To Roth, or Not to Roth
June 08, 2011Ever 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.