Ever since the invention of the Roth IRA (and subsequent Roth 401(k)), taxpayers have been plagued with the question: Should I contribute to a traditional or Roth account?
The answer is quite simple. If you hold your crystal ball just right, you can peer into the future and see what your tax rates are going to be in retirement. If your rates are higher, Roth! If your rates are lower, traditional! What’s so hard about that?
What’s that? You say your crystal ball is not working? Well, I’d let you borrow mine, but I can’t seem to find it, so here’s what I suggest. Why not split your contributions between both accounts. That way, regardless of what your tax rates are in retirement, you’ll have some taxable money (i.e. traditional) along with some tax-free money (i.e. Roth).
But I thought the benefit of contributing to a traditional account was allowing the money I would have paid in taxes to compound, thus providing more in retirement. Won’t splitting my contributions leave me with less in my retirement account?
Honestly, it would, but that’s only if you are looking at your balance on a before-tax basis. What you really need to focus on is the after-tax benefit of both accounts. Maybe a simple illustration can help.
Imagine you are in the 25% marginal tax bracket today, and you contribute $100 per paycheck to a traditional retirement account. If you are paid every two weeks, and you retire 10 years from now, at a 6% rate of return you would have $35,652.67 in your account.
Now let’s use the same assumptions, but this time you contribute to a Roth account. Since Roth contributions are taxed BEFORE they go into your account, we can only contribute $75 per paycheck. That means at retirement your balance would only be $26,739.50.
If we stopped right there, it would appear that putting money into the Roth account has no benefit, but so far we have only made an assumption about our marginal tax rate today. We now must make an assumption about our marginal tax rate in retirement.
Assumption: My marginal tax rate in retirement is lower
If my marginal tax rate in retirement is lower, say 15%, then my traditional account balance in retirement would be $30,304.77 net of income taxes. This would still be higher than the $26,739.50 in my Roth account.
Assumption: My marginal tax rate in retirement is higher
By the same token, if my marginal tax rate in retirement is higher, say 33%, then my traditional account balance in retirement would be $23,887.29 net of income taxes. This would be lower than the $26,739.50 in my Roth account.
Based on this illustration, if you know that your marginal tax rate in retirement will be lower, you should put all of your contributions into a traditional account today. If you know that your marginal tax rate in retirement will be higher, you should put all of your contributions into a Roth account today. If you don’t know what your marginal tax rate will be in retirement, by not splitting your contributions between traditional and Roth accounts you are taking the chance that your decision to choose one or the other may be the wrong one. You may contribute too much to a traditional retirement account only to find yourself in a higher marginal tax bracket in retirement. Alternatively, you may contribute too much to a Roth account only to find out you are in a lower marginal tax bracket in retirement.
Now here’s the interesting part. If your marginal tax rate in retirement happens to be the same as it is today, IT MAKES NO DIFFERENCE whether you contribute to a traditional account or a Roth account. Using the illustration from above, at a 25% marginal tax rate in retirement, your traditional account balance would be $26,739.50 net of income taxes. It is not by luck that that happens to be the same value as your Roth account. Whether you compound tax-deferred dollars and then take out the taxes, or you take out the taxes and compound after-tax dollars, at the same tax rates it will work out to be the same mathematically every time.
So if your crystal ball is not working (or you can’t find it), you may be better off hedging your bets about the future of tax rates by splitting your contributions between traditional and Roth accounts.
“If your marginal tax rate in retirement happens to be the same as it is today, IT MAKES NO DIFFERENCE whether you contribute to a traditional account or a Roth account.”
Not true.
In retirement, you still have the standard deductions and personal exemptions which are taxed at 0%. To fill this 0% tax bracket, should you use tax-deferred “traditional” money, or already taxed Roth money? (Answer: Traditional). With traditional, you paid no taxes going in, and none coming out for the 0% retirement income bracket.
After the 0% bracket, there is the 10% marginal tax bracket — should you pull that income from tax-deferred traditional accounts or already taxed (likely at 25+% Roth money)? (Answer: Traditional).
After the 10% bracket, you have the 15% marginal tax bracket — should you fill that income from tax-deferred traditional accounts, or already taxed Roth accounts? If you paid into a Roth when you were in a 15% bracket, then it is a wash — If you paid into the Roth when you were in a 25% (or higher bracket), then once again that income in retirement should be pulled from a TRADITIONAL account.
(See the pattern?)
The Roth is only a wash, for retirement income that happens to fall into the same bracket that you paid into it at. The Roth only wins, for retirement income that fills a marginal bracket ABOVE the tax-rate that you paid into the Roth at (which is a tiny percentage of your retirement income, IF ANY).
Hi BG,
You bring up a good point, and if most or all of your retirement income is derived from tax-deferred sources then I would agree with most of your premise. I was merely trying to point out that “at the same tax rates” it is a wash, which you acknowledge. I don’t agree that only a tiny percentage of your retirement income would be above your current marginal tax rate. That may be true for many, but I personally am in a much lower bracket now than I expect to be in when I retire (thanks to exemptions and deductions I have now that I won’t have in retirement). You obviously understand how our marginal tax system works, and it sounds like you have figured out which account, traditional or Roth, makes the most sense for YOU. Hopefully anyone who reads this blog will recognize that it is not an exact science, and that there are many things to consider, including other income sources, potential changes in tax legislation, etc.
Thanks for contributing to the discussion.
Greg
Thanks for the response Greg. As for this statement:
“I don’t agree that only a tiny percentage of your retirement income would be above your current marginal tax rate.”
Maybe a very lucky few will be in a higher marginal tax-bracket during retirement than they were during their working years, but I suspect the majority of people will be in a lower bracket during retirement. But, my point is this: regardless of how much income you think you will have in retirement, you still need money in traditional accounts to fill the lower brackets (especially the future standard deductions and personal exemptions).
For example, I am still in my working years and I am currently in the 25% MFJ marginal tax bracket. Using the often quoted 4% withdrawal rate, I will need to have saved $2.25 million (today’s dollars) in traditional accounts to generate $90,200 yearly income that is needed to fill the 0%, 10%, and 15% brackets. That $90,200 in retirement income will be taxed at these rates, if I pull the money from traditional retirement accounts:
0% tax rate for $0-$19,500 (for the two personal exemptions and the standard deduction MFJ)
10% tax rate for $19,501-$36,900 (this is the 10% marginal tax bracket)
15% tax rate for $36,901-$90,200 (this is the 15% marginal tax bracket)
It is only the dollars that EXCEED $90,200 that will be taxed at 25% in the future — which would be a wash on whether I pay those taxes in the future, or today (via a Roth) since I am currently in the 25% MFJ marginal bracket. Since I don’t think my retirement income will exceed $90,200 (today’s dollars), I am going 100% traditional accounts — essentially deferring a 25% tax today, and pay a 0%, 10%, and 15% tax in the future. From my math, I should not even consider a Roth unless I expect my yearly retirement income to exceed $236,950 (today’s dollars) — and then I’d only use the Roth for the dollars that exceeds that amount. If using the Roth for any income less than $236,950 (today’s dollars), then at BEST it is a wash (for the income that falls in the 25% marginal bracket), and at WORST a waste of money for paying taxes today at 25%, when those dollars would have been taxed less (and some not at all) in the future.
If I am wrong, please correct me — but based on my understanding, the ‘general’ rule of thumb (if there could be one) would be something like this: Everyone should have traditional accounts (IRA, or 401k, etc) if only to cover the future standard deduction / personal exemptions in retirement (tax-free today, and tax-free in the future). Some people will also need Roth accounts, in ADDITION to their traditional accounts (based on certain circumstances). Nobody should be solely using Roth accounts, in lieu to traditional (as you are needlessly throwing away your future standard deduction / personal exemptions which are already tax free).
Thanks for the discussion.
Well, BG, I think we are in full agreement. It absolutely makes sense to have both traditional and Roth assets. For me, having Roth assets will help me avoid moving into the higher tax brackets when I am retired. As you put it, I won’t mind having the traditional assets taxed at the lower rates, but I still contend that other income sources, such as Social Security, pension, profit sharing, rental income, annuities, interest, dividends, part-time work, and others will just as easily fill the exemption and lower brackets in retirement just as my paycheck does today. It may be a question of HOW MUCH you have in these other sources that determines the real value of either a traditional or Roth retirement account.
I’m funding a Roth today, but I don’t intend to fund it for the rest of my life. As my situation changes, so will my choice of which account to fund. Just out of curiosity, how do you feel about using a tax refund to fund a Roth IRA? The reason I ask is because I have four children under the age of 14, so every year I qualify for a $4,000 refundable tax credit which offsets a lot of my income tax liability, and as a result I get money back from the IRS each year. Since this is technically post-tax money, do you think it makes sense to use this to fund a Roth account?
I appreciate your thoughts.
I am no tax expert far from it, I’m just a peon trying to make sense of the tax code and utilize the ‘traditional’ IRA/401k accounting tax loophole to the fullest
You are right about having other income sources in retirement filling those lower brackets — and right now I probably do need to work on diversifying to have multiple income streams (just one right now). But I still don’t envision myself having a greater than $90k a year (todays dollars) in retirement income that would justify a Roth for me. I’m 35ish, and not counting on Social Security being around when I get my turn to retire. I typically don’t get a tax-refund as I keep my W4 at a level where I’m pretty much at $0 when it comes to filing (sometimes I owe a little, sometimes I get a little refund).
Anyhow, for you question about using the $4k (after tax) tax-refund to fund a Roth — I don’t think it matters what the ‘source’ of the money was, since technically it is just a refund of the overpayment of taxes (it is already your money that you have already paid taxes on).
Personally I would put all $5,330 into a traditional IRA (or 401k) — instead of putting the $4,000 into the Roth (and letting the government keep the $1,330 in taxes — assuming the 25% marginal bracket today). Another idea, and what I do myself, is I fully fund an HSA account (requires a high-deductible insurance policy) — this way that money is avoiding the income AND social security taxes (going in and coming out as long as used for qualifying medical expenses).
Basically I am trying to use every loophole in the book to avoid paying a 25% tax on any dollar I make… If someone is reading this and they are in the 15% marginal bracket right now (especially near the top of the 15% bracket), then I probably would lean towards a Roth if I had an expectation to be in the 25% (or higher) brackets eventually during my earning years. For me, I’m near the bottom of the 25% bracket, so perhaps that is why the traditional (and not Roth) is the better option for me: where you are located within your bracket is probably the best indicator?
Thanks for the discussion (I’m learning a lot)!
I must confess you have caused me to rethink the way I look at traditional accounts. I, too, think it is a good idea to fully fund an HSA, so I’m glad to hear that you are taking advantage of this truly tax-free way to save. One other thing you may want to consider is what happens to a traditional account when the owner passes away. Distributions from traditional accounts are treated as taxable income to the recipient, even if the recipient is a beneficiary. Non-spouse beneficiaries are required to begin distributions within five years of when the original owner passes away, so it’s possible a beneficiary could start to receive this income, even while they are still working. One could say that’s an issue for the beneficiary, but Roth beneficiaries don’t have to worry about taxable distributions as long as the original account holder owned their Roth account for at least five years. With so much to consider, who really knows? Thank you for the delightful conversation. I hope you continue to read and respond to all of the blogs on our website.
Greg, good points. Other benefits the Roth has over traditional accounts is that you can take the contributions out of a Roth penalty free (like for an emergency). With the traditional accounts, the money is locked up until you are 59 1/2, and you will be assessed the income taxes plus a 10% penalty if you take it out before then (unless you have a qualified hardship) — so it is best to have other savings (emergency funds) before investing in the traditional accounts.