The debate about Roth vs. Traditional IRA funding/contributions is a tale as old as time… well, not really… as the Roth IRA only came about in 1997 thanks to senator William Roth. For a primer, let’s talk about the key difference between the two account types:
- Pro: Saves you taxes now (as contributions reduce your ordinary income the year the contribution is made).
- Con: Withdrawals are taxed at your ordinary rate when you take them.
- Summary: Traditional IRAs are a tax deferral vehicle. Invest now, pay later.
- Pro: Grows tax-free and all withdrawals are tax free – for you and your heirs.
- Con: Taxes are prepaid as you don’t gain any tax savings when contributions are made.
- Summary: Roth IRAs are a prepayment of tax vehicle. Pay taxes now, invest the remainder, no additional taxes levied.
Founders Note: I currently have both types of IRAs mentioned here. I’ve had to transition back and forth depending on where I was with my W2 income over the years due to limitations, but as this article will discuss the Roth IRA is typically more beneficial based on most people’s current financial situation. The easiest way I’ve had it explained to me is that an IRA is just a house for all of your investments. You can do a lot of stuff (buy different things) in the house and the type of house (Traditional or Roth) determines how they’ll be taxed.
You may notice that in the Roth summary I use a term that isn’t commonly discussed when Roth IRAs come about – which is the prepayment of taxes. If you thought Roth IRAs were a free lunch of tax-free growth and tax-free withdrawals, you are mistaken, as the taxes have to come out of your cash flow the year contributions are made, you just likely don’t notice (and truly, because you don’t notice could be the biggest behavioral benefit of funding a Roth).
What do Roth vs. Traditional IRA growth and balances look like? Well, let’s look at this example:
- Frank is in the 24% bracket, with taxable income of $150,000. He is 32 years old. He has a total of $4,650 in excess cash flow for IRA contributions after accounting for taxes and spending. He assumes that he will be in the 24% bracket when he retires. Should he contribute to a Roth or a traditional IRA?
- If Frank contributes to a Traditional IRA, his contribution amount would actually be $6,000 due to the tax deduction of making that contribution ($6,000 times 24%), which would save him $1,440 in taxes paid for 2022.
- If Frank contributes to a Roth IRA, he will not receive the deduction/free cash flow from reducing his tax bill, so his contribution would only be $4,650.
- Let’s take a look at the investment account balances from this single deposit assuming a rate of return of 7% until Frank is 72 years old:
The after-tax balance is the exact same. Why? Because of the initial “prepayment” of taxes from the Roth funding. If you assume that you are in the same tax bracket now as you will be in retirement, I would argue that the traditional IRA is the better way to go as it gives you more optionality in regard to when you pay the tax vs. prepaying it in year one.
If your tax rate in retirement is lower than your current tax rate, a traditional IRA is the way to go as the bird in hand is worth it. If your tax rate is higher in retirement, then the Roth is the way to go… but…. will your tax rate be higher?
Founders Note: This quite possibly could be the best explanation of both end results I’ve seen after talking to numerous advisors and CPAs. A lot of investors will lean towards the Roth IRA due to the ability to prepay tax on the income and let the gains grow tax free. Sadly depending on where you are in your financial journey, you could potentially be paying a bunch more. This is where talking to someone like Frank and your CPAs makes a world of difference. If you’re just getting started and you’re in a lower tax bracket you could just do what I did and begin investing in a Roth IRA. For reference I did that when I was making approximately $90,000 in annual gross income.
Tax rates in retirement – Can this be projected with accuracy?
In short, no. BUT – we can look at current data and historical tax rates to make some educated guesses and plan in a prudent manner.
Let’s start with the current data:
- Are you in the top tax bracket today and thus have a taxable income in excess of $630,000? If so, the traditional IRA/401k is likely the way to go. Why? Because it is highly unlikely that you will continue to make that much in retirement.
- Are you in a tax bracket of 12% or lower, thus having a taxable income of $40k or less (as a single filer) or $80k or less (as a joint filer)? Then the Roth is the way to go, as you are in a very low tax bracket and the likelihood of your bracket falling even lower is doubtful.
- Do you earn somewhere between $40k and $600k? Welcome to the middle, where most filers end up and why this debate rages on.
Founders Note: When I started investing I was fortunate to not fall under the $40,000 mark (base salary was $50,000) and have consistently been in the last range ($40k to $600k). This is why communicating with my CPA was so important and understanding where my income was tracking for the year. If you fall in the 1st or 2nd bracket, then Frank has provided a very clear answer for you that’s backed by objective data.
Let’s continue with historical tax rates:
As much as higher tax rates are a fear of investors and tax preparers alike, from a historical perspective, the top tax rate has been fairly stable for the past 30 years, and if anything, has dropped over the past ~80 years. While we cannot predict the future, there seems to have been fairly consistent tax rate policies from a historical perspective, and the fear of taxes going up exponentially might be overdone… even if the root cause of keeping taxes low is the cynical nature of politicians wanting to remain in office.
So – What’s the drawback to contributing to a traditional IRA/401k? Being in a higher tax bracket when you retire. Well…. If you are in a higher tax bracket once retired and over the age of 72….. congratulations, you have won at the game of (financial) life. That’s not a terrible drawback in the least bit, and one I would accept 365 days a year.
So… when is the right time to make Roth contributions?
Here are a few no-brainer Roth contributions opportunities:
- When the market is down: We all know timing the market is a loser’s game, however, if the market is down 20% or more, Roth contributions can be ideal. Excluding the great depression, once markets bottom out, the recovery back to previous highs takes an average of 14 months (the longest being 37 months from 2009-2012 and the shortest being 3 months in 1982). This means that you have a high probability of recovering that prepayment of taxes in 1-2 years, with the remaining years compounding tax free. A slam-dunk as long as you have the stomach to buy when the market is down.
- Low-income years: Did you take a sabbatical, get laid off, or change career paths? If so, and you have a short-term period (1-5 years) of lower earnings and lower tax brackets, Roth contributions (and possibly conversions) are a great strategy. This allows you to “fill” your income tax brackets instead of having a year or two where your earned income is close to zero (which is to be avoided).
- Other unique circumstances: This starts to get into the weeds, but a few of the unique planning purposes for Roth conversions are around age gap between spouses, tax rate of descendants, and estate tax planning. If these seem relevant to you, consult your CPA or financial advisor to determine if they should be considered.
Founders Note: A fun strategy I’ve used that I didn’t see mentioned is something called a “Backdoor Roth IRA” that can help with when you can no longer contribute directly into a Roth but still want the tax benefits of one. That is worth a conversation with your CPA.
Fun stuff, right? Want to learn more about refinement of IRA contributions? Schedule a call with us.