Roth on Roth IRAs and 401(k)s

I'm not related to the late Sen. William Roth, who established the Roth IRA, but as a financial planner I'm asked about it all the time. And what I'm often asked is, which is better -- a traditional or a Roth? Let me give a little background, dispel a common myth, and then offer some advice.

The basics
The two most common retirement plans are the IRA and the 401(k). While there are exceptions (after all, we are talking about our tax code), an IRA is generally an account held directly by the investor while a 401(k) is through an employer. Both IRAs and 401(k)s now have traditional and Roth versions. The traditional gives the investor a tax-deduction immediately, but requires that taxes be paid on it when it is withdrawn. On the other hand, a Roth doesn't provide the tax break today, but instead allows the account to grow tax free so there are no taxes to pay when the investor withdraws it.

Worthless rules of thumb for which is better -- Roth vs. traditional
I have clients come to me regularly with things they have heard or read to determine which is better. They typically seem to always be based on age or the number of years before withdrawal. Take this article that says a Roth is better if you have more than ten years before withdrawing the money. Other rules of thumb advise that those under the age of 40 should go with a Roth.

Some of my clients believe they are too old for a Roth. For them and those other investors out there who are thinking the same thing, I have some good news -- you are never too old! It doesn't actually make a difference whether the funds are invested for one year or fifty. The only thing that matters is your marginal tax rate today versus the year you withdraw the funds. If you think your bracket will be higher today -- go with the traditional. If you think it will be higher upon withdrawal, go with the Roth. I've worked up countless spreadsheets illustrating the numbers, and the number of years has nothing to do with it.

You may be tempted to say that the Roth is superior because taxes are bound to go up with all of the money our government is borrowing. That's always a possibility, yet it doesn't necessarily translate to your marginal tax bracket going up. You may be making $100,000 today while working, but you might have a much lower income when you withdraw upon retirement.

Roth's advice on Roths
It's not so easy to predict what our income will be in retirement, and even harder to predict what Congress will do with our tax code. If rates do go up dramatically, then the Roth will have been the superior choice. If, on the other hand, we do something radical like taxing consumption along the lines of the Fair Tax Act, then the Roth would be a disaster since we'd pay taxes again when we spend it.

So I always give the same answer when I'm asked the question on which is better. The easy answer is both. By having some money in a pretax plan (traditional) and some in a tax-free (Roth), we diversify against the unknown. I call it the fourth dimension of diversification with the first three being multiple asset classes, number of securities within each asset class, and time. None of these completely insulates the investor against risk, but does tend to lower risk. Having both a traditional and a Roth diversifies us against what Congress may do to the tax code.

So if you are like most people and have a larger traditional IRA or 401(k) than a Roth, consider a Roth IRA if you qualify or your employer offers one. Be sure, though, that you don't put all of your eggs in any one vehicle.