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When Should I Contribute to a Roth IRA as Opposed to Traditional IRA?

In reply to a recent Vanguard blog post indicating that investors contribute significantly more to Roth IRAs than to traditional IRAs, a reader asked for an explanation of when it makes sense to use a Roth IRA as opposed to traditional IRA.

For most people, the question of whether to make tax-deferred (i.e., “traditional”) retirement account contributions as opposed to Roth contributions is a function of marginal tax rates. (At any given time, your marginal tax rate is the rate of tax you would have to pay on an additional dollar of income.)

A simplified example illustrates how this works:

  • Let’s say you’re a 60-year-old taxpayer in the 25% tax bracket. You contribute $1,000 to a traditional IRA. You leave the money there for one year, during which it earns a 10% return (growing to $1,100). Then you take it out, while still in the 25% tax bracket, leaving you with $825 (i.e., $1,100 x 0.75) available to spend.
  • Alternatively, you could contribute to a Roth IRA. In this case, however, you can only afford to contribute $750, because you’ll no longer be getting the $250 of tax savings that you would have gotten in Year 1 via the $1,000 traditional IRA contribution. The $750 grows by 10%, to $825. When you take it out, you get to keep all $825 because the distribution is nontaxable.**

The key observation here is that if your marginal tax rate in the period of the contribution is the same as your marginal tax rate in the period of the distribution, then you’re left with exactly the same amount of money whether you use a Roth IRA or traditional IRA.

This is just the commutative property of multiplication at work. That is, at some point, the sum of money involved has to be multiplied by 0.75 to account for the 25% tax bite. It doesn’t matter whether we do that multiplication at the beginning (as is the case with a Roth IRA, where you have to pay tax on the income before being able to contribute it) or at the end (as is the case with a traditional IRA, in which you can contribute pre-tax money, but you have to pay taxes on distributions).

If, however, your marginal tax rate changes from the time of the contribution to the time of the distribution, one type of retirement account will come out ahead. Specifically:

  • If your marginal tax rate is greater in the year of the contribution, the traditional IRA will come out ahead, and
  • If your marginal tax rate is greater in the year of the distribution, the Roth IRA will come out ahead.

Guessing Tax Rates

In terms of guessing whether you’ll have a higher or lower marginal tax rate during retirement than during your working years, there are several factors at work.

One big factor in favor of traditional contributions is the fact that most taxpayers have lower levels of taxable income in retirement, because they’re no longer working. And, generally speaking, a lower level of taxable income leads to a lower marginal tax rate.

On the other hand, it’s likely that your marginal tax rate in many years of retirement will be higher than just your retirement tax bracket (e.g., you could be in the 15% tax bracket, yet have a marginal tax rate of 27%). For example:

  • In some cases, with the unique way in which Social Security benefits are taxed, a dollar of income in retirement not only causes the normal amount of income tax (e.g., 15 cents if you’re in the 15% tax bracket), it can also cause an additional 50 or 85 cents of your Social Security benefits to become taxable, which results in even more income tax.
  • If you retire prior to Medicare eligibility (and you do not have health insurance coverage through your former employer or your spouse’s employer), additional income can not only cause the normal amount of income tax, it can also shrink the amount of Affordable Care Act health insurance subsidies for which you’re eligible.

Both of those factors are points in favor of making Roth contributions during working years.

Frankly, I think that for investors who are many years away from retirement, trying to guess their marginal tax rate so far in the future is an exercise in futility, and the best approach is to simply do some of both (i.e., “tax diversify” by having some money in tax-deferred accounts and some money in Roth accounts).

Other Roth IRA Advantages

Finally, it’s important to note that regardless of this marginal tax rate guessing game, Roth IRAs do have three advantages over traditional IRAs:

  • There are no required minimum distributions (RMDs) during the original owner’s lifetime,
  • You can take contributions back out of the account tax-free and penalty-free at any time, and
  • They effectively allow you to tax-shelter more money (though this is irrelevant for anybody who does not have sufficient cash flow to max out their retirement accounts).

**We’re assuming here that you have satisfied the 5-year rule via prior Roth IRA contributions.

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