 or more per year—or $208,000 or more if they’re married and file a joint return. In 2022, those thresholds increase to $144,000 and $214,000.

Contributions are also reduced, though not eliminated, at lower incomes. In 2021, phaseouts begin at $125,000 for single filers and $198,000 for couples filing jointly; in 2022, they begin at $129,000 and $204,000, respectively. While there are a few strategies to legally circumvent these rules, those with a higher tax rate may not have a compelling reason to do so.

By contrast, you won’t be disqualified due to income from contributing to a traditional IRA. You may, however, have your contributions capped at below the full maximum if you qualify within your company as a highly compensated employee.

Using a Traditional Account to Lower Your AGI

A traditional IRA or 401(k) can result in a lower adjusted gross income (AGI) because your pretax contributions are deducted from that figure, whereas after-tax contributions to a Roth are not. And if you have a relatively modest income, that lower AGI can help you maximize the amount you receive from the saver’s tax credit, which is available to eligible taxpayers who contribute to an employer-sponsored retirement plan or a traditional or Roth IRA.

Under the program, the percentage of contributions credited back to your taxes depends on your AGI. As the credit is designed to encourage lower-income workers to contribute more to their retirement plans, the lower the AGI, the higher the percentage credited back to you. For 2021, joint filers with an AGI above $66,000 ($68,000 in 2022) receive no credit, but those with a lower AGI get between 20% and 50% of their contributions credited back to them.

Consequently, pre-tax retirement contributions can boost credit by lowering your AGI. That lowering can be especially useful if your AGI is just above a threshold figure that, if met, would deliver a bigger credit to you.

Skipping the Roth to Boost Immediate Income

There’s another reason to hedge on a Roth, and it relates to access to income now versus potential tax savings down the road. A Roth can take more income out of your hands in the short term because you’re forced to contribute in post-tax dollars. With a traditional IRA or 401(k), by contrast, the income required to contribute the same maximum amount to the account would be lower, because the account draws on pretax income.

If that immediate windfall from using a traditional account is invested, we argued above, a Roth can actually offer the better tax option. Nevertheless, there are many other uses for the money other than investing it. The amount “saved” by making a maximum contribution to the account in pretax dollars could instead be used for any number of useful, even vital, purposes—buying a home, creating an emergency fund, taking vacations, and so on.

The upshot is that a traditional retirement account increases your financial flexibility. It allows you to make the maximum allowed contribution to the IRA or 401(k) while having extra cash in hand for other purposes before you retire.

The Argument for Both Roth and Traditional

If you’re somewhere in the middle of your career, predicting your future tax status might seem like a complete shot in the dark. In that case, you can contribute to both a traditional and a Roth account in the same year, thereby hedging your bet. The main stipulation is that your combined contribution for 2021 or 2022 can’t exceed $6,000 annually or $7,000 if you’re age 50 or over.

There can be other advantages to owning both a traditional and a Roth IRA or 401(k), says James B. Twining, CFP, CEO, and founder of Financial Plan Inc., in Bellingham, Wash. He notes:

In retirement, there may be some “low tax” years due to large long-term care expenses or other factors. Withdrawals can be taken from the traditional IRA in those years at a very low or even a 0% tax bracket. There may also be some “high tax” years, due to large capital gains or other issues. In those years the distributions can come from the Roth IRA to prevent “bracket spiking,” which can occur with large traditional IRA withdrawals if the total taxable income causes the investor to enter a higher graduated tax bracket.