If given the choice, should you make traditional (i.e., tax-deductible) or Roth retirement contributions? This has been a hot question in financial planning circles ever since Roth plans were created in 1997.
For the sake of simplicity, I’m going to restrict today’s discussion to IRAs, but it’s applicable to any retirement vehicle with a tax-deferred vs. Roth option. For example, an increasing number of 401(k) and 403(b) plans offer a Roth option.
As a quick refresher, traditional IRA contributions are tax deductible (assuming you don’t make too much money). Your money will then grow tax-deferred until you take it out, at which time taxes will be due at regular income tax rates.
With a Roth IRA, you lose the upfront tax deduction. However… Your distributions will be completely tax free, meaning that you don’t pay a dime of taxes on your investment gains.
Traditional vs. Roth
The common arguments when it comes to debating traditional vs. Roth IRA contributions revolve around your current and future tax brackets. If you’re in a lower tax bracket now than you expect to be in at retirement, you should use a Roth.
In contrast, if you’re in a higher tax bracket now than you expect to be at retirement, you should make deductible contribution to a traditional IRA. That way you can get the tax break now (in the higher bracket) and pay less in taxes later.
The future of taxation
Of course, this all assumes that you can accurately predict future tax rates. While you might be able to accurately predict whether your inflation-adjusted income will be higher or lower in retirement, you’ll need a crystal ball to predict what tax rates will look like in 30 years.
In other words, while you may drop to a lower bracket, future tax increases could mean that the percentage associated with this bracket is higher higher than what you’re paying today.
And what if we convert to a consumption-based tax system (such as the “Fair Tax”) in place of our current tax system? That seems unlikely, but if it happened, people with Roth IRAs could get if they paid income taxes on the front end and then got hit with a consumption tax on the back end.
How to avoid current and future taxes
Another consideration that many people overlook is that, while the current income tax brackets bottom out at 10%, a married couple filing jointly will pay no taxes on their first $18, 700.
Why? Because they’d be entitled to the standard deduction ($11, 400 in 2009) and two personal exemptions ($3650 each). Beyond this, the 10% tax bracket for married couples extends up to $16, 750 and the 15% tax bracket extends up to $68, 000.
Ultimately, this means that at least a small amount of traditional IRA money could be very valuable. Consider the following scenarios for a married couple filing jointly:
- With $18, 700 in income…
…no taxes are due. - With $35, 450 in income…
…the Federal tax bill will be $1675.00 (10% of $16, 750). - With $86, 700 in income…
…the Federal tax bill will be $9362.50 (10% of $16, 750 and 15% of $51, 250).
This works out to a effective income tax rate of 0.0%, 4.7%, or 10.8%. By taking advantage of the very low end of the income tax brackets, you can take a tax deduction now and pay very little in income taxes later.
In other words… You can have your cake and eat it to. By balancing traditional and Roth contributions during your pre-retirement years, you’ll have the flexibility to minimize your tax hit on both ends.
If you only make Roth contributions, then you’re paying taxes now to pay nothing later. But with at least a small amount of traditional IRA income, you can avoid taxes now and later.
In your last paragraph you state that if you are contributing to IRA, (which I think is same as tax deferred annuity) you can get away with paying Now and Later. My question is what do you consider a small amount. I’m very confused about these , I’m retired and have a TDA! Thank for your advise
@April 19th, 2010 at 10:07 am
You didn’t consider that when investing into a traditional, you have more money to invest. Say you could invest
$10,000 into a ROTH. Now, imagine you would be in the 25% bracket and contributing
$12,500 into a traditional will
a) likely bring you down into the 15% bracket
b) increase that much more at the age of retirement that the taxes you need to pay are covered!!!
Dan) I was using the inflation calculator at:
http://www.westegg.com/inflation/infl.cgi
I put in: 128000
start year: 1970
end year: 2009
it spit out $700k for that specific (39-year) period…
BG,
I sure do agree with your conclusion — that is, that it is hard to see the value in a Roth for the vast majority of people out there. The more I think about the issue, the more I think the government pulled a fast one on the American public. At the same time, I like having options, and options can rarely be bad.
One small bone to pick — I’m not sure I agree with your inflation calculations. I would calculate $128k today as being worth $384k 40 years from now.
On second thought, maybe you’re right. I use an inflation rate of 2.65%, and it looks like you’re using 4.3%. I guess a little goes a long way in this case, doesn’t it?
(And this also brings up the need to run sensitivity models — it’s pretty apparent that a relatively small difference in inflation rates creates huge differences down the road.)
I agree with the idea that hedging your retirement funds between pre-tax and aftertax is a good strategy. Everyone gets at least a standard deduction and exemption so at least that much of your income should be taxable.
#13 Dan) I’m assuming that the minimum required distributions (MRD) and the tax-brackets will all be adjusted for inflation every year.
When I said that I’d need to have $3-$4 million saved up to make a Roth worthwhile for me (25% marginal bracket) I’m talking about in today’s dollars. 40 years from now, my account would likely be $19-$20 million for it to be worth investing in a Roth today.
$128k today, will likely be worth the same as $700k 40-years from now (I’m using inflation data from the past 40 years to compute this). Likewise, I’d expect the $700k to put you near the top of the 25% MFJ tax bracket in 2050 — just like $128k does today.
The government does a good job of readjusting the brackets every year for inflation (and the AMT for that matter), let’s just hope they keep that up.
Of course, if you think the government is going to raise the ‘real’ income tax rates — go with the Roth. But I don’t think the gov will ever eliminate the 0% bracket (standard deductions & personal exemptions) — they will always give us a poverty/living allowance, so you still want at least something in a traditional account (pay no taxes today, or in retirement on that money).
If you’re married and in the 15% bracket, then you only want to use a Roth for the money that you’d draw to use in the 25% bracket in retirement — that is where you win with the Roth: pay 15% today, to not have to pay 25% in the future.
Assuming you are pulling 4% from your retirement accounts (in retirement), you need to have $1.7 million in traditional accounts (today’s dollars) to fill the lower brackets (0%, 10%, 15%). Any amount you can somehow manage to save over $1.7million (today’s dollars) you should invest in a Roth — if you are in the 15% bracket today.
If you are in the 25% bracket today, then you need to save more than $3.5 million to make a Roth worthwhile: $3.44 million * 4% == $137k == top of the 25% bracket.
At least, that is how I understand things — I just don’t see the value in Roths for the majority of people out there. If anyone can dispute this, please do so as I want to learn more.
@BG
See my post above, but I’m with you. I’m actually in the 15% bracket right now (and will be until my wife starts working), and I am tempted to fund a Roth at these rates. However, between my 401k contribution and employer match, I’m already sticking aside 11% of my income. We also have a profit sharing contribution that gets made on top of that. So, I’m not inclined to contribute any more than that right now, and when my wife starts working, I think I’ll touch the Roth at the 25% rate.
@Nickel:
Thanks for writing on this subject. I’ve discussed it before in the comments section of a couple of different blogs, so it’s good to see an actual post on it.
One thing you could do to extend the subject is to take a gander what inflation-adjusted brackets, standard deductions, and exemptions would look like in 20, 30, and 40 years from now. (It’s not that hard, really!) When I look at what the MRD would be on my nest egg ($128,000 when I’m 70 1/2 on $3.5 million or so) I won’t be anywhere close to the 25% bracket.
Matt and BG: You are both correct. Changes made, and lesson learned… No more late night math/editing for me! Thanks. 🙂
Nickel) Also, you have a slight typo in your article:
“This works out to a marginal income tax rate of 0%, 4.7%, or 7.6%.”
Technically those are ‘effective tax rates’.
Anyhow, my plan is to use traditional accounts to fill the 0% (first $18,700), the 10%, the 15%, and the 25% marginal brackets. I’m in the 25% marginal bracket today. Any investments that I think would put me into the 28% bracket in retirement, those would go to Roth.
Since I don’t think I’m saving enough to worry about getting into the 28% bracket (would need 3-4 million or so saved up), I’m 100% traditional 401k and traditional IRAs…
Nickel) That’s right. You can pay 0% in taxes on both sides (today and in retirement) for the $18k or so if you use the 401k (traditional) options.
Not everyone should use a Roth, but everyone should have at least something going into traditional accounts.
Minor correction, bottom of first paragraph in my previous comment:
…”because 15% tax was only calculated on the $32,550 difference between $35,450 and $68,000.”
Apologies.
I may be wrong, but I think the Federal tax due on $86,700 is incorrect. Seems to me the $18,700 is double-counted. It was counted once for the $35,450, then counted again for the $86,700 total, because 15% tax was only calculated on the $32,550 difference between $35,450 and $86,700.
For the $86,700 case, the $18,700 deduction gets you back down to the $68,000 limit, but the total tax should be 10% on income up to $16,750 ($1,675) and 15% from $16,750 to $68,000 ($7,687.50) for total Federal Tax of $9,362.50 or 10.8% effective (not marginal, as the posting indicates) tax rate.
I’m currently contributing to the company’s 401(k) and plan to open a Roth IRA in 2011. (Debt repayment is more important to me right now!) As already mentioned in previous comments, this provides tax diversification, which reduces risk when it comes to changes in tax laws, etc.
For as long as I can afford it and am able to, I will contribute to a Roth IRA. Regardless of my current tax situation vs. my expected future one, I will contribue to a Roth.
I also agree that a split contribution is the right thing for many people. I plan to make contributions to my 401(k) to keep myself out of the 25% tax bracket unless I reach my contribution limits. any other money I have available I can contribute to a Roth IRA. In the future if I have some very low income years I can do a conversion at low tax rates if the opportunity presents itself.
MikeS: Yep, this sort of tax diversification is just one more way to reduce risk. Since we can’t be certain what will happen with taxes in the future, having both types of investments at your disposal will make it easier to make the best of whatever the future holds.
Love the ROTH: I agree with pretty much everything you said. The point of this article was simply that a small amount of tax-deferred holdings will allow you to benefit from a *completely* tax-free investments (i.e., deductible going in, not taxed coming out).
Even with a very long timeframe, people would still benefit by being able to fill up the 0% bucket with distributions from a tax-deferred account. Of course, this assumes that all things remain the same.
If/when a VAT is implemented, the impact will depend on the details. I agree that it is exceedingly unlikely that a consumption-based tax would replace the current system. Rather, it would likely be in addition to your regular obligations.
Something else that neither of us mentioned is that Roth accounts aren’t subject to RMDs, which could be a major consideration depending on your circumstances.
In the end, however, I think we’re both on the same page.
The answer as to which one is better will not be the same for everyone.
A big argument you missed is the amount of time one has until he/she retires. Someone who has 20+ years until retirement seriously needs to consider a ROTH due to the earnings potential (and that all earnings can be withdrawn tax-free). Say for example, a person who has 20 years until retirement contributes $5,000 to a ROTH each year for the next 5 years. That’s $25,000 of contributions on which taxes have already been paid (no tax benefit upon contribution). Using a conservative 5% return for this example, that $25K will be worth approx $60,000 at retirement!! NONE of which will be taxable (a 6% return would result in a $75K balance at the end of 20 years).
So you see – it’s not as simple as “do I pay taxes on the $5,000 this year, or when I withdraw it in retirement?” The ROTH gives the added benefit of withdrawing all the EARNINGS tax free as well – a HUGE benefit to us younger folks.
IMO – the optimal strategy is to have enough taxable income to wipe out the standard deduction and your exemption(s), and, depending on your current tax bracket, maybe enough to take you half way into the next tax bracket. I say MAYBE because there is no guaranty that it will still be 10% (I’m willing to bet it won’t. And if/when a VAT is implemented, I promise you it will be in ADDITION to the FIT, not to replace it!). THEN, the remaining income should come from a ROTH, so as to avoid the taxes on the rest. This is the strategy I am following. We have a sizable 401K (for our age) and are currently maxing out the ROTHs each year, while we are still young-ish and (just barely) in the 10% tax bracket. As we get older (and into the 25% bracket), we will begin to contribute to Traditional IRA each year instead of a ROTH (I reevaluate our positions each year).
Sadly, too many people are just concerned with what benefits them the most NOW, and don’t even consider future benefit or consequences (just like my 5 year old!)
Since my company offers both, a traditional 401k and a Roth 401k, I’m taking advantage of both. I’m simply contributing enough in the regular 401k to receive the company match (3% company match on 6% contribution) and then putting everything else in the Roth. I figure diversification works for investments, it can work for taxes strategies as well.