Should You Make Roth or Traditional Retirement Plan Contributions?

Key Concepts

• Traditional Account: A tax-deferred retirement account where contributions are generally tax-deductible, but withdrawals are taxed as ordinary income.
• Roth Account: A retirement account funded with after-tax dollars, where growth and qualified withdrawals are tax-free.
• Tax-Deferred Growth: Investment earnings that are not subject to taxes until the money is withdrawn.
• RMD (Required Minimum Distribution): Mandatory withdrawals from retirement accounts that the IRS requires account holders to take starting at a certain age.
• Backdoor Roth: A strategy used by high-income earners to contribute to a Roth IRA by first contributing to a non-deductible traditional IRA and then converting it.
• Tax Diversification: The strategy of holding assets in both taxable, tax-deferred, and tax-free accounts to provide flexibility in managing tax liabilities during retirement.
• Conversion: The process of moving funds from a traditional (tax-deferred) account to a Roth (tax-free) account, which triggers an immediate tax liability on the converted amount.

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1. Comparison of Retirement Account Structures

Tim Steffen explains that traditional and Roth accounts are "mirror images" of each other regarding tax treatment:

• Traditional: Contributions are typically tax-deductible (lowering current taxable income), growth is tax-deferred, and withdrawals are taxed as ordinary income.
• Roth: Contributions are made with after-tax dollars (no current deduction), growth is tax-deferred, and withdrawals are fully tax-free, provided specific rules are met.

2. Income Limits and Eligibility

• IRAs: Eligibility to deduct traditional IRA contributions or contribute directly to a Roth IRA is restricted by income thresholds. For example, married couples begin losing the ability to contribute to a Roth IRA once their income exceeds $242,000. High-income earners who exceed these limits are often restricted to non-deductible traditional IRAs.
• Employer Plans (401k/403b): These plans offer significantly more flexibility. Regardless of income level, participants can generally choose between traditional or Roth contributions, provided the employer’s plan offers both options.

3. Decision-Making Framework: The "Tax Rate" Strategy

The primary factor in choosing between Roth and traditional contributions is comparing your current tax rate to your expected tax rate in retirement.

• The Core Argument: If you are in a high tax bracket today, a traditional contribution provides a valuable immediate tax deduction. If you are in a low tax bracket (e.g., early in your career), a Roth contribution is often superior because the tax "cost" of the contribution is low, while the future tax-free benefit is high.
• The "Income Level" Proxy: Since predicting future tax rates is difficult, Steffen suggests focusing on your current income level. If you are in your peak earning years, you are likely in a higher tax bracket, making traditional contributions more attractive. If you are early in your career or in a period of lower income, Roth contributions are generally preferred.

4. Addressing "Tax Diversification"

Steffen cautions against the common advice of prioritizing Roth contributions simply to achieve "tax diversification" if you currently lack Roth assets.

• The "Ship Has Sailed" Argument: If you missed the opportunity to contribute to a Roth earlier in your career when your income was lower, do not "compound the mistake" by forcing Roth contributions during your peak earning years just to fill a bucket.
• Strategic Conversions: Instead of forcing Roth contributions during high-income years, Steffen suggests using the "trough period"—the time after retirement but before RMDs begin—to perform Roth conversions. During this window, your income is typically lower, making it a more cost-effective time to move money into a tax-free environment.

5. Notable Quotes

• "If you missed the opportunity to do it when it was right back then, don't compound that by doing it now when maybe it's not the right time." — Tim Steffen, regarding the urge to create Roth accounts late in one's career.
• "The ideal Roth candidate is somebody who's at a lower income level, lower tax rate." — Tim Steffen.

6. Synthesis and Conclusion

The decision between Roth and traditional retirement accounts should not be based on a desire for "diversification" alone, but rather on a strategic assessment of current versus future tax rates.

• Younger/Lower-Income Workers: Should prioritize Roth accounts to lock in tax-free growth while their current tax burden is minimal.
• Peak-Earning/Older Workers: Should prioritize traditional contributions to maximize current tax deductions, then consider Roth conversions during the "trough" years of early retirement when income levels drop.
• Flexibility: Employer-sponsored plans offer the greatest flexibility, and investors should prioritize the tax deduction when income is high and tax-free growth when income is low.