To Roth or not to Roth?

Retirement planning is tricky. You’re trying to save as much as possible for your future. You’re looking for appropriate investments. That’s enough, right?

You also need to consider the tax consequences of different retirement accounts. That means choosing between a Traditional or Roth IRA/401(k).

There’s an overwhelming desire to pay lower taxes now. Deferring taxes on current income is why Traditional IRAs and 401(k)s are popular.

But Traditional IRAs/401(k)s are a potential tax bomb in retirement. Every dollar of distribution from a pre-tax retirement plan is taxed as ordinary income. Do you know what your tax rate will be in 10, 20 or 30 years, or how much money will be in your retirement accounts? It’s impossible to know. And you’re required to take an IRS distribution when you’re 70 K whether you need the money or not.

Example: You contributed $10,000 a year to a Traditional 401(k) for 20 years. Your total contribution is $200,000. If your tax rate was 25 percent, you saved $50,000 in taxes along the way. At a 7 percent average annual return, you would have about $418,000 at the end of 20 years. If you pay the same 25 percent in taxes, you would have a potential tax liability from your IRA/401(k) of a little over $100,000.

Is there another option? Yes! You can use a Roth IRA or Roth 401(k). The Roth is the opposite of the traditional option. You don’t take a tax deduction now, gains are tax deferred, and withdrawals are free from federal and state taxes at retirement.

Roth example: You contributed $10,000 a year to a Roth 401(k) for 20 years. Your total contribution is $200,000. If you were in the 25 percent tax bracket, you would have paid $50,000 in taxes along the way on your contributions. At a 7 percent average annual return, you would have approximately $418,000 at the end of 20 years. If you were in the 25 percent tax bracket, you would have a potential tax liability from your Roth of $0.

The Roth sounds like a good idea. Under current regulations, it allows you to pre-pay taxes on your retirement distributions. That will give you more certainty and allow you to avoid unpleasant surprises. The catch? You may not qualify to contribute to a Roth IRA and your employer may not have a Roth option in the 401(k) plan. However, you may still be able to convert some or all of your Traditional IRA/401(k) to a Roth IRA. You’ll pay taxes now versus later. Ask a financial or tax adviser whether a conversion might be right for you.

Managing the amount of taxable income in retirement is vital because it impacts your overall taxes and the taxation of Social Security and the cost of Medicare. A Roth savings account might make your taxes more management in retirement because you could avoid unpleasant surprises.