As you save for retirement you can choose between Roth and Traditional accounts. You’ve probably already decided what’s best based on your future tax rates, but did you look at how your choice affects your Social Security income? Assuming you get anything, your Social Security benefits might be taxable, depending in part on whether you use Roth or Traditional accounts to save for retirement.
Another way of saying your Social Security benefits will be taxable: you’ll get less. On the bright side, Social Security will probably still be around for a while.
Roth vs. Traditional
A quick review: you often get to choose whether to save in Roth or Traditional retirement accounts. Uncle Sam says you can pay now or later – your call. Whether or not you have all the options available depends on a number of things (your income level, what types of retirement accounts are available to you through an employer, and so on), but most people have some opportunity to choose Roth or Traditional.
With Traditional accounts, you defer taxes – you’ll pay later what you didn’t have to pay today. That includes a reduction of this year’s income (because you got a deduction or made pre-tax contributions) as well as any earnings inside of your account over the years. After the age of 70.5, the IRS makes you take required minimum distributions (RMDs) to start generating income.
With Roth accounts, you pay taxes now so that you (hopefully) won’t have to do so later. Assuming you follow all of the IRS rules (and that the rules don’t change), you get to take all of your money out and spend it – no need to budget for taxes.
Most people choose between Roth and Traditional (or a combination of the two) by asking the magic eight ball what their tax rate will be in the future. Will you earn more or less when you take money out of your retirement accounts? Will tax rates change, even if your income doesn’t (in other words, will the income tax rate for a given level income increase or decrease – perhaps to pay for deficits and such)?
There’s really no way to know what will happen. Even if you’re worried about government spending, there’s no guarantee that higher income tax rates are on the way (there are lots of other creative ways to solve problems, for better or worse).
In addition to the tax rate question, you should also consider Social Security income.
Pay Tax on Social Security?
What does Social Security have to do with anything? Your Social Security benefits can be taxable, depending on your “income.” The definition of income is a bit goofy, but the point is this: taking money out of a Traditional retirement account increases your income, while taking money out of a Roth account does not.
If you want to maximize what you can actually spend in retirement, keep this in mind. It doesn’t matter how much you have – the important thing is how much of it you actually get to spend on cool and important stuff. Things like food, vacations, gifts for people you love, and insurance.
How much tax are we talking about here, and how much income is a problem? The Social Security Administration provides the following:
No one pays federal income tax on more than 85 percent of his or her Social Security benefits based on Internal Revenue Service (IRS) rules. If you:
- file a federal tax return as an “individual” and your combined income* is
- between $25,000 and $34,000, you may have to pay income tax on up to 50 percent of your benefits.
- more than $34,000, up to 85 percent of your benefits may be taxable.
- file a joint return, and you and your spouse have a combined income* that is
- between $32,000 and $44,000, you may have to pay income tax on up to 50 percent of your benefits
- more than $44,000, up to 85 percent of your benefits may be taxable.
- are married and file a separate tax return, you probably will pay taxes on your benefits.
Again, “income” probably isn’t exactly what you think (only one half of your Social Security income is considered), so be sure to read through the page linked above and talk to your tax preparer for more details.
Does this mean that Roth is better? Not necessarily, everything depends on your particular situation. What it does mean is that the Roth vs. Traditional question is about more than what tax bracket you’ll be in when you retire (well, it is still about that, because your Social Security benefits will be taxed according to whatever bracket you’re in).
Ask Again Later
If your magic eight ball is unable to tell you exactly what’s best, it’s probably being honest. The farther out you’re trying to predict, the harder it is. Diversifying is always a good idea, and that extends to the Roth vs. Traditional question. Just like it’s helpful to have US stocks and foreign stocks, it may be wise to have pre-tax money and post-tax (or tax-free) money saved for the future. You may find, when the time comes, that you didn’t get it 100% right – that you would have been better off doing one or the other – but it’s risky to put all of your eggs in one basket.
Having both kinds of accounts gives you more choice in retirement. If you have a good year (or rates are high), you can take money out of Roth accounts without having to pay more in taxes. On the other hand, if you have a lean year (or rates are low), you can feel free to take money out of Traditional accounts and pay taxes at a reasonable rate.
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