If given the choice, should you make traditional (i.e., tax-deductible) or Roth retirement contributions? This has been a hot question in financial planning circles ever since Roth plans were created in 1997.
For the sake of simplicity, I’m going to restrict today’s discussion to IRAs, but it’s applicable to any retirement vehicle with a tax-deferred vs. Roth option. For example, an increasing number of 401(k) and 403(b) plans offer a Roth option.
As a quick refresher, traditional IRA contributions are tax deductible (assuming you don’t make too much money). Your money will then grow tax-deferred until you take it out, at which time taxes will be due at regular income tax rates.
With a Roth IRA, you lose the upfront tax deduction. However… Your distributions will be completely tax free, meaning that you don’t pay a dime of taxes on your investment gains.
Traditional vs. Roth
The common arguments when it comes to debating traditional vs. Roth IRA contributions revolve around your current and future tax brackets. If you’re in a lower tax bracket now than you expect to be in at retirement, you should use a Roth.
In contrast, if you’re in a higher tax bracket now than you expect to be at retirement, you should make deductible contribution to a traditional IRA. That way you can get the tax break now (in the higher bracket) and pay less in taxes later.
The future of taxation
Of course, this all assumes that you can accurately predict future tax rates. While you might be able to accurately predict whether your inflation-adjusted income will be higher or lower in retirement, you’ll need a crystal ball to predict what tax rates will look like in 30 years.
In other words, while you may drop to a lower bracket, future tax increases could mean that the percentage associated with this bracket is higher higher than what you’re paying today.
And what if we convert to a consumption-based tax system (such as the “Fair Tax”) in place of our current tax system? That seems unlikely, but if it happened, people with Roth IRAs could get if they paid income taxes on the front end and then got hit with a consumption tax on the back end.
How to avoid current and future taxes
Another consideration that many people overlook is that, while the current income tax brackets bottom out at 10%, a married couple filing jointly will pay no taxes on their first $18, 700.
Why? Because they’d be entitled to the standard deduction ($11, 400 in 2009) and two personal exemptions ($3650 each). Beyond this, the 10% tax bracket for married couples extends up to $16, 750 and the 15% tax bracket extends up to $68, 000.
Ultimately, this means that at least a small amount of traditional IRA money could be very valuable. Consider the following scenarios for a married couple filing jointly:
- With $18, 700 in income…
…no taxes are due.
- With $35, 450 in income…
…the Federal tax bill will be $1675.00 (10% of $16, 750).
- With $86, 700 in income…
…the Federal tax bill will be $9362.50 (10% of $16, 750 and 15% of $51, 250).
This works out to a effective income tax rate of 0.0%, 4.7%, or 10.8%. By taking advantage of the very low end of the income tax brackets, you can take a tax deduction now and pay very little in income taxes later.
In other words… You can have your cake and eat it to. By balancing traditional and Roth contributions during your pre-retirement years, you’ll have the flexibility to minimize your tax hit on both ends.
If you only make Roth contributions, then you’re paying taxes now to pay nothing later. But with at least a small amount of traditional IRA income, you can avoid taxes now and later.