T. Rowe Price has an article Evaluating Roth and Pretax Retirement Savings Options by Roger Young that covers the basics on the choice between a “Traditional” pretax or Roth IRA or 401k account:
The primary factor to consider is whether your marginal tax rate will be higher or lower during retirement. If your tax rate will be higher later, paying taxes now with the Roth makes sense. If your tax rate will be lower, you want to defer taxes until then by using the pretax approach.
With the Traditional pretax, you get to avoid paying income taxes on the contribution now, but you must pay taxes up on withdrawal. With the Roth, you pay income taxes now, but you don’t own any taxes upon withdrawal. However, I am linking to it because it also includes a table with some sample worker profiles. This may help clarify things for people who are still confused about which to pick.
There are other considerations due to our overly-complex tax code, but I think this is still a helpful tool.
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“The primary factor to consider is whether your marginal tax rate will be higher or lower during retirement.”
This is subtly wrong. The comparison should be your marginal tax rate now, vs your average tax rate in retirement.
A traditional IRA/401k will “save you taxes” at your marginal rate now, at the expense of paying taxes on the entire sum you remove during retirement.
I see your point, but I think for most people, it may be an over complication. When making this decision, the average tax rate in retirement is not appropriate. You are really interested in the blended tax rate on the additional traditional IRA/401K income in retirement. You are essentially saying, I think, that people should recognize that some of this income may hit a tax bracket that is beneath their marginal bracket in retirement. People do not want to include taxable income in retirement from other sources (SSI, pension, taxable investments, etc.) in this calculation.
To your point – people shouldn’t simply look at their marginal tax rate today – but the blended tax rate on the amount they are putting away today. For example, if your marginal tax rate is 24% (after accounting for IRA deferrals), but if you are only a little bit away from the 32% tax bracket – then your tax savings from the deferrals may be higher than just the 24% rate…
I liked teh fact that you could withdraw what you put into a Roth if necessary. Plus no taxes when you withdraw from irt
I’m curious if anyone here factors in their ability to contribute to Roth IRA. Previously, our household income allowed us to contribute to both Roth 401K and Roth IRA, but as we have increased our income through investments and higher paying jobs, we now must both contribute to traditional 401k’s if we want the ability to contribute to Roth IRAs (without using the Roth backdoor method) due to the maximum income cap for Roth IRAs. Since over the years we have accrued quite a bit in Roth funds, I think it seems like a reasonable plan to contribute some traditional 401k until our income exceeds Roth IRA limitations even with the breaks that traditional 401k is currently providing. Anyone else have thoughts or feedback regarding this approach?
What is the reason that you can’t use the Roth backdoor method? Do you have pretax IRAs? If so, have you looked into rolling them into your pretax 401k?
There’s not any reason that I can’t use a Roth backdoor (as far as I know). It’s more that I’ve had trouble finding a good explanation of the tax implications of using that method. At one point I spent several hours trying to wrap my head around exactly how it would effect me at tax time. It seemed to have a lot of uncertainties around capital gains during the time that the money set in the pre-tax account prior to being converted (if I remember correctly). Since I was never able to completely understand it, I have just avoided the scenario. If you know of any particularly good articles that explain it, I would definitely be interested.
Well, I think my overall point would be that any capital gains tax you might pay now would be dwarfed by the benefit of having that Roth space forever. For example, if you put in $6,000 and for some reason you didn’t want to convert to Roth right away and it went up 15% and now it’s $7,000. You would owe capital gains tax on $1,000, but hey (1) you still made a profit and (2) you now have $7,000 in a Roth that will grow tax-free forever with no RMDs ever. Your eventual tax benefit will be a lot more than paying $150 (15% cap gains tax on $1,000) or anything in that neighborhood.
I no longer have earned income, which means I am no longer contributing to any type of IRA. When I was working, though, I always favored Roth contributions because of the simple fact that by paying taxes then on a few thousand dollars, all of the growth of that money would be forever tax free, in some cases tens of thousands of dollars. To me that makes the marginal tax rate/tax bracket issue practically irrelevant. Am I missing something here?
Yes. You want the money to be taxed at the lowest rate.
Suppose the tax rate today and in retirement are both 22%. Suppose an individual has $100 of income (before tax) to invest. Lets see what an individual would be left with assuming investment appreciates to be 1,000% (10X) the size of the initial investment (over the entire life of the traditional/ROTH investment account).
Traditional:
Initial taxes: 0. Entire 100 is invested.
Investment appreciation: 1,000% (10x). 100 x 10=1,000.
Taxes in future: 22%. 1,000*22%=220.
The retiree is left with $780 in retirement (1,000-220).
Roth:
Initial taxes: 22%. 100*22%=$22. Only $78 is invested.
Investment appreciation: 1,000% (10x). 78×10=$780.
Taxes in future: 0%.
The retiree is left with $780 in retirement.
If either the initial (future) tax rate increases (and the other rate stays the same), then the traditional (ROTH) investment will leave the individual with more money in retirement.
As Blake shows, the reason is essentially the commutative property of multiplication. A*B*C = C*B*A. Taking the same 25% (or whatever) tax haircut now or later has the same final effect.
Jonathan, I appreciate the responses you and Blake provided. The numbers certainly don’t lie. Given Blake’s example, I guess I always found it easier to find the $22 in upfront taxes from another “bucket”, and could still invest the full “$100”, meaning it was psychologically easier to find and pay $22 now than $220 later. Again, you are both correct and have helped put the numbers in a different perspective for me. Thanks!
As Kevin suggests, one piece of the puzzle is that pre-tax contributions can lower your taxable income, which (by avoiding/reducing income phase outs) open up things like Roth IRAs, the saver’s credit, student loan interest deduction, etc. Run a good spreadsheet/do A LOT of homework or pay an advisor if this is important to you.
Oh and if you are one of the rare workers with a defined benefit pension, that’s another big variable the article misses.
Determining your tax rate in retirement if you are working today is…impossible. Tax law will change, couples will no longer be couples, people will work more/less than they planned, return on taxable investments will vary, etc. I mean I could be in a 50% marginal rate (yay socialism) or maybe a 0% rate (we abolish income tax for under 100K and institute a VAT).
So for me, I am shooting for a roughly equal size pot of pre-tax and post-tax. YMMV.
“So for me, I am shooting for a roughly equal size pot of pre-tax and post-tax. YMMV.”
me too