One of the more common questions facing savers is whether they should be saving in a Traditional IRA (or another pre-tax account such as a 401k or other employer sponsored plan) or into a Roth IRA (and now for many, Roth 401k).
In a traditional IRA you get to deduct your contribution on your current year taxes, then come retirement (after age 59 ½) all of the money you withdraw is taxed like ordinary income. In a Roth IRA you do not get a current deduction, but in retirement all the contributions plus all the growth comes out tax-free. In both cases all taxes are deferred while the account grows, so you won’t be paying taxes on dividends or capital gains while your investment grows.
For many, the Roth sounds like a no brainer. Tax-free money? Sign me up! The reality is a bit more nuanced than that, however. For starters, it is useful to understand that IF (a big if) your tax bracket stays the same before retirement and during retirement it doesn’t actually matter which path you choose, at least when it comes to the value of the money you put into the account. Follow along:
– You put in $10,000
– It doubles to $20,000
– You withdraw it and pay 25% in taxes: you are left with $15,000
– You earn $10,000 but because you pay 25% in taxes, you only have $7,500 to invest.
– It doubles to $15,000
– You withdraw it tax free, you are left with $15,000
In either case you start with the same amount of money, and after you pay your taxes you end up with the same amount of money. So how do you choose what path to take? There are a number of assumptions and other side-effects that are worth taking into account. Let’s take a look a few.
Key Assumption: Tax Rate / Tax Bracket
Generally speaking, if your taxes are going to go up in the future you should invest in a Roth, if they’re going to go down you should invest in a traditional account. In my example above, the key assumption is that your tax bracket stays the same. There are a number of reasons that this may not happen:
- Politicians– Tax rates and tax brackets can change based on who is in power. They could go up or down for any particular group of tax payers. If you have strong feelings about the direction of taxes 10, 20, 30 years from now then perhaps you should place your bet in that direction.
- State Taxes– I live in a state where the top state income tax rate is 9.85%. My in-laws live in a state with zero state income tax. If you plan to move from a state with an income tax to a state without one you could see your tax rate decrease. Currently Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming do not have income taxes. We can add New Hampshire and Tennessee to the list since they only tax dividends and interest.
- Income Need in Retirement– Generally speaking, I would expect your income needs in retirement to go down. There are elements of your current cash flow that tend to go away in retirement. For starters, you are (hopefully) saving money on a monthly basis for retirement, and possibly for other causes as well such as your kids’ future education. If you’re saving 10% for retirement, then in retirement your income need is already about 10% less than your current income. Many people (although it seems like fewer and fewer) will also pay off their mortgage in retirement, which can further reduce your income need. These savings can be offset by increased travel expenses and increased medical costs, but our general experience is that your gross income need goes down. In retirement, your income should generally match up to your need, and so your income will likely decrease, and along with it your tax burden should decrease.
- Tax diversification– This is a bit of a moving target since how you save can affect your future tax rate. During your working career, your tax bracket is primarily determined by your working income (unless you already have a large investment portfolio or other income sources such as rental income). However, during retirement, much of your tax bracket is determined by where you are drawing money from. Leaving other income sources aside, if a single person pulls $50,000 from their Traditional IRA they are in the 25% federal tax bracket. If that some person instead pulls $50,000 from their Roth they pay no taxes. If that same person pulls $25,000 from a Traditional IRA and $25,000 from a Roth, they end up in the 15% tax bracket (since they only have $25,000 of “income”). Where you draw your money from can have a big impact on how much you pay in taxes. So, by saving money into a Roth you can reduce your future effective tax rate. But if you have a lower tax rate in the future you would be better off saving in a Traditional account. But if you don’t save into the Roth you won’t have a lower tax bracket since you won’t have Roth savings to draw on… It gets a bit circular, but the point is that diversifying the tax treatment of your accounts can help you reduce your future tax burden.
Beyond the money that you have saved into your account, your total income can create extra taxes beyond the dollars you withdrew from your savings. A few examples of where this can come into play:
- Social Security– Based on a calculation (found here on ssa.gov) your social security benefit in retirement will either be tax free, 50% of it will be subject to taxes, or 85% will be subject to taxes. So shifting your savings to a tax-free status can help you keep more of your social security benefit.
- Medicare surtax– The Affordable Care Act (ACA or “Obamacare”) added a Medicare surtax, which began in 2013, on investment income. Investment income basically refers to interest, dividends, and capital gains generated by your general investments. (Your IRA distributions are not considered “investment income” but they can push your income above the limit where this tax may apply). If your Modified Adjust Gross Income (MAGI) is above $200,000 (single filers) or $250,000 (joint filers) then an additional 3.8% tax will be charged against your investment income. If you’re close to these limits during your working career, making a deductible investment can help you avoid it. If you’re going to be close to these limits in retirement, a tax free account could help you stay below it.
- MedicarePremiums – As your income goes up your Medicare part B premiums will increase as well. Again, having lower “income” can help you save money.
- Required Minimum Distributions (RMD’s)– Beginning at age 70 ½ (the IRS loves half-birthdays) you are required to begin drawing from your Traditional IRA and similar accounts. This is basically the IRS saying, “You’ve delayed paying tax long enough, time to pony up.” For those who save lots of money in pre-tax accounts, RMD’s can create income they don’t really want and taxes that they really don’t want! Since Roth accounts come out tax free, the IRS doesn’t really care whether you withdraw from it or not, and so the RMD rules don’t apply to Roth accounts.
Given the slew of side effects that come with higher income, if your tax bracket is going to stay fairly steady I prefer using a Roth account (if you’re eligible: Roth IRA’s come with limitations). However, if you are a high income earner you are probably desperate for some tax deductions, and I would argue that the chance your tax bracket goes down in retirement is pretty likely (again, especially true for high income earners). The above discussion touches on a number of issues but it is not a comprehensive list of considerations. Choices like these really are individual decisions that will be impacted by your personal financial situation. Making a good decision here can make a very meaningful difference on your future financial success. Unfortunately this article won’t tell you what to do, and any article that tells you what to do without knowing your situation is very suspect. I will suggest that either you spend the time understanding the various impacts of your decision, or seek out some good help.
I touch on a number of subjects here including taxes. This article is not meant to provide tax advice. You should discuss this and other tax related issues with your tax advisor. The calculations are for illustration only and do not represent any guarantees or specific advice. Statements regarding taxes laws are based on current laws but are subject to change. A Roth IRA distribution is qualified if you’ve had the account for at least five years and/or the distribution is made after you’ve reached age 59 ½, because of your total and permanent disability, in the event of your death or for first-time homebuyer expenses. Distributions made prior to age 59 ½ may be subject to a federal income tax penalty. If converting a traditional IRA to a Roth IRA, you will owe ordinary income taxes on any previously deducted traditional IRA contributions and on all earnings. PLEASE NOTE: The information being provided is strictly as a courtesy. When you link to any of the web sites provided here, you are leaving this web site. We make no representation as to the completeness or accuracy of information provided at these web sites.