With Roth accounts increasing in popularity, more interest and inquiries arise. The main question being: "Is a Roth account better than a traditional qualified plan?"

Unfortunately, the answer to this question is not a simple 'yes' or 'no.' It is actually quite complex and must be answered on different levels.

Mathematical Comparison

On a purely mathematical comparison, it depends only upon the marginal tax bracket when the money is being deposited (pre-retirement) and when the money is being distributed (in retirement). If the marginal tax bracket is higher before retirement, the advantage is to put the money away pre-tax. If the marginal tax bracket is higher in retirement, the advantage is to put the money in a Roth account. If they are the same, both accounts are equal. The difference presents itself when the taxation is applied.

Getting Technical

The mathematical equation provides the proof.

The equation for a Roth deposit's value at distribution, where the taxes are taken out when it is deposited, is:

 (Deposit x (1 - Marginal Tax Bracket before retirement)) x ( 1 + Interest Rate)Number of Years  

to write this in short hand:

 (d x (1 - tb)) x (1 + i)n

where

 d        deposit

 tb        Marginal Tax Bracket before retirement (e.g. 28%, or 0.28)

 i        interest rate (e.g. 3%, or a value of 0.03)

 n        number of years

When changing the account to a pre-tax qualified plan, the only difference is when the money is taxed. So the equation becomes;

 (Deposit x (1 + Interest Rate)Number of Years) x (1 - Marginal Tax Bracket after retirement)

and in short hand:

 (d x (1 + i)n) x (1 - ta)

where

 ta        Marginal tax bracket after retirement.

If the client's values are inserted for the deposit value (d), interest rate (i), and number of years (n), the only difference in the two equations becomes the tax bracket before retirement.

If the marginal tax brackets before retirement and after retirement are the same, then the only difference is when the money is taxed.

Tax Brackets

But not all money is taxed the same. Under the progressive taxation system, initial distributions are not taxed. Then as the total distribution increases over the calendar year, they are initially taxed at a lower rate. As more money is taken out during a tax year, however, the tax bracket may increase. Therefore, in the lower tax brackets, it is best to distribute money from a pre-tax qualified plan.

In most situations, the income a client requires in retirement will be less than the income needed prior to retirement. But this may not necessarily always be the case. If the client would like to take a lump sum distribution (e.g. for a vacation), that lump sum may raise their marginal tax bracket; in which case distributions from a Roth account could be used. (Ideally the distribution may take place over two or more years, to minimize the higher tax bracket.)

Another item to take into consideration is that tax brackets do not remain the same each year. They are raised and lowered over time.

When a client is contributing to a retirement plan, if the marginal tax bracket for the client is historically lower than what it has been, this may be reason to consider depositing money to a Roth. If the marginal tax bracket for a client is higher than the historical average, the pre-tax qualified plan should be given strong consideration.

Also, marginal tax brackets will probably fluctuate during a client's retirement years. During retirement years with higher marginal tax rates, a client may choose to withdraw monies from a Roth account to reduce their tax liability. During years with lower tax rates, a client may choose to withdraw monies from just their qualified plan accounts.

Conclusion

Roth accounts are a great tool for retirement. However, good planning requires an understanding of how to effectively use them for good tax planning. The client's marginal tax bracket, historic tax brackets, and client retirement needs all play important roles in strategic tax planning.