Roth IRAs and Roth 401(k)s offer great tax benefits in that all funds deposited within the accounts are able to grow tax-free and withdrawals after age 59½ are exempt from taxation. Tax-exempt– sign me up for that! However, are Roth accounts always the best retirement savings vessel? Not always.
Let’s say you have $6,000 available to invest in your retirement savings account and you are trying to decide whether to utilize a traditional IRA or a Roth IRA. If you deposit the money in a traditional IRA, the $6,000 will be subtracted from your annual income and you will not pay any tax on the deposited amount. If you choose to deposit the funds in a Roth IRA, you will need to pay tax on the deposited funds. If you are in the 24% tax bracket, $1,440 will need to be paid in taxes while the remaining $4,560 can be contributed to the Roth IRA.
Now let’s say your investments grow at a rate of 8% over ten years, you are now 62 years old and looking to withdraw the retirement funds. Let’s also assume that you are still in the same 24% tax bracket. The $6,000 deposited in the traditional IRA account will have grown to $12,950. When you withdraw it from the traditional IRA, your tax bill will be $3,108; leaving you with an after-tax distribution of $9,842. On the other hand, the $4,560 Roth IRA contribution will have grown to a value of $9,842 over that same time period. The after-tax values are the same!
Interestingly, the example above illustrates that there is no after-tax difference to investing in either the traditional IRA or Roth IRA if tax rates are the same at the time of the contribution and distribution. The benefit of using one savings mechanism over the other comes when there is a difference in tax rates between the time of contribution and the time of distribution.
What happens in our example when the tax rate at the time of distribution is 12%, instead of the 24% at the time of contribution? In this case, there is no change in the Roth IRA. The after-tax distribution will still be $9,842 as the 24% tax was paid at the time of contribution. For the traditional IRA, however, the tax due on the $12,950 distribution will be $1,554, resulting in an after-tax distribution of $11,396. Therefore, in the case of reduced tax rates, the traditional IRA provides superior after-tax performance.
The opposite is true when tax rates are higher at the time of distribution than they were when the deposit is made. What if the tax rate at the time of contribution was 12%, but you will be in the 24% tax bracket when distributions are made? The after-tax value of the traditional IRA is still $9,842. The initial deposit in the Roth IRA will be $5,280 after-tax, which will grow to $11,400 in 10 years. The Roth provides superior after-tax performance in this case.
The lesson here is that current and anticipated future tax rates should be utilized to determine whether to contribute to traditional tax-deferred accounts or Roth accounts. Why would tax rates be different between the time of contribution and distribution? The primary driver is income. Traditional IRA’s and tax-deferred retirement accounts were established assuming that your income would be higher during working years than in retirement. This may not always be the case, however. What if you retire at age 62 with a significant balance in your 401(k)? Before age 72, let’s say you take $50,000 annual distributions to support your lifestyle and the 401(k) continues to grow. These distributions will be taxed as ordinary income but you still might be in a lower tax bracket than you were when you made the 401(k) contributions. The potential trap might kick in at age 72, when the IRS’s Required Minimum Distributions (RMDs) start. What if the age 72 RMD was $150,000, which would again be taxed as ordinary income? In this case you would need to take more out of your retirement plan than you need and you might be pushed into a higher tax bracket. The RMD will also generally increase each year and you could be pushed into even higher tax brackets in future years.
Other examples might occur during your working career. In early career stages, you will likely be in low-income tax brackets and Roth accounts might provide the greatest benefit. Same thing if you were to go on a sabbatical and have a low-earning year, a Roth account might make the most sense. On the other hand, if you are in your peak earning years, you are likely to be in the higher tax brackets and it might make sense to utilize tax-deferred retirement savings accounts, such as the traditional IRA.
Tax rates might also differ between the time of contribution and distribution through changes in tax regulations. Current United States federal tax rates are low by historical standards and the national debt continues to grow. Both of these factors may result in future tax rate increases.
The logic above can also be applied to Roth conversions, where traditional tax-deferred assets are transferred into a tax-exempt account. For these conversions, the re-categorized amount is taxed as ordinary income in the year of the conversion and then funds deposited in the tax-exempt account (such as a Roth) can grow tax-free. A Roth conversion is best utilized when you are in a lower tax bracket and expect future tax rates to be higher. Some of the best times to consider Roth conversions are during early retirement years when income is low and RMDs are not yet required out of the tax-deferred accounts.
The decision on whether to contribute to a Roth or traditional retirement savings account is not always straightforward and different strategies may be more appropriate through different stages of life. A financial planning professional can help you navigate through these decisions and guide you down a path to optimize your personal financial situation.