Quick housekeeping note: I’m taking some time off for the holidays, so there will be no article next week. So on that note, Happy Holidays and Happy New Year to each of you, and thanks for reading!

Today’s article was inspired by a few recent online discussions (and one article) I encountered during open enrollment season, all of which made the same mistake when discussing what type of retirement account to contribute to each year. Specifically, they did not speak at all to the question of what the household’s retirement account balances already look like. It’s such a simple point, but it’s often left out.

People almost always ask about current income level, which is relevant. But we need to know more than that.

Example: Beth and Brian are married filing jointly, in the 24% tax bracket. Most of their income this year is in the form of W-2 wages.

Tim and Tiffany are also married filing jointly, in the 24% tax bracket. Most of their income this year is in the form of W-2 wages. In fact, everything about their income and deductions for this year is identical to Beth and Brian.

But Beth and Brian are age 60. They’ve been maxing out their tax-deferred accounts for 30 years. They’ve had a mostly-stock allocation this whole time, and now they have about $3.5 million in tax-deferred accounts.

Tim and Tiffany, on the other hand, are age 35. They’ve been making Roth 401(k) contributions and Roth IRA (or backdoor Roth IRA) contributions through their whole careers so far. They have a considerable amount of Roth savings and literally nothing in tax-deferred accounts.

Both households are in the 24% bracket, so they’d each get the same amount of tax savings this year from making deductible/pre-tax 401(k) contributions. But Beth and Brian, with their large tax-deferred balance, are already going to have a significant amount of taxable income in retirement, which makes Roth savings start to look better. Tim and Tiffany, on the other hand, will have almost no taxable income in retirement if they continue along their Roth-only path. At some point (perhaps now) it makes sense to start making tax-deferred contributions, so they have income to “use up” their low tax brackets in retirement.

Every decision should be made “at the margin.” When deciding whether to contribute to Roth or tax-deferred accounts, what we want to know is: if you make this contribution as tax-deferred, what would be the tax rate that you’d pay on these dollars and the associated growth when they come out of the account later. All else being equal, the more money you already have in tax-deferred accounts (and, to a lesser extent, in taxable accounts), the higher that tax rate will likely be — and the more sense it makes for this contribution to be made as Roth.

In response to my recent article about RMD timing, a handful of people wrote in with comments/questions similar to this one:

“Maybe I am missing something, but to the extent that there is significant equity in the retirement account, then isn’t it better to take the RMD earlier in the year so that growth is ultimately taxed at capital gains rates rather than as ordinary income from future RMDs? Thanks for any clarification.”

A key point to understand about traditional IRAs is that the growth is tax-free. This is fundamental to understanding all of the “Roth or tax-deferred” decisions as well as Roth conversion decisions.

A traditional IRA can be thought of as a Roth IRA (i.e., an account with tax-free growth) in which the government owns a share. (The other two differences are that Roth IRAs don’t have RMDs during the original owner’s lifetime, and with Roth IRAs you can withdraw contributions at any time tax-free and penalty-free. Those differences are often important. But in terms of the math of how the accounts grow, there is no difference.)

The Classic Example (Contributions)

The classic example illustrating this point is in the context of whether to contribute to a Roth or tax-deferred account. And the point of the illustration is that the two options work out the same, if the tax rate at the time of contribution is the same as the tax rate at the time of distribution.

Let’s imagine:

• Reiley has a current marginal tax rate of 20%, and we can somehow predict that her future marginal tax rate will be 20% as well. (Of course this level of certainty is entirely unrealistic, but the point here is just to demonstrate the math.)
• Reiley can currently afford to make a $2,000 contribution to a Roth IRA, or she could make a $2,500 contribution to a traditional IRA (because the deductible contribution would net her $500 in tax savings this year, so her net out-of-pocket would be $2,000).
• In either case, the contribution will eventually grow to eight-times its initial value, and then be distributed.

If Reiley contributes $2,000 to a Roth IRA, it will turn into $16,000. And that $16,000 distribution will be tax-free.

If Reiley contributes $2,500 to a traditional IRA, it will turn into $20,000. That $20,000 distribution will be taxable at at 20% rate ($4,000 of tax), leaving Reiley with $16,000.

Point being, if the tax rate is the same at the time of contribution and the time of distribution, the after-tax amount available for spending will be the same. In other words:

1. We have no preference between paying tax at the start (in the case of Roth) or at the end (in the case of tax-deferred) if the tax rate is the same.
2. And #1 is true because both the Roth IRA and the traditional IRA grow tax-free.

RMDs (And When to Take Them)

Now let’s move on to the topic at hand (RMDs), so we can see how the same concept (tax-free growth in a traditional IRA) is applicable.

Let’s imagine:

• Your RMD for this year is $30,000.
• The dollars in question will earn a 10% return this year.
• The tax rate you pay on the distribution will be 22%.

If you take the RMD on January 1, it will be $30,000 before the distribution. And after accounting for the 22% tax, it will be $23,400 that actually gets invested in the taxable account. That $23,400 grows by 10% over the course of the year, to $25,740.

Conversely, if you take the RMD on December 31 (not a good idea in real life to take it on literally the last day of the year, but let’s ignore that for a moment), the $30,000 from the start of the year will have grown to $33,000 by that point. If you take out the whole $33,000, pay tax at 22%, what’s left is $25,740.

Not coincidentally, those two amounts are exactly the same. $25,740 in either case. It’s the same exact amount that’s left after taxes, whether you take the distribution at the start or end of the year, because we don’t care whether we pay the tax at the start or end of the year, due to the commutative property of multiplication.

But we’ve left out something important!

In the “RMD at the start of the year” case, when the $23,400 that’s now in your taxable brokerage account grows to $25,740, some portion of that is usually going to be taxable, either as interest, dividends, or capital gains. (Even if the dollars are kept entirely in stocks, and you’re in the income range where qualified dividends and long-term capital gains are taxed at a 0% rate, most stock funds still pay some amount of unqualified dividends.) And thus the “RMD at the start of the year” strategy falls behind by however much tax gets paid on the return earned in the taxable account over the course of the year. (Again, returns in an IRA are tax-free, whereas returns earned in a taxable account generally are not.)

In addition, to illustrate the “it’s the same dollar amount” concept in the example above, I was assuming that, if the RMD for the year was $30,000 and the dollars in question grow to $33,000 over the course of the year, you take out the whole $33,000 if you’re following an “RMD at year-end” strategy. But you don’t actually have to do that. The RMD is still just $30,000.

Overall point being, as a general principle, because growth in IRAs isn’t taxed whereas growth in taxable accounts usually is taxed to some extent, we want to keep our money in IRAs for as long as possible.

A reader writes in, asking:

“I recently read about a rule of thumb for deciding whether to contribute to Roth or traditional accounts. The idea is to divide your current balance in traditional accounts by 25, subtract the standard deduction, and if the remaining amount of taxable income would be in a low tax bracket, contribute to traditional. What do you think about that?”

I haven’t encountered this rule of thumb before. I think the most positive things I can say about it are that:

• It isn’t the worst personal finance rule of thumb I’ve ever seen. (That award clearly goes to Dave Ramsey’s “spend 8% per year in retirement” rule.)
• There are only two options for this decision (i.e., contribute to Roth or contribute to tax-deferred), so even a rule that makes no sense will accidentally get it right pretty often.
• For this decision, both options are good choices. That is, in a given year, if you should have contributed to Roth, but you contributed instead to tax-deferred (or vice-versa), you still did something good (i.e., you’re saving and investing in a tax-advantaged account). So even a rule that makes no sense can only do so much harm.

But it should not be controversial to say that proposed rule makes no sense.

To back up a step, in general, the driving force behind the “Roth or tax-deferred” decision is that:

• If your current marginal tax rate is greater than the marginal tax rate that would be paid on the money whenever it comes out of the account later, tax-deferred contributions are generally preferable (i.e., make a deductible contribution now, while your tax rate is high).
• If your current marginal tax rate is lower than the marginal tax rate that would be paid on the money whenever it comes out of the account later, Roth contributions are generally preferable.

And then there are three other factors, all of which favor Roth contributions:

1. Roth accounts have no RMDs during the original owner’s lifetime.
2. Contributions to a Roth IRA can be withdrawn tax-free and penalty-free at any time, so Roth IRAs (as well as Roth 401(k) or Roth 403(b) contributions that have been rolled over to a Roth IRA) can do double-duty as an emergency fund in some cases.
3. A maximum contribution to a Roth account in a given year allows you to effectively contribute more than the same contribution to a tax-deferred account. (For instance, with a $7,000 Roth IRA contribution, the whole $7,000 is yours. You get to take advantage of $7,000 of tax-advantaged space. With a $7,000 traditional IRA contribution, a portion of that account is essentially the government’s money. You’re letting the government use a portion of your tax-advantaged space.)

The proposed rule of thumb is taking a stab at the “future tax rate” end of the analysis. But it doesn’t even try to account for the current tax rate part of it. It completely ignores one of the two most important factors in the decision! At its core, this decision is a comparison. And you can’t do a comparison by only looking at one side. This, by itself, should be enough to comfortably discard the proposed rule.

But it’s worse than that.

With respect to the “future tax rate” part of the analysis, the proposed rule doesn’t account at all for other sources of income. You’ll likely have taxable Social Security benefits. Maybe you’ll have taxable pension benefits. Maybe you’ll have taxable dividends, interest, or capital gain income. Those will all affect the tax rate that would be paid on distributions from a tax-deferred account.

The proposed rule also doesn’t account for any deductions you might have other than the standard deduction.

It doesn’t account for the fact that your marginal tax rate may be different than just your tax bracket.

It doesn’t account for the fact that somebody other than you (i.e., your beneficiary) might ultimately be the one taking a large portion of the money out of the account.

It doesn’t account for the fact that in most years you’ll be taking out some percentage other than 4% from the account.

It doesn’t account for the three “other factors” mentioned above that favor Roth accounts.

Truly, the proposed rule does not strike me as better than flipping a coin. But again, as ridiculous as it would be, flipping a coin wouldn’t actually be a total disaster — because both choices are good choices and because you’d still get it “right” a meaningful portion of the time.

A reader writes in, asking:

“I’ve read numerous articles about the benefits of purchasing a SPIA with part of my assets to create a floor of guaranteed income (along with Social Security) in retirement. But I’ve never seen any discussion of the best funds to use to pay for the annuity. Can an annuity be purchased using traditional IRA or Roth IRA dollars? If so, what are the tax ramifications of each? Can I buy a joint life annuity to cover the lifetimes of both myself and my spouse with money from my IRA?”

Yes, a single premium immediate annuity (SPIA) can be purchased using traditional IRA or Roth IRA dollars.

If you read Internal Revenue Code section 408 (which is where we get the rules for IRAs), you’ll see that IRA can stand for individual retirement account or individual retirement annuity.

In every case I’ve ever seen personally, when IRA dollars are used to purchase an immediate annuity, the annuity is created as an individual retirement annuity. And that means two things:

1. Whether traditional or Roth, the payments from the annuity are simply treated as distributions from the IRA and taxed accordingly.
2. If it’s a traditional IRA, the payment from the annuity is considered to satisfy the RMD from the individual retirement annuity each year. (Point being, you don’t have to worry about calculating an RMD amount which might be different from the payment from the annuity. The payment satisfies the RMD by definition.)

Point being, payments from a traditional individual retirement annuity will generally be fully taxable, just as would be any other distribution from a traditional IRA. (If you have basis in your traditional IRA(s) due to having made nondeductible traditional IRA contributions, a pro-rata calculation would apply.)

And if it’s a Roth individual retirement annuity, payments/distributions will be treated as normal Roth IRA distributions. So they’ll be first considered to come out of contribution amounts, then converted amounts, and then earnings. And the tax treatment will be exactly what it would be if these amounts were coming out of a Roth individual retirement account. (This calculator/tool, as well as the article linked earlier in this paragraph, maybe helpful there.)

In theory, immediate lifetime annuities could be purchased within an individual retirement account, with the payments from the annuity made back into the IRA (rather than being distributions from the IRA). The tax code does not prohibit such. I’ve never seen such a thing in real life, so it doesn’t seem that many insurance companies offer this. I am aware of one person on the Bogleheads forum who has encountered such an annuity, but it’s definitely a rare situation.

Can a Joint Life Annuity (Myself and Spouse) be Purchased with IRA Dollars?

The short answer to this question is, yes, a joint life annuity that pays out for the longer of your life or your spouse’s life can be purchased with IRA dollars. One potential point to be aware of is that things get complicated if you also pick a period certain (i.e., the annuity will pay out for the longer of your lives but will also pay out for at least X years). You’ll want to read the rules in Treasury Regulation 1.401(a)(9)-6, to make sure the period certain does not cause any problems.

A reader writes in, asking:

“In a recent meeting at work, my team got to talking about retirement accounts and who makes tax-deferred contributions and who makes Roth contributions to our 401k. One person was arguing that Roth is almost always better because Roth accounts grow tax free. What I’ve read, from you and elsewhere, is that the decision comes down to tax rates. Should my coworker’s point not be considered though?”

This is something you’ll see frequently — the argument that a Roth account is better because with a tax-deferred account you have to pay tax on the growth. But that’s incorrect. It’s a fundamental misunderstanding of the math involved.

Both Roth accounts and tax-deferred accounts get to grow tax-free. This is in contrast to taxable brokerage accounts, in which you have to pay tax on interest, dividends, and realized capital gains each year. That is, tax-deferred accounts and Roth accounts grow more quickly because you don’t have to pay tax on the growth. This is the primary advantage of retirement accounts: you literally earn a greater rate of return in them than you do in taxable accounts. And when compounded over many years, that’s a big deal.

This is one of the most critical points to understand about retirement accounts, so I apologize if it feels like I’m belaboring it. When choosing which type of account to contribute to (Roth vs. tax-deferred), they are the same in this regard. If you have the same tax rate now (at the time of contribution) as you have at the time of distribution, both accounts will give you the same after-tax amount available for spending.

Example: Imagine a simplified world in which you have a constant 25% marginal tax rate. And this year you could contribute $4,000 to a traditional IRA or $3,000 to a Roth IRA (because the $4,000 contribution to traditional only “costs” you $3,000 of cash flow given the $1,000 tax savings you’d get from the contribution). After the contribution, both accounts would grow (or shrink) by the same rate of return each year. And regardless of what that rate of return is or how long the period is, at the end, you would have 75% as much in the Roth account as in the tax-deferred account. And after applying a 25% tax to the traditional IRA balance, the amount that’s left is the same.

So again, both Roth accounts and tax-deferred accounts get to grow tax-free. And that’s a big deal. It’s why maxing out your retirement accounts each year (if you have the cash flow to do so) is a good default recommendation before investing at all in a taxable brokerage account.

Of course, our simplified example above is unrealistic. In real life we don’t have a constant marginal tax rate. And so it’s worthwhile to try to judge whether your marginal tax rate at the time of the contribution is more or less than the tax rate you expect to face at the time the money comes out of the account later. (If your current tax rate is higher, tax-deferred contributions are preferable. If your current tax rate is lower, Roth contributions are preferable.)

But when in doubt — and frankly that’s a lot of the time because it’s hard to predict what marginal tax rate you’ll face many years from now — I think it’s prudent to prioritize Roth contributions.

That’s because Roth accounts have a few major advantages over tax-deferred accounts — advantages completely separate from this current-tax-rate-vs-future-tax-rate analysis.

• Roth accounts do not have required minimum distributions (RMDs) during your lifetime.
• Contributions to a Roth IRA can be taken back out, tax-free and penalty-free at any age. (Ditto for contributions to a Roth 401(k) or Roth 403(b) that have been rolled over to a Roth IRA.)
• If you’re maxing out your contributions, Roth accounts have the advantage of effectively letting you shelter more dollars than tax-deferred accounts do. That is, when you contribute to tax-deferred accounts, a portion of that money (specifically, the portion that will ultimately go toward taxes when you take the money out) is effectively the government’s money. So you’re using up a portion of your contribution limit for something that doesn’t benefit you, whereas when you contribute to Roth accounts, the full amount is yours.

So contributing to a tax-deferred account instead of a Roth account only makes sense if your “I have a higher marginal tax rate now than I’ll have when these dollars come of the account later” bet turns out to be right and that difference in tax rate outweighs those three factors above.

To summarize:

• The idea that with tax-deferred contributions you have to pay tax on the growth — and that you should therefore prioritize Roth contributions instead of tax-deferred contributions — is a fundamental misunderstanding of the math involved.
• But Roth accounts are often preferable, for a completely separate list of reasons.

A reader writes in, asking:

“You have written before about the rules for distributions from a Roth IRA, in which the treatment depends on whether the money coming out was a contribution, conversion, or earnings. What about money that was rolled over to the Roth IRA from a Roth 401K? That doesn’t seem to fit neatly into any of those 3 categories? My best guess is it would be treated as conversion money?”

As background information for anybody who hasn’t seen the articles the reader is referencing, here they are:

• Roth IRA distribution rules
• Roth IRA distribution tool

The short answer to the reader’s question is that when you roll money from an employer plan such as a 401(k) or 403(b) into a Roth IRA, the dollars in question essentially “remember” what they were to begin with and are lumped into the appropriate category in the Roth IRA.

• Amounts that you contributed to a Roth 401(k) or Roth 403(b), which you then roll into a Roth IRA, fall into the contributions category. That is, they now count as if they were contributions directly to the Roth IRA to begin with. (Point being, they can come out tax-free, penalty-free at any time.)
• Any growth (earnings) in the Roth 401(k) or Roth 403(b) that gets rolled to a Roth IRA counts the same as earnings in the Roth IRA.
• Any amounts that were rolled from a traditional 401(k) or traditional 403(b) to a Roth IRA are treated as converted amounts — because they are converted amounts (i.e., you moved them from tax-deferred to Roth).

Example: You have the following accounts:

• A Roth IRA with a $100,000 balance, consisting of $40,000 of contributions and $60,000 of earnings.
• A Roth 401(k) with a $50,000 balance, consisting of $30,000 of contributions and $20,000 of earnings.

You roll the Roth 401(k) into your Roth IRA. Your Roth IRA now has $150,000 in it. And that’s considered to be $70,000 of contributions ($40,000 + $30,000) and $80,000 of earnings ($60,000 + $20,000). Nothing in the IRA is considered to be from a conversion.

Track Your Contributions to Roth Accounts and Conversions

A super key point here is that it’s very important to track your contributions to Roth accounts, including Roth accounts in an employer plan. Contributions can come out of a Roth IRA tax-free and penalty-free, but you have to be able to demonstrate how much “contribution” is in the account. You don’t want to count on the brokerage firm having this information, because they likely don’t — especially if you have moved the IRA from one brokerage firm to another.

With contributions to a Roth IRA, that means keeping your Form 5498 each year.

With contributions to a Roth account in an employer-sponsored plan, that means keeping a copy of your Form W-2. (Contributions to the plan are reported in box 12, with the code depending on what type of plan it was. AA for Roth 401(k) contributions. BB for Roth 403(b) contributions. And EE for Roth contributions to a governmental 457(b) plan.)

Similarly, because converted amounts in a Roth IRA have better treatment than earnings, you also want to keep track of how much you have converted over the years (which in this case means keeping copies of your Forms 8606 and Forms 1099-R).