Unconventional Wisdom: Confessions of a Financial Professional

January 18, 2012

When it comes to topics to write about in this blog, I usually look through the news or around the home, but this week’s topic actually comes from another reader, not because they asked me to write on a particular topic—although I welcome your suggestions—but rather because the reader gave me a new way to look at an old subject. I’ve written many times already on the topic of Roth IRAs, and each time I’ve taken the position that the Roth was somehow sacred, and that everyone in America should have one, but my new online friend gave me some compelling arguments as to why I shouldn’t be so down on traditional retirement accounts. Rather than try to recap the conversation, I welcome you to scroll through the dialogue that is found in the comments section of my June 8, 2011 blog titled To Roth, or Not to Roth.

What I love so much about BG’s argument is the basic understanding of the federal income tax system. Specifically, BG appreciates that not all income is taxed equally. In fact, some income is not taxed at all! The amount of income that is not taxed is based on the number of personal and dependent exemptions you claim, along with your standard or itemized deductions. Taxpayers may claim an exemption for themselves, as well as a spouse if married filing jointly, along with certain qualifying dependents. For 2012, each exemption is worth $3,800 ($3,700 in 2011). Standard deductions are $5,950 ($5,800 in 2011) if you’re a single filer, and $11,900 ($11,600 in 2011) if you’re married filing jointly. That means a family of six (like mine) could have as much as $34,700 or more of income before incurring a single cent in income tax.

This is all good to know, but it doesn’t necessarily answer the question about whether or not you should contribute to a Roth retirement account. Here are additional things you’ll need to consider:

How much income will you need in retirement?

That’s a loaded question, and there is no single answer, but for many, replacing 60 – 80% of their income in retirement should allow them to enjoy the retirement they’ve been looking forward to. If you would like a more precise number, use the Retirement Budget Planner to get you started. From there, use a Retirement Planning Estimator to help you reach your goal.

What are your retirement income sources, and how are they taxed?

Retirement income sources may include retirement benefits through work (e.g. pension, 401(k)), Social Security, IRAs, annuities, part-time work, personal savings, etc. Some, like the traditional 401(k) and part-time work, are subject to ordinary income tax while others, such as personal savings, may be subject to little or no income tax.

How much income can you exclude from income taxes (via exemptions and deductions) in retirement?

Just as a portion of your income is tax free today, so will a portion of your income be tax free in retirement. The primary difference may be how much, and that will depend on the number of exemptions you claim, whether you claim a standard or itemized deduction, and how the tax code changes.

When you put it all together, how does your income tax picture in retirement compare to the picture today?

Perhaps the best way to answer this question is to look at an example:

Let’s say you’re married with two kids and your combined household income is $75,000. Here is the tax picture today:

Gross income: $75,000

Less exemptions: (4 x $3,800) -$15,200

Less standard deduction: -$11,900

Taxable income: $47,900

Based on the current income tax tables, you fall into the 15% marginal tax bracket. That means putting money in a Roth account will cost you 15% in income tax, while putting money into a traditional account will save you 15%.

Let’s fast forward 20 years. Your need for income is about $95,000 (based on 70% of $75,000 and a 3% rate of inflation). The kids are gone, and your income sources are Social Security and a traditional 401(k). All things considered, your projected tax picture in retirement (assuming a 3% cost of living increase) may look like this:

Gross taxable income*: $90,500

Less exemptions: (2 x $6,900) -$13,800

Less standard deduction: -$21,500

Taxable income: $55,200

*Up to 85% of Social Security income is taxable.

It looks like you’ll still be in the 15% marginal tax bracket, so it really doesn’t matter whether you use a traditional or Roth account, right? Not necessarily. Let’s take a closer look:

Of the $90,000, assume $30,000 comes from Social Security and the rest from a traditional retirement account. Because of the exemptions and deductions—in this case worth $35,300—the entire amount of Social Security, plus an additional $5,300 of tax-deferred income, pays 0% income tax. In addition, a portion of the remaining taxable income is taxed at the 10% marginal tax rate. So in essence, some of the money contributed to the traditional retirement account will be taxed at only 10%, and some will not be taxed at all! Comparing that to the 15% you would have paid on Roth contributions, the traditional account looks very favorable.

Now before you run out and start putting all of your retirement funds into a traditional account, please note the following ASSUMPTIONS:

I assumed how much income would be required in retirement.
I assumed how much exemptions and deductions would be worth.
I assumed that the tax brackets would be similar.
I assumed that there were only two sources of income.
I assumed that more money would be contributed to a traditional account because of the tax savings.

It is very important to recognize that a change in any one of these assumptions could turn the argument in the other direction, but nonetheless this illustration makes the point that not all income, present or future, is taxed equally.

Many financial professionals, including me, would look at someone in the 15% marginal tax bracket and say “hey, you’re in a pretty low tax bracket; you should consider putting money in a Roth retirement account.” While that is the conventional wisdom, as you can see from the above example, even the conventional wisdom has its limitations.