Roth vs. Tax-Deferred Contributions — Evaluating a Bad Rule of Thumb

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 Contributions to a Roth IRA can be withdrawn tax-free and penalty-free at any time, so Roth IRAs (as well as Roth 401(k) or Roth 403(b) contributions that have been rolled over to a Roth IRA) can do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.