Is a Roth IRA the Best Retirement Plan for Therapists?

Photo above by Brett Jordan on Unsplash.

When deciding on the right Retirement Plan for yourself, you’ll eventually be confronted with deciding between a Roth or Traditional type of Retirement Account.

What the heck does this mean and how do you decide the right plan for you? Read on to find out!

What ARE Retirement Plans?

Before we get into the nitty gritty of discussing the differences between Roth and Traditional Retirement Accounts, let’s take a moment to define what a Retirement Plan is exactly.

Retirement Plans enable the plan participants to receive certain tax benefits when they save for retirement. The Retirement Plan provides an overall plan, and part of that plan is that each participant in the plan receives their own Retirement Account in which they can hold investments.

It’s important to note that Retirement Plans and Retirement Accounts are themselves not a specific type of investment. Rather, they are a container that can hold a wide variety of different investments.

First, you need to pick the type of Retirement Plan you want to have, then you pick if you prefer the Roth or Traditional account type, and finally, you must decide what investments to hold within that Retirement Account.

Whew, that's a lot of decisions! 😮‍💨

This post will focus on the Roth versus Traditional decision. For a complete discussion of the other topics mentioned in this section, check out our comprehensive guide to Retirement Plans for Therapists here.

The Only Difference Between Roth and Traditional Retirement Accounts is the Timing of Taxes

The difference between a Roth and Traditional all boils down to when you pay income tax.

Retirement accounts are special because they offer tax advantages. The government wants to encourage you to save for retirement and they do that by offering tax perks.

The specific flavor of the tax perk differs between Roth and Traditional Retirement Accounts.

Traditional Retirement Accounts Reduce Taxes Today

In a Traditional account, you receive an income tax deduction for the amount of the traditional retirement contribution you make.

In other words, you avoid paying income taxes on those earnings TODAY. Instead, you pay income tax when you take distributions out of the Traditional IRA during retirement.

With a Traditional Retirement Account, you avoid taxes today (or this year) and instead pay income taxes in the future.

Roth Retirement Accounts Reduce Taxes in the Future

The Roth IRA tax advantage is the exact opposite of that offered by the Traditional Retirement Account.

When you contribute to a Roth account, you receive NO income tax deduction.

That means you pay income tax today. But then you never pay income tax again!

When you take a distribution from a Roth IRA in retirement, that distribution is free and clear of any income tax. (Yes, there are rules you need to carefully follow to make sure you get this tax-free treatment.)

With a Roth Retirement Account, you pay taxes today and avoid income taxes in the future.

Is a Roth Better Than a Traditional Retirement Account?

A Roth Retirement Account sounds like a good deal - and it is. But it isn’t necessarily a better tax deal than what’s offered by a Traditional Retirement Account.

What you want to do is pay taxes when your tax rate is lowest. Your tax rate is the percent of every dollar of income you pay in taxes.

To decide if a Roth or Traditional Retirement Account is better for you, we simply decide when your tax rate will be lower (today or in the future) and then opt to pay taxes at that time of lower tax rates.

• If you believe your tax rate today is lower than it will be in the future, choose a Roth Retirement Account. You’ll pay taxes today, when your tax rate is lower.
• If you believe your tax rate today is higher than it will be in the future, choose a Traditional Retirement Account. You’ll avoid taxes today (when your tax rate is high) and pay in the future (when your tax rate is lower).

That might sound (reasonably) simple in theory – but how can you possibly know what your future taxes will look like?! It’s hard enough to try and understand what’s happening with your taxes today!

The Roth vs Traditional Debate is Overblown

The truth is, the difference between a Roth and Traditional account isn’t actually that big of a deal.

Contributing to Either a Roth or Traditional Retirement Account is the Win 👍

What’s most important is that you are actually contributing to some type of retirement account.

Whether that’s a Traditional or Roth is really just an optimization. Don’t feel bad (or get stuck) thinking you need to get this decision perfect or exactly right.

Often It’s Best to Split Savings Between Roth and Traditional Account Types

You can - and in many cases should - have investments in both Roth and Traditional accounts.

We call this diversification of asset location: some assets are located in a Roth account and some assets are located in a Traditional account.

And this asset location diversity is a great thing because it gives you flexibility around how and when you pay taxes. That flexibility can help you pay less in taxes over the course of your lifetime! 🎉

It's Impossible to Get the Roth versus Traditional Decision Perfect

It literally is impossible to know with 100% certainty whether a Traditional or Roth Retirement Account contribution is better for you.

Why? Because it requires predicting the future – and I’m willing to bet you can’t do that.

You have to predict two things: what your future taxable income will be AND what future tax rates will be.

Predicting your future income is pretty tough. But can you predict future tax rates? I sure can’t! Which is why I suggest you don’t get too hung up on which is better.

But of course you do have to make a decision to use either a Roth or Traditional account, so let's discuss some general rules of thumb.

(By the way, you can always split each year's contributions between a Roth and Traditional, which often isn't a bad idea at all!) 

When a Roth Account is Better

There are a couple situations when it is often (but not always) better to contribute to a Roth account rather than a Traditional Retirement Account.

When Your Earnings are Low(er) a Roth is Often Better

If you’re earlier in your career or navigating a professional transition where your income is temporarily lower, that’s often a good time to contribute to a Roth.

When your income is lower, you’re in a lower tax bracket – which means your tax rate is lower. So it often makes sense to pay taxes at that lower rate today.

If You Think Tax Rates Will Go Up in the Future a Roth is often Better

If you believe the future tax rates will be higher than the rates we have today, then contributing to a Roth today will usually be better.

There are plenty of people who think that longer-term tax rates will have to go up to keep pace with government spending. That might happen. Or it might not. And even if overall tax rates did go up, might Congress create a special set of tax rates just for retirement accounts? It wouldn't totally shock me.

My point is just to be careful when making assumptions about the future.

When You Really Want to Max Out Your Retirement Contribution a Roth is Often Better

When you contribute to a Roth account, you get to keep 100% of that contribution (because you never pay taxes again on that money).

In contrast, when you contribute to a Traditional Retirement Account, you do NOT get to keep all that money – you owe a portion in taxes.

For that reason, you effectively make a bigger contribution when contributing to a Roth.

This is another optimization that I don’t want you to worry about too much, but if you’re really focused on maxing out your Retirement Account contributions, the Roth can help.

If You Live in a Low (or No) Income Tax State a Roth is Sometimes Better

You might also want to contribute to a Roth if you’re currently living in a low (or no) income tax state. This might be especially true if you think you might retire in a state where there is an income tax. This is just a different way of thinking about the question of when will your tax rate be lower – now or in the future.

When All Your Savings Are in Traditional Retirement Accounts a Roth Might be Better

If you have all, or virtually all, of your retirement savings in Traditional Retirement Accounts, it might make sense to diversify and begin building up Roth Account balances.

You might want to do this even if your tax rate is pretty high today (a situation where a traditional Traditional Retirement Account contribution would typically make more sense). This is a more nuanced approach and it probably one best implemented in consultation with a financial professional.

When a Traditional Account is Better Than a Roth

Conversely, there are a some situations when it is often (but not always) better to contribute to a Traditional account rather than a Roth Retirement Account.

When Your Earnings are High a Traditional Is Often Better

If you suspect your income is much higher today than it will be in retirement, then there’s a good chance that contributing to a traditional retirement plan will give you a slight tax benefit relative to a Roth contribution.

If You Believe Tax Rates Will Decline a Traditional Is Often Better

If you think future tax rates will be lower than those we have today, you’d rather pay taxes in the future – so contribute to a Traditional Retirement Account. You’ll get a tax reduction today and pay taxes down the road.

Historically, tax rates are at pretty low levels, so I’m not sure I believe tax rates will go down further… but again, who knows!

If You Live in a High Income Tax State a Traditional Is Often Better

If you’re currently living in a high-income tax state, like California or New York (among others) – a Traditional Retirement Account contribution may make good sense.

The reason is, again, because your tax rate today is high. Especially if you think you might retire in a low (or no) income tax state, you’d rather pay taxes in the future.

Naturally, state tax law will change, so be cautious when making this assumption.

How to Contribute to a Roth Account

If you're sold on making a contribution to a Roth Retirement Account, the next obvious question is HOW to actually do that!

It used to be that the only way to get a Roth Retirement Account was to use a Roth IRA. That is no longer the case.

Most Retirement Plans Offer a Roth Account Option

Virtually any Retirement Plan which you establish through your practice will offer a Roth option.

You can establish a 401(k) with a designated Roth Account. Even the SEP-IRA and SIMPLE IRA both offer Roth options.

This proliferation of Roth availability is pretty new, so not every financial institution yet makes them available, but it can be done. I think it’ll quickly become more common for every flavor of Retirement Plan to come with a Roth option.

Contribute Directly to a Roth IRA (if your income is low enough)

Often you don’t need to establish a complicated Retirement Plan through your practice to set up a Roth account.

If your household earnings are below certain levels, you can contribute directly to a Roth IRA. The specific amount of these income thresholds changes most years to adjust for the impact of inflation.

Here are the limits for tax-year 2024 contributions:

• If you file your taxes as Single and your income is below $146,000 you may contribute directly to a Roth IRA.
• If you file your taxes Married Filing Joint and your household income is below $230,000 you may contribute directly to a Roth IRA.

These income limits reference a specific income calculated from your tax return called Modified Adjusted Gross Income or "MAGI." 

MAGI sounds sorta magical to me and in a sense it is: it's  very confusing to calculate.

If your income is close to the income thresholds above, I highly suggest working with a qualified tax or financial advisor to help you determine the right move.

Also, remember that there are strict limits dictating how much you can contribute each year to an IRA! ⚠️

For 2024, that annual IRA contribution limit is $7,000 – if you are under age 50.

If you’ll be 50 or older on December 31st, you may contribute $8,000. These limits typically increase most (though not every) year.

Contribute to a Backdoor Roth IRA (when your income is too high)

If your income is above those limits we just discussed, in many cases you can still contribute to a Roth IRA – you just can’t do so directly.

Instead, you can use what’s known as the Backdoor Roth IRA strategy.

Importantly, there is no point in using a Backdoor Roth IRA if your income is below the Roth limits discussed above.

Also important to note, if you have meaningful amounts saved in Traditional IRAs, the Backdoor Roth IRA won’t work. The reasons are complex and technical but nonetheless true.

The Backdoor Roth IRA move is a technical one that I don’t recommend completing without the aid of a tax and/or financial advisor. ⚠️

But in essence, you make a non-deductible contribution to a Traditional IRA and then you convert that contribution from a Traditional IRA to a Roth.

That might sound pretty simple – and in some ways it is – but you can get yourself in trouble quickly, so tread carefully! 👢

Convert Existing Traditional Retirement Accounts to a Roth

You can also take existing traditional Retirement Account balances and convert them to Roth balances.

That’s a neat trick, but you will immediately owe income taxes on the converted balances! So be cautious.

This conversion can make a lot of sense in low-income years. It will increase the taxes you pay that year, yes – but if done properly will decrease your lifetime tax burden.

The Bottom Line on Roth and Traditional Retirement Accounts

There is a LOT of detail to navigate here obviously.

To me, the bottom line is what I said earlier: don’t stress the decision too much.

The big win is contributing to ANY Retirement Account.

Deciding between a Roth or Traditional is a slight optimization – a potentially valuable one, but don’t sweat the small stuff.

And of course, if you still have questions, please contact me!

👉  If you haven’t already, be sure and sign up for the Free Retirement Plans webinar. 🎞️

In that webinar, my friend Julie Herres and I cover these topics in more detail and answer Frequently Asked Questions we hear from therapists.

Disclaimer

Turning Point is a registered investment advisor in the state of California. Please visit turningpointhq.com for important information and additional disclosures. This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes financial, legal or tax advice; a recommendation for purchase or sale of any security; or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Read the full Disclaimer here.