To Roth or Not? That is the Question for Young Professionals
To Roth or not? That is the question. It’s a question on many young professional’s minds and one we hear frequently. Fortunately, the answer doesn’t prove to be as difficult as it first might appear and the standard advice of “young people should do Roth” is only partially correct. In today’s post, we’ll first break down what is Roth and its alternative, as well as simple tips for determining when it makes sense to contribute to each account.
Traditional or Pre-Tax IRAs and 401(k)s
When people talk generally about contributing to an Individual Retirement Account (IRA) or their 401(k) it usually, if not specified otherwise, means to contribute to what is known as a traditional IRA or a traditional 401(k).
Traditional IRAs and 401(k)s use pre-tax dollars to fund their account that grows tax-deferred and are taxed as ordinary income upon distribution (after age 59.5, with exceptions). In the case of an IRA, you might wonder how you’re using pre-tax dollars when you’re contributing with money you’ve already paid taxes on.
In the case of an IRA, you do use after-tax dollars to fund the account, however, when you go to file your tax return you get to deduct the money you contributed to the traditional IRA from your taxable income, thus turning those dollars into pre-tax dollars.
With your 401(k) you make contributions with pre-tax dollars via payroll deduction, so the process is a bit more seamless and you’re able to contribute on a pre-tax basis or deductible basis regardless of your income level. Contrast that with a traditional IRA, which you are only able to contribute to on a deductible basis if you make less than $72,000/$119,000 (and are covered by an employer-sponsored plan).
So, what the heck is a Roth?
Roth is a type of account in the form of an IRA or 401(k) that allows investors to contribute money on an after-tax basis. First proposed in 1989, Roths didn’t come into existence until 1997 with the passing of the Taxpayer Relief Act of 1997. The accounts are named after their chief legislative sponsor, Senator William Roth.
Unlike a traditional IRA or 401(k), a Roth allows young professionals to pay their taxes upfront, with the benefit of then being able to withdraw money from the account on a completely tax-free basis (after 59.5, with exceptions) in retirement.
Similarly, the contribution limits to Roth IRAs and 401(k)s still mirror those of their traditional counterparts. In the case of a Roth IRA, young professionals are limited to a $5,500 contribution per year ($6,500 if over the age of 50), while Roth 401(k) contributions are limited to $18,000 per year ($24,000 if over the age of 50).
Additionally, a Roth IRA has higher income limits. Single young professionals can contribute to a Roth IRA if they make under $133,000 and if married filing jointly they can contribute to a Roth IRA if they make below $196,000.
Note: account maximums are limited to $5,500 and $18,000 for IRAs and 401(k)s respectively. Meaning you cannot contribute $5,500 to a traditional IRA and a Roth IRA, instead you can contribute any combination of $5,500 to either account (assuming you are not phased out by your income level).
So, should I contribute to a traditional or a Roth IRA/401(k)?
Answering this common question comes down to taxes. Will you pay more now, or will you pay more later, that is the question. Determining whether to contribute to a Roth or a traditional account is fundamentally a tax question: how do I minimize the amount I pay to Uncle Sam?
The often-cited advice is for young professionals is to simply “contribute to a Roth when you’re young” but unfortunately that advice is based solely on the assumption that young professionals are in a low tax bracket, which may not be the case.
In fact, the advice should be as follows: if you believe that you are in a higher tax bracket today than you will be in the future, then contribute on a pre-tax or traditional basis. If on the other hand, you believe that you are in a lower tax bracket today, than you will be in the future, then contribute to a Roth with after-tax dollars.
In short, your goal is to pay taxes at whatever rate is the lowest, whether that be today or in the future.
Take a simple example of a young professional couple. John is 38 and an attorney and Laura is 36 and a pediatrician, they make a combined income of $450,000 per year. Despite the common wisdom to “Roth if you’re young” they should not contribute to a Roth, as they currently fall into the 35% tax bracket, one that they will likely not find themselves in when they retire.
On the flipside, take Kate, a 32-year old IT specialist making $90,000 as a single taxpayer. She currently falls into the 25% tax bracket and is anticipating big raises as her career progresses. In this case, it’s likely that Kate will find herself in a higher tax bracket in the future, so it makes sense to pay taxes now (contribute to a Roth), at a lower rate, so she can pull money out tax-free in retirement.
Tip: If you’ve seen a major dip in income, whether to a lost job or a slow sales year, it can be a great time to consider a Roth conversion. For example, if you usually find yourself in a top bracket, but your income is now in the 15% bracket for the year, and likely will never be there again, converting pre-tax money into after-tax dollars in a “down” income year can be hugely beneficial.
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