Traditional or Roth Retirement Accounts

[EngineerYogi]

http://www.gocurrycracker.com/roth-sucks/

This was a really good article and am wondering if there are any holes in his argument I should be wary of. Currently DH and I are contributing strictly Roth (TSP, 401k and IRA) even though we have an AGI of $150k. We did so because of the assumption we'll have a $30k pension to pay taxes on at the outright of DH's retirement at age 40(military pension). But this article shows that the math still doesn't work out and I'm beginning to think it's right. At most I'd expect to be living on around $75k annually in retirement and that half of what we currently have as income that we are paying taxes on. Switching to a traditional 401k and TSP would reduce our taxable income by $36k since we currently max out our contributions in those accounts. If my math is right, at a 25% tax rate on those funds we could save $9,000 a year by switching to a traditional TSP and 401k. (We still will contribute to Roth IRAs)

Am I missing anything?

[MDM]

That article is generally correct in saying traditional accounts will be better for most.

The math used in the article, however, is not correct and overstates the value of a traditional account.

You need to look at marginal rates, both your marginal tax saving rate when contributing and your marginal withdrawal tax rate in retirement, to judge whether a given contribution should be made to a traditional or a Roth account.

Note the possibility of self-defeating predictions:
a) predict high taxable retirement income > contribute to Roth > get low taxable retirement income
b) predict low taxable retirement income > contribute to traditional > get high taxable retirement income

Estimating withdrawal tax rates is not an exact science, but here is one approach:
1) Include any guaranteed pension amount that you can't defer in return for higher payments when you do start
2) Take current traditional balance and predict value at retirement (e.g., with Excel's FV function) using a conservative real return, maybe 3% or so.  Take 4% of that value as an annual withdrawal.
3) Take current taxable balance and predict value at retirement (e.g., with Excel's FV function) using a conservative real return, maybe 3% or so.  Take 2% of that value as qualified dividends.
4a) Decide whether SS income should be considered, or whether you will be able to do enough traditional->Roth conversions before taking SS.
4b) Include SS income projections (using today's dollars) if needed from step 4a.
5) Calculate marginal rate using today's tax law on the numbers from step 1-4.
6) Make your traditional vs. Roth decision for this year's contribution
7) Repeat steps 1-6 every year until retirement

The steps above may look complicated at first, but you don't need great precision.  The answer will either be "obvious" or "difficult to choose".  If the latter, it likely won't make much difference which you pick anyway.

Also, if you pick traditional and that ends up being wrong it will be because you have "too much money" - not the worst problem.
If you pick Roth and that ends up being wrong it will be because you have "too little money" - that can be a real problem.
Thus using traditional is a "safer" choice.

But see also Most TSP Participants Should Switch To the Roth TSP for an additional perspective.

[EngineerYogi]

Thank you so much for that very detailed response! I finally did my homework (hello rough ugly (and conservative) numbers, but something to work from at least).
Assumptions: 3% return on all, continue contributing 36k/yr to traditional, 11k/yr to roth, 18k/yr to taxable, 2025 is current ER target date, 2049 is the year I turn 60(DH will be 64), I divided the taxable account by 24 so any growth during that 24 years while drawing down is not included, annual income at 2049 is at the 4% safe withdrawal, taxes are based on a 2016 calculator and we'll have at least one dependent in 2025

Things I learned: wow, I had no idea my husband's pension was that generous! Also, we'll have "too" much money by the time I turn 60 but maybe not enough to retire in 2025 (I'll be 36, DH 40). It may be worthwhile to move investments around a bit to increase our taxable brokerage contributions rather than maxing the other retirement accounts?

	current balance	projected balance in 2025	projected balance in 2049	annual income in 2025	annual income in 2049
Guaranteed Pension				$54,443.00	$66,443.00
current traditional balance	$20,285.31	$391,452.39	$803,490.53		$32,139.62
current roth balance	$136,259.08	$272,485.81	$559,301.13		$22,372.05
Taxable Brokerage	0	$162,521.08		$6,771.71
Taxed Total				$61,214.71	$98,582.62
Tax-Free Total					$22,372.05
Total	$156,544.39	$826,459.28	$1,362,791.66	$61,214.71	$120,954.67
marginal tax rate				0.15	0.15
taxes owed				4000	10000
Income to Live On				$57,214.71	$110,954.67

[EngineerYogi]

Omitted a critical detail, we're targeting $75k for annual retirement income.

[MDM]

I finally did my homework (hello rough ugly (and conservative) numbers, but something to work from at least).

Great!  Now you can update ~once/yr and the situation should get clearer as time goes by.

It may be worthwhile to move investments around a bit to increase our taxable brokerage contributions rather than maxing the other retirement accounts?

It's usually better to use tax-advantaged accounts rather than taxable accounts.  See How to withdraw funds from your IRA and 401k without penalty before age 59.5 if that topic concerns you.

[ooeei]

That article is generally correct in saying traditional accounts will be better for most.

The math used in the article, however, is not correct and overstates the value of a traditional account.

You need to look at marginal rates, both your marginal tax saving rate when contributing and your marginal withdrawal tax rate in retirement, to judge whether a given contribution should be make to a traditional or a Roth account.

This is an important and not very intuitive point.  The strategy in the article assumes you will have 0 income in retirement at the time you decide which to contribute towards.  The strategy works with that assumption, but that assumption is immediately broken once you have any money in a traditional account (the very strategy they recommend).  The following scenario shows a (rather uncommon) situation where you might be worse off contributing to a traditional.

Scenario:  You already have $1,000,000 in a traditional 401k.  In this case, you can safely withdraw around $40,000 per year forever.  If you're currently making $35,000 in taxable income, you have two options.

1.  Put your additional savings in a Roth, paying taxes at your current rate consistent with $35,000 in income.

2.  Put your additional savings in a traditional, paying taxes at the rate consistent with $40,000 in income (which it will be when you withdraw it).

Obviously this is not going to be a common scenario, and is somewhat simplified, but it hopefully highlights the balance you have to consider.  If you have any money currently in traditional accounts, you already have some retirement income you need to think about.   It's simply a matter of how much, and then deciding where your money is best put to use. 

Luckily the article is generally correct in that for most people traditional will work out better.

[EngineerYogi]

That article is generally correct in saying traditional accounts will be better for most.

The math used in the article, however, is not correct and overstates the value of a traditional account.

You need to look at marginal rates, both your marginal tax saving rate when contributing and your marginal withdrawal tax rate in retirement, to judge whether a given contribution should be make to a traditional or a Roth account.

This is an important and not very intuitive point.  The strategy in the article assumes you will have 0 income in retirement at the time you decide which to contribute towards.  The strategy works with that assumption, but that assumption is immediately broken once you have any money in a traditional account (the very strategy they recommend).  The following scenario shows a (rather uncommon) situation where you might be worse off contributing to a traditional.

Scenario:  You already have $1,000,000 in a traditional 401k.  In this case, you can safely withdraw around $40,000 per year forever.  If you're currently making $35,000 in taxable income, you have two options.

1.  Put your additional savings in a Roth, paying taxes at your current rate consistent with $35,000 in income.

2.  Put your additional savings in a traditional, paying taxes at the rate consistent with $40,000 in income (which it will be when you withdraw it).

Obviously this is not going to be a common scenario, and is somewhat simplified, but it hopefully highlights the balance you have to consider.  If you have any money currently in traditional accounts, you already have some retirement income you need to think about.   It's simply a matter of how much, and then deciding where your money is best put to use. 

Luckily the article is generally correct in that for most people traditional will work out better.

Right, that is why I had the question. We'll have $55k in the form of a taxable pension the day my husband retires from the military (possibly more, depends on how long he chooses to stay in). But with us already in the 25% tax bracket and pushing the 28% tax bracket, how much of a difference does it make if we go one way or the other. Based on the numbers I ran for my specific situation, I think it may actually be a wash either way, though contributing traditional now frees up some income to invest now. Having the money now to increase investments enables us to meet an earlier retirement date which is exactly what we want. Our little Roth nest egg will continue to grow and we'll make contributions to it for as long as we qualify (we're close to phase out due to income but not quite).

[ooeei]

That article is generally correct in saying traditional accounts will be better for most.

The math used in the article, however, is not correct and overstates the value of a traditional account.

You need to look at marginal rates, both your marginal tax saving rate when contributing and your marginal withdrawal tax rate in retirement, to judge whether a given contribution should be make to a traditional or a Roth account.

This is an important and not very intuitive point.  The strategy in the article assumes you will have 0 income in retirement at the time you decide which to contribute towards.  The strategy works with that assumption, but that assumption is immediately broken once you have any money in a traditional account (the very strategy they recommend).  The following scenario shows a (rather uncommon) situation where you might be worse off contributing to a traditional.

Scenario:  You already have $1,000,000 in a traditional 401k.  In this case, you can safely withdraw around $40,000 per year forever.  If you're currently making $35,000 in taxable income, you have two options.

1.  Put your additional savings in a Roth, paying taxes at your current rate consistent with $35,000 in income.

2.  Put your additional savings in a traditional, paying taxes at the rate consistent with $40,000 in income (which it will be when you withdraw it).

Obviously this is not going to be a common scenario, and is somewhat simplified, but it hopefully highlights the balance you have to consider.  If you have any money currently in traditional accounts, you already have some retirement income you need to think about.   It's simply a matter of how much, and then deciding where your money is best put to use. 

Luckily the article is generally correct in that for most people traditional will work out better.

Right, that is why I had the question. We'll have $55k in the form of a taxable pension the day my husband retires from the military (possibly more, depends on how long he chooses to stay in). But with us already in the 25% tax bracket and pushing the 28% tax bracket, how much of a difference does it make if we go one way or the other. Based on the numbers I ran for my specific situation, I think it may actually be a wash either way, though contributing traditional now frees up some income to invest now. Having the money now to increase investments enables us to meet an earlier retirement date which is exactly what we want. Our little Roth nest egg will continue to grow and we'll make contributions to it for as long as we qualify (we're close to phase out due to income but not quite).

Ah okay, I guess you already understood that point then.  It's one that took me a little while to grasp.

One thing I notice in your calculations is you seem to be treating your taxable brokerage the same as a pension.  Are you assuming you're only withdrawing earnings at this point?  If you assume you're withdrawing some principal, then you're probably overestimating your tax liability as you already paid income taxes on that money.

Something else to consider is running the calculations again with a higher return rate to see what about your strategy would need to change.  If it's significantly different than the calculations you just ran, you may want to shoot for some sort of middle ground between the two as that's the more likely outcome.  3% is nice and conservative as far as FIRE date, but being extra conservative when deciding on a tax strategy isn't necessarily going to help you.

[EngineerYogi]

That article is generally correct in saying traditional accounts will be better for most.

The math used in the article, however, is not correct and overstates the value of a traditional account.

You need to look at marginal rates, both your marginal tax saving rate when contributing and your marginal withdrawal tax rate in retirement, to judge whether a given contribution should be make to a traditional or a Roth account.

This is an important and not very intuitive point.  The strategy in the article assumes you will have 0 income in retirement at the time you decide which to contribute towards.  The strategy works with that assumption, but that assumption is immediately broken once you have any money in a traditional account (the very strategy they recommend).  The following scenario shows a (rather uncommon) situation where you might be worse off contributing to a traditional.

Scenario:  You already have $1,000,000 in a traditional 401k.  In this case, you can safely withdraw around $40,000 per year forever.  If you're currently making $35,000 in taxable income, you have two options.

1.  Put your additional savings in a Roth, paying taxes at your current rate consistent with $35,000 in income.

2.  Put your additional savings in a traditional, paying taxes at the rate consistent with $40,000 in income (which it will be when you withdraw it).

Obviously this is not going to be a common scenario, and is somewhat simplified, but it hopefully highlights the balance you have to consider.  If you have any money currently in traditional accounts, you already have some retirement income you need to think about.   It's simply a matter of how much, and then deciding where your money is best put to use. 

Luckily the article is generally correct in that for most people traditional will work out better.

Right, that is why I had the question. We'll have $55k in the form of a taxable pension the day my husband retires from the military (possibly more, depends on how long he chooses to stay in). But with us already in the 25% tax bracket and pushing the 28% tax bracket, how much of a difference does it make if we go one way or the other. Based on the numbers I ran for my specific situation, I think it may actually be a wash either way, though contributing traditional now frees up some income to invest now. Having the money now to increase investments enables us to meet an earlier retirement date which is exactly what we want. Our little Roth nest egg will continue to grow and we'll make contributions to it for as long as we qualify (we're close to phase out due to income but not quite).

Ah okay, I guess you already understood that point then.  It's one that took me a little while to grasp.

One thing I notice in your calculations is you seem to be treating your taxable brokerage the same as a pension.  Are you assuming you're only withdrawing earnings at this point?  If you assume you're withdrawing some principal, then you're probably overestimating your tax liability as you already paid income taxes on that money.

Something else to consider is running the calculations again with a higher return rate to see what about your strategy would need to change.  If it's significantly different than the calculations you just ran, you may want to shoot for some sort of middle ground between the two as that's the more likely outcome.  3% is nice and conservative as far as FIRE date, but being extra conservative when deciding on a tax strategy isn't necessarily going to help you.

Yes, I looked at it again with a 7% return and we'll be back around the 25% tax bracket in retirement in that case rather than a cushy 15%. But we're already in that bracket now and almost in the 28% so traditional still makes sense to avoid the 28% bracket now.

Good point on the taxable, I suppose that makes sense that is kind of tax free money other than paying taxes on earnings. No, I would assume we'd be withdrawing both earnings and principal in order to reach true retirement age. So that needs a little tweaking on my spreadsheet.

It was a fun exercise to do, I feel like it's so easy to say, "this is too complicated why can't I just have someone figure it out for me." But sitting down and taking the time to work the numbers is educational and empowering and even soothing in it's own way.

[MDM]

It was a fun exercise to do, I feel like it's so easy to say, "this is too complicated why can't I just have someone figure it out for me." But sitting down and taking the time to work the numbers is educational and empowering and even soothing in it's own way.

Good for you - well done!

[ulrichw]

One element that argues in favor of Roth that I don't see mentioned here is the issue of RMDs (Required Minimum Distributions).

Money in a Roth IRA is not subject to RMDs while the owner is alive. This means that you get increased flexibility.

The article's misuse of marginal vs. effective tax rates glosses over the value of this flexibility.

Basically if you have a larger IRA, RMDs will quickly force you into the 25% tax bracket. This means that your marginal tax rate will continuously be high after a certain age.

Having a significant amount of Roth savings means you can make a large withdrawal if you need to without having to pay high taxes on the withdrawal.

[Brother Esau]

It was a fun exercise to do, I feel like it's so easy to say, "this is too complicated why can't I just have someone figure it out for me." But sitting down and taking the time to work the numbers is educational and empowering and even soothing in it's own way.


This! MMM has made me discover that working the numbers is empowering and totally worth the additional green soldiers joining my team.

[EngineerYogi]

Thanks again forall the thoughts, input and help! MMM is a bunch of awesome, smart people!