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Remember the Stanford Marshmallow Study? This was a study on delayed gratification that offered children a smaller (but immediate) reward or a larger (but delayed) reward.

The original study found that children who waited for the larger reward had better life outcomes than the children who opted for the immediate reward.

I feel like the same forces are at work with our retirement savings decisions.  Pre-tax retirement accounts offer an immediate reward (tax savings) on any amount you save. Roth accounts offer an even better reward (tax free withdrawals) but at a much later date.

When it comes to choosing retirement accounts, I believe the delayed gratification of Roth accounts is best in most situations.

Why a Roth could be better

Contributions to Roth accounts are made with after-tax money, or money that’s already been taxed when you earned it. As a result, retirement withdrawals are tax-free.

Contributions to pre-tax accounts are not taxed, but the withdrawals are taxed as income.

Why do I prefer Roth?

1.Tax the seed, not the crop.

The first reason I prefer Roth is because the dollars I’m taxed on today should grow into much larger amounts in the future.

Think of a farmer planting a field of corn. The government is going to tax him on his corn, but has given him the option to:

  1. Pay tax on the seed that he plants or;
  2. Pay tax on the ears of corn that he harvests

Because each stalk is likely to produce two or three ears of corn, the farmer decides to be taxed on the seed. After all, he would be taxed two to three times more if he has a good harvest.

The same concept is at play with retirement savings. You seed your accounts with small deposits through your working years. If the money is invested and grows, the resulting growth can be many times more than the amount you contributed.

2. It’s insurance against future unknown tax rates.

Our government loves spending money it doesn’t have. Will tax rates go up in the future to pay for it all? I don’t know–in fact, no one knows.  

As a result, I view a Roth as insurance against future unknown tax rates. If taxes go up, I don’t have to worry. If all I had was savings in pre-tax accounts, you bet I’d be worrying. Why? Because the government “owns” a piece of every pre-tax retirement account. Some people call this the retirement savings time bomb.

On the flip side, what if tax rates don’t go up? If this happens, I still have money in tax-free accounts. If this is the worst-case scenario for saving in Roth accounts, it’s a risk I’m willing to take.

Doesn’t it depend on your tax bracket?

The correct way to answer the “pre-tax vs Roth” debate is:

If you’re going to be in a lower tax bracket in retirement, choose pre-tax.

This is absolutely correct. By taking advantage of “tax arbitrage” you can defer income while in a higher tax bracket until retirement when you are in a lower tax bracket.

As I previously mentioned, future tax rates are unknown. Making a plan that assumes the current tax rates will stay the same is unwise. Look at all possibilities—including an increase in future tax rates.

Diversify your tax allocation

If you’re paying a lot in taxes now and are using pre-tax retirement accounts to try spreading out tax in the future, that’s fine! However, I recommend diversifying your tax allocation, just as you diversify your investments.

When I work with clients, not only do we work on their investment allocation, I also show them their tax allocation (below).

This helps clients visualize their retirement tax strategy, especially if they are heavily weighted in tax-deferred accounts. Making a strategy to diversify your tax allocation by getting money into Roth accounts is smart, no matter which direction tax rates go.

Advice for high-income earners

If you’re a high-income earner, try keeping money out of your Traditional IRA’s.  

A problem with Roth IRA’s is high-income earners cannot contribute to them. But you can make non-deductible contributions to your Traditional IRA and then convert them to a Roth IRA. This so-called “back door” Roth contribution is a great way to diversify your tax allocation. Doing this tricky maneuver requires no other money in your Traditional IRA’s (including SEP IRA’s and SIMPLE IRA’s), or else most of your conversion will be taxable (in addition to being a record keeping pain).

By keeping your IRA’s reserved for back door Roth contributions, you can get current tax savings from a pre-tax 401k with the tax-free growth of your Roth IRA.

Make a plan to get money into your Roth

Of course, tax advice cannot be given in a vacuum. The best account to use depends on your situation. My recommendation is this: make a plan to get money into Roth accounts—either now or in the future. This can be through a Roth 401(k), Roth IRA, back door Roth contributions, or Roth conversions.

After all, what’s better than tax-free?