According to the Investment Company Institute’s 2023 handbook, as of the beginning of 2023, some $33.6 trillion worth of assets had been earmarked for retirement.

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That seems like a mind-boggling amount of assets. However, running out of money in retirement is the number one concern for retirees. After all, that massive number needs to be split among a large number of retirees, over what is likely to be about 20 years.

Thus, it is as important as ever to maximize our savings for retirement and consider taxation in retirement. One of the recurring questions on that front is whether to choose a Traditional or Roth account for retirement savings.

Traditional vs. Roth – what does it mean?

The traditional IRA was first made available in 1974 along with the ERISA overhaul of retirement plan regulation. Contributions may be deductible, depending on the taxpayer’s income, and distributions are taxable as ordinary income. The Roth IRA became available in 1998. There are no deductions for contributions but, if all conditions are met, all the distributions from a Roth IRA during retirement are tax-free.

The question of whether to go with a Traditional or Roth account may seem like a preference question with wildly different opinions (like the value of pineapple on pizza) but, really, they are each appropriate for different situations. The trouble is that predicting the future is hard, and we don’t know what the absolute best choice is without the benefit of hindsight.

A simplified way to think about it is that the traditional approach defers the taxes initially and has tax-deferred growth, but the taxes are paid when the money comes out. The Roth approach is taxed initially, has tax-free growth and is not taxed when distributions come out (assuming conditions are met).

Factors to consider when starting out.

What is your current income? Can you max out your contribution without needing the tax deduction? If the deduction is important, then the traditional pre-tax approach is likely the way to go. However, if your income is too high, there is no deduction.

What is your future income and tax bracket? The idea of being able to take out tax-free growth from a Roth IRA is quite an appealing carrot, but many people’s tax bracket is lower in their retirement years than when they were in the workforce. Taking advantage of lower tax brackets can make a substantial difference over the long-term of a portfolio.

What about changing your course part way through, and converting?

Some 401(k) plans have added a Roth account option. Some allow conversions of the traditional account to the Roth approach, while others only allow new contributions to the Roth 401(K). However, rolling over a traditional 401(k) or a traditional IRA to a Roth IRA is available to everyone.

There are three main benefits to converting to a Roth:

Planning flexibility – Minimum annual distributions are required from traditional IRAs once the owner reaches age 73. There are no such requirements for Roth IRAs. The required minimum distributions are not large in the early years on a percentage basis, but the only way to avoid them is to arrange for a distribution to charity (limited to $100,000 per year).

Tax freedom – After five years, if you are 59 ½ or older, distributions from the Roth IRA are not included in income. The income taxes have effectively been prepaid.

Lower taxes on Social Security benefits – Those required minimum distributions from traditional IRAs may have the side effect of increasing the taxes the retiree must pay on Social Security benefits received. Singles with adjusted gross incomes (AGI) below $25,000 and married couples below $32,000 do not have to worry about taxes on benefits.

For singles with AGI from $25,000 to $34,000, up to 50% of their benefits will be taxed, and above $34,000, up to 85% will be taxed. For married couples, the 50% inclusion bracket is $32,000 to $44,000, and 85% above $44,000.

When is the best time for a Roth conversion?

Although you are unlikely to know what tax brackets you are going to fall into throughout your working career, it may be a little easier to estimate as you come closer to retirement. The biggest barrier to converting traditional retirement funds to a Roth account is that all the income taxes on that conversion must be paid in that tax year. With larger accounts, that’s likely to push someone into a higher tax bracket and that burden may be higher than drawing out the funds over many years in the traditional route.

Thus, the best time to do a Roth conversion is when wage income is lowest. One example of this might be with an early retirement. A person is 65, has other sources of wealth for expenses from after-tax accounts and is delaying Social Security to maximize the benefit received. She has a traditional IRA worth $250,000, and may do a partial Roth conversion each year of $50,000, keeping the income in a much lower tax bracket than if it were all done in the same year.

Another consideration for timing a Roth conversion could be market conditions. If there were to be a market crash, and the conversion was made at that time, the amount of appreciation on the assets (and thus taxes that need to be paid) would likely be significantly lower. Should there be a subsequent market recovery, all of that growth would then become tax-free. Of course, this may still incur a substantial tax liability, and if assets need to be sold to cover the taxes, they would also be sold at the bottom of the market.

Consider a consultation.

Understanding the benefits and risks associated with Roth conversions should take more factors into account than just your potential tax bracket and growth. This is where it can be helpful to consult with one of Arvest’s client advisors. We can conduct a holistic overview of your entire retirement picture, and provide some insights into what options are available to help you make an informed decision. Let us know if you’re interested.

This content has been prepared by The Merrill Anderson Company and is intended as a general guideline.

© 2023 M.A. Co. All rights reserved.

Arvest and its associates do not provide tax or legal advice. The information presented here is not intended as, and should not be considered, tax or legal advice. Consult your tax and legal advisors accordingly.