As we’ve discussed here before, the question of whether you should use Roth savings (i.e., a Roth 401(k) or Roth IRA) as opposed to tax-deferred savings (such as a regular 401(k) or traditional IRA) is primarily a function of tax brackets:
- If you expect your tax bracket to be higher when you’re withdrawing the money than it is when you’re contributing the money, a Roth is a better choice.
- If you expect your tax bracket to be lower when you’re withdrawing the money than it is when you’re contributing the money, tax-deferred savings are a better choice.
- If you have no idea, it’s probably wise to do some of both.
There are exceptions of course. But the above breakdown is generally true.
What if Tax Rates Are Going Up?
One of the most common arguments I see in favor of choosing Roth accounts is that tax rates are likely to rise in the future as a result of our country’s enormous deficit.
Leaving aside any qualms about that assumption, there’s a big hole in this line of thinking: It overlooks the fact that most people have meaningfully less taxable income during retirement than they had when working. (This is pretty intuitive; for most people, when they leave their jobs, their taxable income goes down.)
Where Will Your Income Come From?
When making the Roth vs. tax-deferred decision, rather than basing it entirely on the direction in which you expect legislative tax rates to move, it’s important to also ask what types income you’ll have in retirement.
For example, how much of your income will be from fully taxable sources such as:
- A pension,
- Part-time job income,
- Tax-deferred savings, or
- Rental property?
And how much of your income will be from sources that are only partially taxable (or fully taxable, but at lower rates) — things like:
- Social Security,
- Dividend income, or
- Long-term capital gains?
And how much of your expenses will be satisfied with money that’s entirely tax-free, such as:
- Roth IRA savings,
- Roth 401(k) savings, or
- Taxable holdings where your cost basis is equal to (or greater than) the market value?
The less of your income that you expect to come from the first (fully taxable) category, the lower your tax bracket in retirement is likely to be (even if legislative tax rates do rise), and the less sense Roth savings make relative to tax-deferred savings.
Hi. I'm Mike Piper, the author of this blog. I'm 
Hey Mike,
I like your advice on doing both. If you can utilize taxable, tax-deferred and tax-free accounts you may be able to maximize your retirement efficiency.
On the other hand, its a pretty big myth that taxes will lower for retirees, based on data shown in one of my CPE courses.. was pretty interesting.
Hi Joe,
Is there any chance you could get your hands on that data? Everything I’ve seen indicates that taxable income does in fact go down in retirement.
For instance, I put together this spreadsheet last week, which is basically just an easier-to-read version of a spreadsheet found here.
Admittedly, it has 2 shortcomings:
1) It doesn’t track individual taxpayers over time, and
2) It shows AGI rather than taxable income.
But it pretty clearly shows that those in the 65 and up group usually have lower AGI than those in the 35-65 group.
I may be incorrect, but, A big advantage of Roth accounts is that you can withdraw from them without making your social security taxable. I never started a Roth. So when I withdraw money from my 401k or IRA I create taxable income from social security. It feels like double taxation.
If withdrawals from roth accounts also create social security to be taxable let me know so I will feel better. I never have heard this mentioned when considering a IRA rollover to a Roth. So, I may be incorrect.
Steve,
You’re correct. If your income is in a certain range (see here for more on that) distributions from a traditional IRA (along with any other sort of taxable income or tax-free interest income) will increase the amount of Social Security that is taxable.
Isn’t another plus of a Roth IRA your ability to withdraw your contributions without tax or penalty if needed? Now, I realize the point of a retirement account is to save until retirement, but sometimes life happens. Thoughts?
Hi Mike,
I agree with Dave Ramsey’s idea that when you use Roth accounts it is like you actually invest more up front so you end up with a higher return.
The idea is that if you invest $1,000 in a Roth account, you put the full $1,000 in and pay the taxes separately on that. So, for example, if you are in the 15% tax bracket, you pay $150 in taxes. It is almost like you can say your “cost basis” for that investment is $1,150. Then at retirement, if your money doubles you owe no taxes on the $2,000. You can take out the full $2,000.
In a traditional account you invest the same $1,000 and pay no taxes on that money for that year. So you cash-flow is better that year but you still only invested $1,000. At retirement, if we use the same 15% tax bracket example, you will have to pay $300 in taxes on the now $2,000 when you take it out. So you end up with only $1,700.
With this example there is a 15% return-on-investment with the Roth account over a traditional account.
It seems to me that your tax bracket would have to be much lower at retirement to make the traditional better than the Roth.
Chris,
Yes, that and estate planning considerations are the two primary reasons why a Roth might make sense even if you anticipate being in a lower tax bracket during retirement than during your working years.
Mike,
Estate planning, even for those with modest assets, is a great reason to use Roths. The question then is: What are the tax brackets for your beneficiaries. If they will be in mid to high earning years then the Roth is a beautiful thing!
Billy,
In your example (15% tax bracket at contribution and 15% tax bracket during withdrawal), it’s a complete wash.
With a Roth, you invest $1,000 now. Let’s say it grows by 50%, then you withdraw it. You pay no taxes, so you’re left with $1,500.
With a traditional IRA, you could invest $1,176 (because the 15% deduction would save you $176 in taxes this year). If that grows by 50%, you have $1,764. After paying 15% taxes, you have $1,500 — the exact same as you’d have with a Roth.
Conclusion: The assertion that a Roth effectively allows you to invest more is true. The assertion that it allows for a higher return when your tax bracket doesn’t change is false.
Edited to add: Dave Ramsey is wonderfully successful at helping people get out of debt, and I admire him greatly for that. Unfortunately, his investment advice tends to be lacking. Recommending 100% stocks for everybody, recommending an 8% withdrawal rate in retirement, and recommending that people use commission-paid advisors are all very poor ideas in my opinion.
Hi Mike,
You are are absolutely correct. The return is no different for Roth vs. Traditional.
My only point is that most people will not invest $1,176 in their Traditional account vs. only $1,000 in their Roth. Most people will invest the same amount or same percentage in either one.
The Roth ends up with more available to the investor in the end *if* the same amount is invested in the account up front.
Good points.
In Canada, there is a similar debate between RRSP (traditional IRA) or TFSA (ROTH IRA).
The main criteria I’ve heard for choosing the TFSA (pay taxes up front) is that some people really like the idea of not paying taxes on withdrawals.
It seems like the fact that they might be losing money by paying taxes up front is not as important as getting those tax-free withdrawals.
I use both my Roth and 401k. I max out my Roth as I use it as my second level (don’t withdraw unless disaster strikes) emergency fund; first level (~6 months expenses) is in cash. I like the security of knowing that sum is available if needed. I then contribute as much as I can in my 401k; but I’m not to a point where it is anywhere near the IRS limit per year… Working to get there though.
Why is everyone touting the excellence of the Roth in terms of estate planning – it isn’t much different than the traditional and most 401(k)s (depending on plan documents). The benefit is to the account holder of no RMDs, so I guess it can compound longer IF THE PERSON DOESN’T need the money.
The beneficiary is going to have an RMD and again it is going to come down to the tax rate discussion.
I think the more important discussion when it comes to estate planning if whether a conduit or accumulation trust is being used?
Mike,
I will check the CPE book and see if it is cited. To be honest, it shocked me as well.
There are a lot of comments about Roth’s and estates. True, they don’t have RMDs. They pass tax-free as long as the 5-year rule that passes through is met. They are really good vehicles for funding trusts compared to traditional IRD assets. They help surviving spouses who will have compressed income tax brackets when they start filing single. Any non-taxable retirement distributions are not included in the SS formula. Contributions do come out first, income tax and penalty free. Lots of great reasons to use them as a tool. Like any tool, they just need to be used correctly. Best case, a proper mix of taxable, tax-deferred and tax-free assets offers retiree the ability to be very tax efficient.
Fun to read all the thoughts. Good stuff 🙂
I will let you know if I find the source of that data.
-Joe
Yes Roth accounts are over-rated for the current generation with no pension. Without a pension, the retirement income will primarily come from 401k and IRA withdrawals. Such withdrawals will first fill the low tax brackets. This makes the average tax rate on the withdrawals very low. Without a pension, people will need to withdraw more than the RMD schedule requires. In that case the “no RMD” feature of Roth accounts becomes moot.
So you’re assuming all income will come from an IRA resulting in a withdrawal greater than the rmd. If that’s the case why would you not consider elements such as social security taxation if there income is low? Your view is extremely esoteric. It doesn’t make Roths over-rated, it emphasizes the importance of using them right. The RMD is not a moot point. It is taxable and it affects other taxable attributes of the taxpayer. If the taxpayer has some Roth money as well they can take any excess tax free and avoid these problems in many situations. And I’m just giving one example.
I apologize for not being clear in the comments, Mike and TFB. I was responding from my phone. The conversation became to interesting for me to wait. 🙂
What I was trying say is that the view stated is esoteric because it lacks other considerations. In the above example, it is possible that the client could take their RMD from the TIRA, and the remainder of their income needed from their Roth, thus avoiding items like SS triggers and so forth. If there is no Roth or tax-free bucket than the entire amount would have to come from the TIRA. The taxpayer would lose the flexibility and control to manage different sources of income in an effort to avoid tax inefficiencies.
Another point to think about is that the given scenario (IRA heavy retirees with no pension) will find any kind of estate planning difficult. If the majority of your assets are IRD (non-step-up assets) this creates multiple problems. Again, some of it could have been avoided if the taxpayer had utilized a Roth in addition to their employer plan / TIRA that moves through an estate like a swiss-army knife…
I hope that sheds some light on why the future generations who (as you stated) will need RMDs doesn’t discount the use of a Roth IRA or any other type of tax-free asset. The picture is much more holistic. Imagine if you had to live on every penny and your SS provisional formula was crossed by $500 dollars because of RMDs. Instantly $0 taxable SS benefits goes to 50% taxable benefits. In some cases, more gross income can result in less net income because of this structure. And to think, there is nothing you could have done because the RMD was to high. The client should have forecasted a proper FMV for their accounts subject to RMDs when they turn 70 1/2 (different subject).
I would probably argue in most situations that a younger generation without a pension (majority of lump-sums are rolled to IRAs anyways..) would actually benefit more from a mix of Roth money.
Sorry for rambling. I think its a great conversation.
TFB and Joe,
Thank you both for taking the time to share your thoughts. As I hope you know, I appreciate your input very much.