Ask Stacy: Traditional or Roth Retirement Plan?

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This week’s reader question is one that’s practically as old as the Roth retirement plan. Namely, when it comes to retirement plans, which is better: Roth or regular?

Should I convert my TSP traditional to a Roth TSP? — Carole

If you’re confused about “TSP,” that stands for Thrift Savings Plan, a federal government plan that functions much like a private company 401(k) or the nonprofit version, the 403(b). For the purposes of this discussion, they’re all interchangeable, but if you’re curious about TSPs, you can read about them here.

The difference between regular and Roth

Both Roth and regular retirement plans provide tax deferral on investment earnings. But when it comes to contributions and withdrawals, a Roth is the mirror image of a traditional plan.

With a traditional retirement plan, you deduct the money you put in, but you pay taxes on withdrawals as ordinary income when you take it out in retirement. With a Roth, you don’t get to deduct your deposits, but when you take the money out, it’s tax-free.

So when you’re asking whether a traditional or Roth is better, what you’re really asking is whether it’s better to get a deduction now or get tax-free income after retirement.

Which is better?

While many financial writers sing the praises of the Roth and recommend it almost universally, which is best isn’t really that cut and dried.

That’s because the answer ultimately depends on factors you can’t know. For example, if you’re in a high tax bracket now but expect to be in a zero tax bracket when you retire, you’d obviously be better off avoiding the Roth and deducting your retirement contributions.

If you’re going to be in the same tax bracket when you retire or a higher one, it would be best to use a Roth and pay no taxes when you take the money out.

Unfortunately, there’s no way to know what the tax tables will look like when you retire, especially if it’s far in the future. And as one of my tax professors was fond of saying, “In the long term, we’re all dead.”

In other words, some might argue that today’s bird in hand — a deduction on contributions — is better than tax-free withdrawals at some future date. After all, while it’s unlikely, Congress could theoretically change the rules and start taxing Roth IRA withdrawals. Then, of course, there’s also the possibility you may not live to see your golden years.

There are calculators online that are supposed to help you decide. Here’s one from Money Chimphere’s one from Bankrate, and here’s one specifically for those in TSP plans. But all require you to know the unknowable: how much you’re going to earn on your investments, and your tax bracket after retirement. 

After fooling around with a few calculators, you’ll probably decide that a Roth is the way to go, especially if you believe taxes will be higher in your golden years. But here’s the answer I most often give: Since you’re not required to fund only one type or the other, why not have both? That way you can get some deductions now, and you’ll have a tax-free source of retirement income, too.

Doing a Roth rollover

Thanks to new rules, more and more employers are allowing plan participants to convert existing 401(k) balances from regular to Roth. The basics are simple. You simply designate all or part of your existing 401(k) to Roth and pay the income taxes on the amount you convert.

Not all employers allow for these conversions. According to this recent Forbes article, about half currently do and more are expected to add the feature this year.

As for TSPs, according to the Federal Retirement Thrift Investment Board, you can’t convert existing TSP balances to Roth. You can, however, designate future contributions as Roth, either in whole or in part.

Got a money-related question you’d like answered?

You can ask a question simply by hitting “reply” to our email newsletter. If you’re not subscribed, fix that right now by clicking here. The questions I’m likeliest to answer are those that will interest other readers. In other words, don’t ask for super-specific advice that applies only to you. And if I don’t get to your question, promise not to hate me. I do my best, but I get a lot more questions than I have time to answer. Got any words of wisdom you can offer for this week’s question? Share your knowledge and experiences on our Facebook page.

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  • Mike

    One thing to know about a Roth account is there is a time limit from when you can start withdrawing from it from when you put money in it. That is 5 years. So you cannot withdraw from the Roth for 5 years without penalty. So if you are in you 50’s start one now. The amount you put in is not important, you just want to start the “clock” as soon as you can.

    • http://www.moneytalksnews.com/ Stacy Johnson

      Good stuff, Mike.

  • Dave

    Stacy, I think that you missed one of the more important reasons to convert, that is the age 701/2 rule. Owners of Roth accounts don’t have to take distributions from the account—ever. So, if one has an adequate retirement income, you don’t need to take withdrawals from the Roth. And, if set up properly, the Roth can be passed tax free to children or grandchildren and continue to grow tax free. That is why I converted. Also, it took only a couple of years to make up the taxes that I had to pay when converting. This of course is not necessarily going to happen in a down market.

    • http://www.moneytalksnews.com/ Stacy Johnson

      Great input, Dave!