Roth accounts (IRAs and 401ks) and traditional accounts both have their time and place. For young professionals, choosing a Roth over a traditional account makes sense. However, as you advance along your career path, earn more money, and build capital, the value of a traditional account over a Roth becomes clearer. My advice is to use the Roth when you’re in your 20s, but then make the switch to a traditional when the tax benefits of a current deduction outweigh the Roth’s benefits. Let’s take a look at why that makes the most sense.
It Comes Down to Taxes
Tax rates predominately (although not exclusively) determine whether a traditional account or a Roth account is better. There are a few pros and cons outside of taxes for both a Roth and a traditional, but let’s touch on taxes first. If your taxes are higher now than you expect them to be in retirement, then using a traditional account provides the best outcome. It’s that simple. On the other hand, low income earners now who expect a higher salary later in their career will benefit from using a Roth first, and then switching their contributions to a traditional. Medical professionals, lawyers, and investment professionals would all fit this description. Their starting salaries and bonuses are modest, while the expected future compensation is high.
To illustrate how it comes down to taxes, let’s use an example. In this case, the marginal tax rate during working years is 28%, while the effective tax rate in retirement is 15% (more on marginal versus effective tax rates below). Our saver does not start saving for retirement until age 35, and can afford to save $17,500 in a traditional, or $12,600 for a Roth (the taxable equivalent to $17,500). We’ll assume that on a real (today’s dollars, so not accounting for inflation) basis, the contributions stay the same, and the portfolio earns a real rate of return of 4%. Upon retirement at age 65, our saver needs $50,000 in after-tax funds for annual spending from their portfolio. They can take $50,000 out of the Roth, or $58,824 out of the traditional account to pay the 15% effective tax. They earn the same 4% real return in retirement.
Investing in a Roth account depletes the portfolio to zero by the time our retiree reaches age 89. Yet, investing through a traditional IRA or 401k would still leave $362,000 at that time with plenty of runway for another decade. Again, the difference between the two values comes from the difference in tax rates.
Now let’s flip that, and say that our saver pays 15% marginal tax rate during their working years, while paying a 28% effective rate in retirement. This scenario is highly unlikely, unless our saver hits it big somehow near the end of retirement. In this case, the outcome is just the opposite. The traditional account runs out by the time our retiree hits 89, while the Roth account is still going strong.
Given that most of us will earn and pay more taxes in our working years, investing in a traditional account is often best.
Marginal vs. Effective Tax
The concept of marginal versus effective tax rate is an important one to understand. Imagine a married couple earning $300,000 in taxable income. The 2017 US federal income tax brackets are below. As you can see, the couple is in the 33% tax rate. However, because the US tax code is progressive, their effective tax rate is 24.74%. The first $18,650 is taxed at 10%, the next $57,250 is taxed at 15%, and so on.
When you invest through a traditional IRA or 401k, you are able to take a tax deduction off of the marginal tax rate – in this case, 33%. However, when you retire, the money you take out from the account is paid at your effective tax rate. This makes the tax deduction today even more powerful.
For example, Social Security is taxed at a very beneficial rate (as an aside, the below concept is just one of the reasons why the US tax code is so insane). Social Security benefits have a maximum level of taxation equal to only 85% of benefits received (you pay taxes on up to $85 for every $100 received from Social Security). In order to determine that fraction of taxable Social Security benefits, the IRS uses a concept of combined income. A retiree takes their non-Social Security income and adds half their Social Security benefit. If that number is below $25,000, your Social Security is tax free. Between $25,000 and $34,000, only 50% of the benefit is taxable, and over $34,000, only 85% of the benefit is taxable. Since Social Security will likely be one, if not the only one, of your base income streams in retirement, this has the net effect of lowering your effective tax rate. The odds of you having a lower effective tax rate in retirement relative to your marginal tax rate during your working years are very high.
Further, investing in a Roth IRA or 401k makes you look richer in the eyes of the government during your working years. This impacts certain tax credits that phase out depending on your taxable income. For example, the Hope Scholarship Credit is a $2,500 credit per student for tuition and related education expenses. It phases out with taxable income between $160,000 and $180,000 for joint filers. If you had earned $180,000 per year and invested $20,000 in a Roth account, you would not be able to take the $2,500 credit. If you instead invested that $20,000 through a traditional account, the IRS would calculate your taxable income at $160,000, and you would be able to take the entire $2,500 tax credit. There are several credits like this, including the Child Tax Credit (phase out begins at $110,000 for joint filers) and the Lifetime Learning Credit (phase out begins at $131,000 for joint filers). These credits come straight off your tax bill, as opposed to a tax deduction, which lowers your taxable income. A tax credit is far more valuable than a tax deduction.
Known vs. Unknown Tax Break
When you invest through a Roth account, you give up a known tax break now for an unknown tax break later. In effect, you are prepaying your taxes. Do you trust Congress not to change the tax code disadvantageously at some point over the next 30 years?
The idea of making distributions from Roth IRAs taxable for “wealthy” Americans has been floated in Washington, as has the notion of changing Roth IRA required minimum distribution rules and other advantageous provisions. The Obama administration tried to require investors to start withdrawing money from Roth IRAs at age 70 1/2, just like traditional IRAs. President Obama also briefly attempted to tax 529 college savings plans, an event that inadvertently reminded everyone that government promises can often be temporary. The rules of the game can change in a moment – this makes a known tax break much more valuable than a promise from Congress later.
Granted, the change in administration has likely taken those off of the table, but as I write this (October, 2017), Congress and President Trump are still formulating their tax proposal. Some or all of these could be included. Also, at some point between now and your retirement, a Democrat will be in the White House again, possibly with a sympathetic Congress. When that time comes, who knows what happens to high income earners. Take the known tax break now, and leave the uncertainty alone.
Other Pros and Cons
There are other pros and cons to both Roth accounts and traditional accounts. For example, you can withdraw the principal from a Roth IRA (but not a 401k) after five years without a penalty. As of right now, there are no required minimum distributions for the Roth IRA. The Roth 401k does have required distributions, but it’s easy enough to roll that into a Roth IRA.
However, a traditional IRA or 401k has a huge benefit over the Roth: optionality. You can always convert a traditional account into a Roth account, but not the other way around. Since you have to pay tax on the conversion, low income years (for example, a bad bonus or in the first few years after you start a business when income is low) would be a great time to do that.
State income tax rates matter as well, and this is yet another way to preserve optionality. Many people work in high state income areas (New York, San Francisco, Boston, Chicago, etc.) because that’s where many opportunities lie and that’s where you have the ability to earn a large paycheck. The income tax deduction at these high marginal tax levels is incredibly valuable. Upon retirement, moving to a low tax state is always a possibility. In effect, you’ve taken advantage of tax arbitrage by earning in a high income tax state but moving to a lower income tax state to spend your nest egg. For example, California has a 13.3% marginal income tax rate, while Washington, Texas, and Florida all have none.
Pick a Roth, But Only When You’re Young
A Roth account only really makes sense when you’re young and still earning a low salary. Once you reach into the six figures, switching to a traditional IRA and 401k makes the most financial sense. You’re more likely to have a higher marginal tax rate now than an effective tax rate in retirement. By not appearing richer than you actually are to the IRS, you’ll still be able to access certain valuable tax credits. There is no risk to Congress changing the tax laws adversely since you’ve already taken the deduction in previous years. And investing through a traditional account allows you to maintain optionality in the future.
Keep building my friends.