Author Topic: When does it make sense to use a Roth Retirement Account over a Traditional?  (Read 2025 times)

OneCoolCat

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The way I have been approaching it is that I have been putting as much as I can into Roth accounts without leaving the 12% tax bracket.  The next tax bracket is 22% and I'm avoiding that entirely. 

I've heard some people on here say that its always best to do traditional if you plan to FIRE because of the ROTH IRA conversion ladder.  I don't know enough about that to know if it makes the best sense for me.  I do hope to FIRE at around 45 (13 years away).


seattlecyclone

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Roth makes more sense when you expect your marginal tax rate in retirement will be greater than or equal to your marginal rate today.

Note that for your marginal rate to be higher, you're probably going to need a higher taxable income in retirement than you have now. For that to happen, you're going to need some savings in traditional accounts and/or a pension, since Roth withdrawals generally don't count as income. Therein lies the reasoning behind the general advice to prefer traditional: the more money you have in Roth, the less likely it is that putting more in Roth is going to be an optimal decision. Roth can be great when it's the only tax-sheltering option available (if you have too high of an income to deduct traditional IRA contributions, or if you have the mega backdoor available at work), or if you're in an unusually low-income year, or if there are other special circumstances in play. For most of us, we should do as much pre-tax saving as we can.

FireAnt

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Roth makes more sense when you expect your marginal tax rate in retirement will be greater than or equal to your marginal rate today.

Note that for your marginal rate to be higher, you're probably going to need a higher taxable income in retirement than you have now. For that to happen, you're going to need some savings in traditional accounts and/or a pension, since Roth withdrawals generally don't count as income. Therein lies the reasoning behind the general advice to prefer traditional: the more money you have in Roth, the less likely it is that putting more in Roth is going to be an optimal decision. Roth can be great when it's the only tax-sheltering option available (if you have too high of an income to deduct traditional IRA contributions, or if you have the mega backdoor available at work), or if you're in an unusually low-income year, or if there are other special circumstances in play. For most of us, we should do as much pre-tax saving as we can.

Okay- but the part that gets me on a Roth is that it is sitting in an account tax free so all the gains will also be tax free. In a traditional you will get taxed on the gains when you're ready to pull out. Doesn't it make more sense to utilize the Roth when possible?

seattlecyclone

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The amount of tax you pay doesn't matter nearly so much as the amount you get to keep after taxes.

Suppose that you know your tax rate will be some fraction T now and forever. Suppose that you have some amount of pre-tax money ($X) available to invest and you expect it to grow by a factor of G between now and when you withdraw the money.

If you contribute to traditional, you pay no tax now. Your $X investment grows by a factor of G, leaving you with $XG before you withdraw. At the time of withdrawal, you pay $XGT in taxes, leaving you with (1-T)$XG to spend.

If you contribute to Roth, you pay $XT in taxes now, leaving you with (1-T)$X to invest in your Roth account. That money grows to (1-T)$XG by the time you want to withdraw, and you get to keep the whole amount since it's a Roth account.

You get to keep the same amount either way! You paid more dollars in tax with the traditional account because you paid the tax after the growth instead of before, but so what? If the tax rate had even been a fraction of a percentage point lower when you retired the traditional would have left you with more money to spend, despite your tax bill being higher. Hence the advice to look first at whether you expect your tax rate to be lower or higher during retirement when making this decision.

MustacheAndaHalf

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With the Roth ladder in mind, it might make sense to contribute to a Traditional IRA with the intention of using the Roth ladder before retirement.  But for that to work, you need to not work - you need a lower income year where you can make the conversion.

A couple tie breakers: if you prefer "what you see is what you get", and removing tax rate uncertainty, Roth IRAs do that.  Also, we have historically low tax rates right now, so a Roth lets you take advantage (assuming there's a higher chance of taxes going up instead of down).

DadJokes

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Assuming you make $100k, have annual expenses of $50,000, and want the same take-home pay in either scenario, here is how the investing and draw-down phases would look:

During investing yearsTraditionalRoth
Gross income100,000100,000
Invested46,95041,316
AGI53,050100,000
Std deduction24,40024,400
MAGI28,65075,600
Tax3,0508,684
Take-home50,00050,000

During draw-down yearsTraditionalRoth
Gross income53,05050,000
AGI53,0500
Std deduction24,400N/A
MAGI28,6500
Tax3,0500
Take-home50,00050,000
Effective tax rate5.7%0%

I'm assuming that tax brackets and spending increase steadily with inflation and am putting everything in 2019 dollars.

When you invest, you are investing at your marginal tax rate. In this example, your marginal rate is 12%. By choosing a Roth instead of traditional, you would be choosing to pay 12% more in taxes today to avoid paying 5.7% in retirement.

Now, it would be just as effective to invest enough in traditional so that you could withdraw the tax-free amount in retirement, which would be the standard/itemized deduction amount, as well as any above the line adjustments. That would, at best, be just as effective as going 100% traditional if tax brackets remain the same, and your spending does not drastically increase in retirement. However, it can be a good idea to split between the two, just in case politicians ever realize that we have a national debt that is going to have to be paid. Even then though, middle class tax brackets would have to increase substantially before 100% Roth was better than 100% traditional.

OneCoolCat

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Assuming you make $100k, have annual expenses of $50,000, and want the same take-home pay in either scenario, here is how the investing and draw-down phases would look:

During investing yearsTraditionalRoth
Gross income100,000100,000
Invested46,95041,316
AGI53,050100,000
Std deduction24,40024,400
MAGI28,65075,600
Tax3,0508,684
Take-home50,00050,000

During draw-down yearsTraditionalRoth
Gross income53,05050,000
AGI53,0500
Std deduction24,400N/A
MAGI28,6500
Tax3,0500
Take-home50,00050,000
Effective tax rate5.7%0%

I'm assuming that tax brackets and spending increase steadily with inflation and am putting everything in 2019 dollars.

When you invest, you are investing at your marginal tax rate. In this example, your marginal rate is 12%. By choosing a Roth instead of traditional, you would be choosing to pay 12% more in taxes today to avoid paying 5.7% in retirement.

Now, it would be just as effective to invest enough in traditional so that you could withdraw the tax-free amount in retirement, which would be the standard/itemized deduction amount, as well as any above the line adjustments. That would, at best, be just as effective as going 100% traditional if tax brackets remain the same, and your spending does not drastically increase in retirement. However, it can be a good idea to split between the two, just in case politicians ever realize that we have a national debt that is going to have to be paid. Even then though, middle class tax brackets would have to increase substantially before 100% Roth was better than 100% traditional.

Interesting.  I didn't factor in that you could receive the standard deduction if you pull from a traditional account.  That definitely makes it more appealing.

AccidentalMiser

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So, here's my thing with this.  I have a good income now and I don't have much in my Roth accounts.  I am going to retire at 55.  My Roth 401k money will be available to me any time and I won't have to worry about the tax implications of taking it out.  My plan is to draw out pre-tax money up to the limit of the 12% bracket plus the standard deduction for living on.  I will also start laddering my pre-tax money into my Roth at the same time with a view to using up or converting all the money or spending it prior to RMD time.  Having a nice Roth cushion will allow us to have high spending years without getting killed on taxes.

I don't mind paying up for the Roth now since I am able to pay the taxes comfortably.  Maybe I'm dumb but I like flexibility. 

MustacheAndaHalf

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Let's take two scenarios where you need $50k.  I'll round off the tax brackets to make this simpler ($10k is actually $9,526 .. etc):

You withdraw from a Traditional IRA, for income + Roth Conversion:
$12k std deduct = $0 tax
$10k taxed at 10% = $1k tax
$28k taxed at 12%  = $3k tax
Using that approach, you pay $4k tax on $50k withdrawn from taxable accounts (or Roth Conversions)

Or, you limit Roth Conversion to $12k (the std deduction):
$12k std deduct, Roth convert = $0k tax
$38k long-term taxable gain at 0% = $0k tax
Which means paying $0k

This assumes you have a mix of taxable and Traditional IRAs.  When you do, selling within the 0% long-term capital gains tax bracket results in the lowest tax.

MDM

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When you invest, you are investing at your marginal tax rate.
And when you take an elective withdrawal from a traditional account, you are also withdrawing at your marginal tax rate.

See Traditional versus Roth - Bogleheads for more details.  Effective rates are irrelevant in this analysis, unless one wants to make a lifetime choice of contribution type.  Fortunately the IRS allows one to switch contribution types from year to year - or even within a year.

ender

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Roth makes more sense when you expect your marginal tax rate in retirement will be greater than or equal to your marginal rate today.

Note that for your marginal rate to be higher, you're probably going to need a higher taxable income in retirement than you have now. For that to happen, you're going to need some savings in traditional accounts and/or a pension, since Roth withdrawals generally don't count as income. Therein lies the reasoning behind the general advice to prefer traditional: the more money you have in Roth, the less likely it is that putting more in Roth is going to be an optimal decision. Roth can be great when it's the only tax-sheltering option available (if you have too high of an income to deduct traditional IRA contributions, or if you have the mega backdoor available at work), or if you're in an unusually low-income year, or if there are other special circumstances in play. For most of us, we should do as much pre-tax saving as we can.

One other consideration is whether you are likely to inherit any money in pretax accounts.


SeattleCPA

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Roth makes more sense when you expect your marginal tax rate in retirement will be greater than or equal to your marginal rate today.

Note that for your marginal rate to be higher, you're probably going to need a higher taxable income in retirement than you have now. For that to happen, you're going to need some savings in traditional accounts and/or a pension, since Roth withdrawals generally don't count as income. Therein lies the reasoning behind the general advice to prefer traditional: the more money you have in Roth, the less likely it is that putting more in Roth is going to be an optimal decision. Roth can be great when it's the only tax-sheltering option available (if you have too high of an income to deduct traditional IRA contributions, or if you have the mega backdoor available at work), or if you're in an unusually low-income year, or if there are other special circumstances in play. For most of us, we should do as much pre-tax saving as we can.

+1

seattlecyclone

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Roth makes more sense when you expect your marginal tax rate in retirement will be greater than or equal to your marginal rate today.

Note that for your marginal rate to be higher, you're probably going to need a higher taxable income in retirement than you have now. For that to happen, you're going to need some savings in traditional accounts and/or a pension, since Roth withdrawals generally don't count as income. Therein lies the reasoning behind the general advice to prefer traditional: the more money you have in Roth, the less likely it is that putting more in Roth is going to be an optimal decision. Roth can be great when it's the only tax-sheltering option available (if you have too high of an income to deduct traditional IRA contributions, or if you have the mega backdoor available at work), or if you're in an unusually low-income year, or if there are other special circumstances in play. For most of us, we should do as much pre-tax saving as we can.

One other consideration is whether you are likely to inherit any money in pretax accounts.

Sure, maybe, if you inherit a bunch.

If you inherit a $1 million traditional IRA at age 50, you'll have an RMD of $29,239 that first year. That's not going to put you in a very high tax bracket on its own, not right away.

Suppose you get to age 70 with the inherited IRA still worth $1 million (your RMDs and any additional withdrawals took out the growth but nothing more). Suppose you also have your own traditional IRA with a $1 million balance at that time. Your RMD for the inherited account will have grown to about $70k at that point, with the RMD for your own account starting out at about $36k. Now we're getting to the point where being in a higher tax bracket than you were in while working is a real possibility.

How many of us actually expect to inherit a $1 million IRA, though? My parents did pretty well for themselves (as far as "normal" age retirement goes), and yet they still aren't millionaires. Furthermore we all hope they live long enough to spend most of it before they pass away, and anything left will be split three ways anyway. So how much inheritance am I planning to get from them? I'm not factoring it into our plans at all. They could leave us a six-figure amount, but it could just as easily be nothing at all.

If you are reasonably certain you'll get a $1 million IRA inheritance, you should definitely take that into account when estimating your retirement tax bracket and make your own retirement contribution decisions accordingly. Keep in mind that in the above example it still seems pretty doable to structure things so that you never exceed the 12% bracket. A single person who takes the standard deduction is still in the 12% tax bracket all the way up to $51,675. Double that amount for a married couple. If you pull out more than the RMD from the inherited account early on, you're much less likely to have your RMDs push you into a higher tax bracket later in life.

ender

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@seattlecyclone well, there are a lot of potential factors.

In that example, if someone has a nominal pension income (I have ~$6k/year in pension income at 67 or something from my first job), some social security income, Roth conversions, etc, you can get a lot of pieces into that pie.

That being said if you plan on retiring early most of these considerations don't matter because if you end up having to pay too much tax at any point in your retirement it just means you worked too long and/or ended up with way more money than you planned.

I also do 100% of what I can into traditional accounts too for this reason - the only time that will hurt me is if we end up with way too much money. Maybe that's from an inherited IRA, maybe SS, or a combination of things. Either way it's the same end result: too much money.

WhiteTrashCash

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Due to Trump's tax plan, I received basically no tax benefit from a Traditional IRA, so I just have a Roth IRA. At least I won't have to pay taxes on it when I retire.

StarBright

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I started my Roth in college so I've just sort of stuck with it, but I will say that one major benefit that I haven't read mentioned in this thread is flexibility.

With a Roth you can:
  • Withdraw 10k penalty free for your first house purchase
  • Use it to penalty free pay for qualified educational expenses (but you do have to pay taxes on those withdrawals)
  • Withdraw contributions at any time penalty free, so it is like a back up emergency fund

We still optimize our work based pre-tax accounts first (401a, 401k, and 457) but if we have extra sitting around we throw it into our Roth's every couple of months.

I used the 10k first house withdraw to grab a deal during the recession and at this point we are planning on using it as our backup for whatever we can't cashflow for our kids' college.

For us, the Roth has been a pleasant surprise. I'm super thankful to the financial guy at my first part-time job who mentioned it to me!
« Last Edit: March 20, 2019, 10:23:08 AM by StarBright »

DadJokes

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I started my Roth in college so I've just sort of stuck with it, but I will say that one major benefit that I haven't read mentioned in this thread is flexibility.

With a Roth you can:
  • Withdraw 10k penalty free for your first house purchase
  • Use it to penalty free pay for qualified educational expenses (but you do have to pay taxes on those withdrawals)
  • Withdraw contributions at any time penalty free, so it like a back up emergency fund

We still optimize our work based pre-tax accounts first (401a, 401k, and 457) but if we have extra sitting around we throw it into our Roth's every couple of months.

I used the 10k first house withdraw to grab a deal during the recession and at this point we are planning on using it as our backup for whatever we can't cashflow for our kids' college.

For us, the Roth has been a pleasant surprise. I'm super thankful to the financial guy at my first part-time job who mentioned it to me!

I do like that last option especially, and whenever a bear market or recession hits, we will move money from our emergency fund into a couple Roth IRAs.

But I am still a fan of maxing out 401(k)s before even thinking about a Roth for normal retirement investing. In our case, we would have to invest $57,000 (two 401(k)s and a 457) before reaching that point.

StarBright

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I started my Roth in college so I've just sort of stuck with it, but I will say that one major benefit that I haven't read mentioned in this thread is flexibility.

With a Roth you can:
  • Withdraw 10k penalty free for your first house purchase
  • Use it to penalty free pay for qualified educational expenses (but you do have to pay taxes on those withdrawals)
  • Withdraw contributions at any time penalty free, so it like a back up emergency fund

We still optimize our work based pre-tax accounts first (401a, 401k, and 457) but if we have extra sitting around we throw it into our Roth's every couple of months.

I used the 10k first house withdraw to grab a deal during the recession and at this point we are planning on using it as our backup for whatever we can't cashflow for our kids' college.

For us, the Roth has been a pleasant surprise. I'm super thankful to the financial guy at my first part-time job who mentioned it to me!

I do like that last option especially, and whenever a bear market or recession hits, we will move money from our emergency fund into a couple Roth IRAs.

But I am still a fan of maxing out 401(k)s before even thinking about a Roth for normal retirement investing. In our case, we would have to invest $57,000 (two 401(k)s and a 457) before reaching that point.

^ I totally get that! I've got two non-neurotypical kids and a husband with no interest in Early Retirement so we choose to keep extra cash on hand  rather than perfectly optimizing our tax advantaged retirement accounts. It makes our lives a little easier. When the extra pile/e fund get larger than we need we just move that money over to the Roths.

Looking at our Roth IRAs as more of a slush/backup emergency fund is newer for us though. It's just that when we weren't paying attention, our Roths grew enough that we are starting to see some real compounding with them now. It seems dumb to start a 529 for college savings when the IRAs are starting to do real work for us.

MDM

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Due to Trump's tax plan, I received basically no tax benefit from a Traditional IRA, so I just have a Roth IRA. At least I won't have to pay taxes on it when I retire.
If one receives no benefit from a tIRA, that implies a marginal tax saving rate of 0% for traditional contributions.  In that case, yes, Roth is preferred: no tax cost to contribute, and no tax on qualified withdrawals.

aceyou

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My wife and I have a situation where Rothing makes sense

Gross Pay of about 155k/year
Married Filing jointly is 12% bracket up to 77,400. 
Tack on 24k for a standard deduction, that makes $101,400
That's $8907 in fed tax.
But we have 2 kids, so subtract 4k in credits. 
So, I pay $4907 on the first $101,400

Strategy
We do enough in our traditional to put us down to an AGI of 101,700.  After that, everything goes into Roths.  And we will have pensions from teaching, so it's not like our income will be super low in retirement. 

seattlecyclone

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My wife and I have a situation where Rothing makes sense

Gross Pay of about 155k/year
Married Filing jointly is 12% bracket up to 77,400. 
Tack on 24k for a standard deduction, that makes $101,400
That's $8907 in fed tax.
But we have 2 kids, so subtract 4k in credits. 
So, I pay $4907 on the first $101,400

Strategy
We do enough in our traditional to put us down to an AGI of 101,700.  After that, everything goes into Roths.  And we will have pensions from teaching, so it's not like our income will be super low in retirement. 


Yep, that's a situation where Roth can certainly make sense. You're going traditional for the income that would be in the 22% bracket, and going Roth for the income that would be in the 12% bracket. You need to put about $50k in traditional before you get to that 12% bracket, so doing this every year would get you a pretty sizable traditional balance. With that plus a pension it seems pretty likely that you would hit the 12% bracket in retirement.

OneCoolCat

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My wife and I have a situation where Rothing makes sense

Gross Pay of about 155k/year
Married Filing jointly is 12% bracket up to 77,400. 
Tack on 24k for a standard deduction, that makes $101,400
That's $8907 in fed tax.
But we have 2 kids, so subtract 4k in credits. 
So, I pay $4907 on the first $101,400

Strategy
We do enough in our traditional to put us down to an AGI of 101,700.  After that, everything goes into Roths.  And we will have pensions from teaching, so it's not like our income will be super low in retirement.

This is nearly identical to my situation.

kanga1622

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No brainer for us - we have $0 tax liability once we account for utilizing medical savings accounts, daycare savings account, child tax credit, and savers credit. So we put everything in Roth because it is $0 tax now and it grows tax free. :)

seattlecyclone

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No brainer for us - we have $0 tax liability once we account for utilizing medical savings accounts, daycare savings account, child tax credit, and savers credit. So we put everything in Roth because it is $0 tax now and it grows tax free. :)

Be aware that $0 isn't a particularly magic number when refundable tax credits (such as the child tax credit) are involved. It's likely that you could have a negative tax liability if your taxable income was a bit lower. That said, your marginal rate at that point is likely low enough to make Roth contributions be a very defensible choice.

kanga1622

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No brainer for us - we have $0 tax liability once we account for utilizing medical savings accounts, daycare savings account, child tax credit, and savers credit. So we put everything in Roth because it is $0 tax now and it grows tax free. :)

Be aware that $0 isn't a particularly magic number when refundable tax credits (such as the child tax credit) are involved. It's likely that you could have a negative tax liability if your taxable income was a bit lower. That said, your marginal rate at that point is likely low enough to make Roth contributions be a very defensible choice.

Thanks for bringing this up. We already feel funny that the IRS thinks we are "poor." We send in $0 taxes during the year and still get a refund. The refund just makes more to set aside for future retirement. :)

Aunt Petunia

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In addition, donít forget state taxes. It might make sense to go traditional if you live in a high tax state now and are open to moving later, or vice versa. Some states exempt traditional retirement withdrawals from state tax, treating them the same as a Roth. State credits can be tricky too, e.g. we got a $500 credit for 529 contributions, that we could only qualify for if we brought our AGI below $75k.

Grande

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It made sense to me this year to contribute to a 401a (Roth equivalent) my new employer offers. They allow employees to contribute a certain percentage of their pay that totals $6000/year for me. Before that I had maxed 403b, Trad IRA, and HSA. The remainder would go in taxable accounts. I figure why not contribute to the 401a account as it allows flexibility come later and apparently many colleges are blind to retirement accounts when it come to financial aid.

Separate topic from that but I had not done any Roth contributions for many years but am rethinking this. These days I am getting my taxable income into the 12% bracket (wife isn't working much and raising kids) and have been tempted to do Roth over Traditional IRA when in the 12% bracket. Not sure if that's optimal but it seems reasonable.

Boofinator

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Roth makes more sense when you expect your marginal tax rate in retirement will be greater than or equal to your marginal rate today.

Note that for your marginal rate to be higher, you're probably going to need a higher taxable income in retirement than you have now. For that to happen, you're going to need some savings in traditional accounts and/or a pension, since Roth withdrawals generally don't count as income. Therein lies the reasoning behind the general advice to prefer traditional: the more money you have in Roth, the less likely it is that putting more in Roth is going to be an optimal decision. Roth can be great when it's the only tax-sheltering option available (if you have too high of an income to deduct traditional IRA contributions, or if you have the mega backdoor available at work), or if you're in an unusually low-income year, or if there are other special circumstances in play. For most of us, we should do as much pre-tax saving as we can.

100% agree with this analysis (in bold), with the exception that it doesn't take into account risk and the utility value of money. The utility value of money is simply the fact that each dollar is worth more (has more utility) to me if I had a smaller amount of money than if I had a larger amount of money. So if someone has a large amount of money in retirement, Roth might have been the better choice, but does it really matter all that much since he or she has won the game? However, if that person has a small amount of money in retirement, Traditional will have been the better choice, and those dollars will be much more precious as well.

ender

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Roth makes more sense when you expect your marginal tax rate in retirement will be greater than or equal to your marginal rate today.

Note that for your marginal rate to be higher, you're probably going to need a higher taxable income in retirement than you have now. For that to happen, you're going to need some savings in traditional accounts and/or a pension, since Roth withdrawals generally don't count as income. Therein lies the reasoning behind the general advice to prefer traditional: the more money you have in Roth, the less likely it is that putting more in Roth is going to be an optimal decision. Roth can be great when it's the only tax-sheltering option available (if you have too high of an income to deduct traditional IRA contributions, or if you have the mega backdoor available at work), or if you're in an unusually low-income year, or if there are other special circumstances in play. For most of us, we should do as much pre-tax saving as we can.

100% agree with this analysis (in bold), with the exception that it doesn't take into account risk and the utility value of money. The utility value of money is simply the fact that each dollar is worth more (has more utility) to me if I had a smaller amount of money than if I had a larger amount of money. So if someone has a large amount of money in retirement, Roth might have been the better choice, but does it really matter all that much since he or she has won the game? However, if that person has a small amount of money in retirement, Traditional will have been the better choice, and those dollars will be much more precious as well.

This is exactly my reasoning too. We're about 30% in Roth right now just based on money we save that can only be Roth (IRAs, etc) and every penny we can do pretax we do.

If we have too much when we retire then I guess we "won" by accident.