Author Topic: Deciding between Roth and Traditional IRA based on marginal tax rate?  (Read 8903 times)

MVal

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Is the general consensus on deciding whether to contribute to a Roth IRA or a traditional something like this? If your tax bracket is 15% or lower, use a Roth; if it's 25% or higher, go with traditional. What do you think?

I have no idea what my bracket will be when I retire, but if I FIRE, then hopefully very low.

nereo

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It's a bit more complicated then just naming your current tax bracket.  Broadly speaking, if you will be in a lower tax bracket when you retire the math favors a tIRA over a ROTH.
However, that's also not the whole story.  You can do a 'backdoor ROTH pipeline' which allows you to take the tax deduction now, convert it when your income is very low, and then pay no taxes after the conversion.  If you plan on utilizing a backdoor roth, you need to first put money into a tIRA.

A few things you might want to read:
http://www.bogleheads.org/wiki/Traditional_versus_Roth
http://www.gocurrycracker.com/roth-sucks/
http://www.bogleheads.org/wiki/Backdoor_Roth_IRA

EDIT: changed thanks to MDM
« Last Edit: July 31, 2015, 09:59:23 AM by nereo »

MVal

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I should add that my current salary is $42K. The pre-tax contributions I'm making so far this year are $2000 to 401K and $2850 to the HSA (employer makes up other $500).

MDM

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You can do a 'backdoor ROTH' which allows you to take the tax deduction now, convert it when your income is very low, and then pay no taxes after the conversion.
Mixing a couple of metaphors there.

A 'backdoor Roth' is an effective way to contribute to a Roth IRA even if you are over the nominal IRS income limit.  To do this, make a non-deductible contribution to a tIRA.  When the funds are in the tIRA (e.g., a couple of days after the deposit is initiated), then roll those over into a Roth.  When you do this, you do not want any other funds in a tIRA (see the Bogleheads article for why).  The only reason to do this is having a very high income now - if you want to contribute to a Roth and fall below the IRS maximum, just do so directly.

A 'Roth pipeline' describes contributing to a tIRA (or 401k) now, then, years later, converting those funds to a Roth when your income is very low (thus reducing your marginal rate), and then pay no taxes after the conversion.


MDM

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...
A few things you might want to read:
http://www.bogleheads.org/wiki/Traditional_versus_Roth
...
+1

This is a great link.  If you read through all of it, and all of the links referenced therein, you'll find many different calculations and situations that prevent giving a concise, 100% accurate, answer.  This quote from near the beginning of that article, however, does as good a job as any:
"The main reason to prefer one type of account over the other is the comparison of marginal tax rates. If your marginal tax rate now is higher than your estimated marginal tax rate at retirement, then the traditional account is better; if it is lower, then the Roth account is better."

Yes, that does require one to estimate marginal tax brackets in retirement.  No way around that, unless one prefers coin flipping to make the trad vs Roth decision each year.

nereo

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You can do a 'backdoor ROTH' which allows you to take the tax deduction now, convert it when your income is very low, and then pay no taxes after the conversion.
Mixing a couple of metaphors there.

Right you are.  My mistake - edited original post to fix.

sirdoug007

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This question really depends on what income sources you expect to have in retirement.

Will you have a pension?
Will you be doing part time work?
Any other sources of income besides social security?

If not, the correct comparision is of your working marginal tax rate (15%) to your retirement average tax rate as described in the gocurrycracker article http://www.gocurrycracker.com/roth-sucks/

A mustachian average tax rate (spending <$40k/year from investments) ranges from 0% to 5% for a married couple and 0% to 10% if single. 

If you are married, you can withdrawal $20,600 in 2015 without a dime in income tax!  Income from $20,600 to $39,050 is taxed at 10%.

If you are single, you can withdrawal $10,300 tax free and income from $10,300 to $19,525 is taxed at 10%.  Income from $19,425 to $47,740 is taxed at 15%.

I've looked at this quite a bit and have come to the conclusion that for low spending mustachians that will not have a pension, if you are in a 15%+ marginal bracket you should do a traditional 401(k) and IRA. 

beltim

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If not, the correct comparision is of your working marginal tax rate (15%) to your retirement average tax rate as described in the gocurrycracker article http://www.gocurrycracker.com/roth-sucks/

Most of your post is right on, but this is not and never has been the appropriate calculation.  It's a simplification that works in some cases, but it's trivially easy to find examples where this calculation gives exactly the wrong answer.

MDM

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If not, the correct comparision is of your working marginal tax rate (15%) to your retirement average tax rate as described in the gocurrycracker article http://www.gocurrycracker.com/roth-sucks/

Most of your post is right on, but this is not and never has been the appropriate calculation.  It's a simplification that works in some cases, but it's trivially easy to find examples where this calculation gives exactly the wrong answer.
+1

Just as the vast majority of what gocurrycracker says is great, but this particular observation at least needs qualifiers and at worst is just wrong.  There is some discussion about this in the comments for that post.

Each year, take your best guess at your withdrawal marginal rate.  Answers to questions noted above (Will you have a pension?  Will you be doing part time work?  Any other sources of income besides social security?), plus the size of your traditional and Roth accounts, will help inform the guess.  Then contribute to traditional or Roth accordingly.  As the years go by and you get closer to withdrawing, the uncertainty in your guesses should decrease.




sirdoug007

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I understand your point, but how do you account for money taxed at multiple rates in retirement?

For example, lets say Joe spends $40k/year now and in retirement.  Joe is married and he and his wife earn $80k/year.

So Joe's marginal rate while working is 15%.

Joe retires and starts withdrawing $40k/year.  The first $20,600 has no income tax.  The next $18450 is taxed at 10% ($1845 in tax).  The remaining $950 is taxed at 15% ($142.50 in tax).

So Joe's retired marginal rate is also 15%.  But Joe's average tax rate is (1845+142.50)/40,000 = 5.0%.

Obviously Joe would much rather give uncle sam 5% of his yearly withdrawals than give him 15% up front.  Joe's marginal rates are the same but the average rate makes the traditional 401(k)/IRA a huge winner.

Thoughts?


MDM

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Re: Deciding between Roth and Traditional IRA based on marginal tax rate?
« Reply #10 on: July 31, 2015, 02:44:13 PM »
I understand your point, but how do you account for money taxed at multiple rates in retirement?

For example, lets say Joe spends $40k/year now and in retirement.  Joe is married and he and his wife earn $80k/year.

So Joe's marginal rate while working is 15%.

Joe retires and starts withdrawing $40k/year.  The first $20,600 has no income tax.  The next $18450 is taxed at 10% ($1845 in tax).  The remaining $950 is taxed at 15% ($142.50 in tax).

So Joe's retired marginal rate is also 15%.  But Joe's average tax rate is (1845+142.50)/40,000 = 5.0%.

Obviously Joe would much rather give uncle sam 5% of his yearly withdrawals than give him 15% up front.  Joe's marginal rates are the same but the average rate makes the traditional 401(k)/IRA a huge winner.

Thoughts?

Good question.  To answer, we need to make some assumptions.

Beyond "obvious" assumptions such as the tax brackets themselves, there is this: the contributed money is eventually withdrawn.  Absent this assumption, Roth is never better (it can be equal) because no withdrawal means no taxes on withdrawal.  Joe can withdraw traditional amounts voluntarily, or be subject to Required Minimum Distributions, or Joe's heirs will be subject to RMDs.  If Joe's investments do so well that RMDs kick him up to the 25% bracket, he'll wish he had done less traditional and more Roth.

But back to the original question.  We need to look at the sources of that $40K in retirement withdrawals. 

If the first $30,050 comes from pension, SS, etc., then all of the IRA withdrawals are taxed at 15%.  If there is no pension, SS, etc., then things are a little more complicated - but we can still untangle the situation.

Go back to when Joe made his first contribution.  Assume that Joe was in the 15% marginal bracket.  At that time, Joe's retirement income prospects were bleak: no pension, no SS, and no retirement funds.  Gazing into his crystal ball, however, Joe figured he would always be in the 15% bracket while earning.  He also knew about the $20,600/yr in deductions/exemptions for withdrawals, so he decided to contribute to a traditional account because the withdrawals would be low enough to be tax free.  So far so good.

Now fast forward a few years.  Joe has continued to contribute to traditional accounts.  Projecting his investment earnings and likely withdrawal time length, he notices that he could expect to withdraw $21K/yr in retirement.  Now he realizes that he will have to pay some tax on withdrawals, but still only 10%, so traditional is still better.

Fast forward a few more years, and Joe's investments have grown enough that withdrawals over his retirement life span are projected to hit $39,050/yr.  The average rate is irrelevant to Joe's decision.  Any future contributions to traditional accounts will be withdrawn at a 15% marginal rate, so Joe might want to switch to Roth (or not) at this point.

If, at the time of Joe's first contribution, his crystal ball predicted a time of earning enough to save 25% on contributions, he might have chosen to contribute to Roth early and save the traditional contributions for later years and the higher marginal rates.  Does that all make sense?

beltim

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Re: Deciding between Roth and Traditional IRA based on marginal tax rate?
« Reply #11 on: July 31, 2015, 03:03:02 PM »
I was about to type a long response, but MDM beat me to it.  I'll add a few points, though.

The example you picked - Joe who just barely gets into the 15% bracket – is a tough one to pick cases where the Roth is an obvious choice.  A "perfect" tax strategy depends on knowing reasonably well the trajectory of career earnings, expenses in retirement, and any changes in tax rates.  If someone were well into the 15% bracket, the number of beneficial cases increases.  That said, there are still some cases where Joe would benefit from using a Roth.

Say Joe, earlier in his working career, was in the 10% tax bracket.  If he knew he would in the future get a raise, and a raise such that he would enter the 15% tax bracket, then he would have been much better off contributing to a Roth while he was in the 10% bracket, even though his effective tax rate in retirement would have been higher than 10%.  This is because he would only pay 10% on the funds contributed to the IRA, instead of the 15% he would pay on withdrawal.  Or, perhaps he drops into the 10% bracket later in his career when he has an unusually high number of deductions - home mortgage, high income tax state, kids in college, etc.  The same math applies.

sirdoug007

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Re: Deciding between Roth and Traditional IRA based on marginal tax rate?
« Reply #12 on: July 31, 2015, 03:19:17 PM »
I understand your point, but how do you account for money taxed at multiple rates in retirement?

For example, lets say Joe spends $40k/year now and in retirement.  Joe is married and he and his wife earn $80k/year.

So Joe's marginal rate while working is 15%.

Joe retires and starts withdrawing $40k/year.  The first $20,600 has no income tax.  The next $18450 is taxed at 10% ($1845 in tax).  The remaining $950 is taxed at 15% ($142.50 in tax).

So Joe's retired marginal rate is also 15%.  But Joe's average tax rate is (1845+142.50)/40,000 = 5.0%.

Obviously Joe would much rather give uncle sam 5% of his yearly withdrawals than give him 15% up front.  Joe's marginal rates are the same but the average rate makes the traditional 401(k)/IRA a huge winner.

Thoughts?

Good question.  To answer, we need to make some assumptions.

Beyond "obvious" assumptions such as the tax brackets themselves, there is this: the contributed money is eventually withdrawn.  Absent this assumption, Roth is never better (it can be equal) because no withdrawal means no taxes on withdrawal.  Joe can withdraw traditional amounts voluntarily, or be subject to Required Minimum Distributions, or Joe's heirs will be subject to RMDs.  If Joe's investments do so well that RMDs kick him up to the 25% bracket, he'll wish he had done less traditional and more Roth.

But back to the original question.  We need to look at the sources of that $40K in retirement withdrawals. 

If the first $30,050 comes from pension, SS, etc., then all of the IRA withdrawals are taxed at 15%.  If there is no pension, SS, etc., then things are a little more complicated - but we can still untangle the situation.

Go back to when Joe made his first contribution.  Assume that Joe was in the 15% marginal bracket.  At that time, Joe's retirement income prospects were bleak: no pension, no SS, and no retirement funds.  Gazing into his crystal ball, however, Joe figured he would always be in the 15% bracket while earning.  He also knew about the $20,600/yr in deductions/exemptions for withdrawals, so he decided to contribute to a traditional account because the withdrawals would be low enough to be tax free.  So far so good.

Now fast forward a few years.  Joe has continued to contribute to traditional accounts.  Projecting his investment earnings and likely withdrawal time length, he notices that he could expect to withdraw $21K/yr in retirement.  Now he realizes that he will have to pay some tax on withdrawals, but still only 10%, so traditional is still better.

Fast forward a few more years, and Joe's investments have grown enough that withdrawals over his retirement life span are projected to hit $39,050/yr.  The average rate is irrelevant to Joe's decision.  Any future contributions to traditional accounts will be withdrawn at a 15% marginal rate, so Joe might want to switch to Roth (or not) at this point.

If, at the time of Joe's first contribution, his crystal ball predicted a time of earning enough to save 25% on contributions, he might have chosen to contribute to Roth early and save the traditional contributions for later years and the higher marginal rates.  Does that all make sense?

Thanks for the breakdown MDM.  I'm starting to see your perspective on this issue.

So in your view, Joe would stop contributing to a traditional pre-tax account when the future value of his investments would reach ~$1MM for a 4% withdrawal rate of around $40k? (assuming 4% is Joe's withdrawal rate plan) 

At that point he would have filled his future 0% and 10% income tax brackets.  So any additional savings would likely be taxed at 15% either way. 

The future value calculation of course depends upon the expected return and the time to retirement.  As Yogi says, it's tough to make predictions, especially about the future!

I looked at this for my own situation which is about 95% pre-tax and if I retire as soon as I hit FIRE I should keep with pre-tax almost to the very end.  However, if I put off RE another 5 or 10 years then I should consider switching to Roth soon (put off 5 years) or immediately (put off 10 years).  [EDIT: was thinking 15% bracket when I've passed personally from the beginning of my career after college]

My earnings put me on the threshold between the 25% and 28% brackets.  For married couples, the 25% bracket doesn't start until around $95k.  25x that (4% WR) is about $2.4MM!  The first round of RMDs make you withdrawal around 3.9% at 71.  I guess I'll keep contributing pre-tax then.

Is this consistent with your approaches MDM and beltim?



« Last Edit: July 31, 2015, 03:55:30 PM by sirdoug007 »

MDM

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Re: Deciding between Roth and Traditional IRA based on marginal tax rate?
« Reply #13 on: July 31, 2015, 04:02:51 PM »
So in your view, Joe would stop contributing to a traditional pre-tax account when the future value of his investments would reach ~$1MM for a 4% withdrawal rate of around $40k? (assuming 4% is Joe's withdrawal rate plan) 

At that point he would have filled his future 0% and 10% income tax brackets.  So any additional savings would likely be taxed at 15% either way. 

The future value calculation of course depends upon the expected return and the time to retirement.

I looked at this for my own situation which is about 95% pre-tax and if I retire as soon as I hit FIRE I should keep with pre-tax almost to the very end.  However, if I put off RE another 5 or 10 years then I should consider switching to Roth soon (put off 5 years) or immediately (put off 10 years).

As Yogi says, it's tough to make predictions, especially about the future!

In short, yes to all that - especially the implication that crystal balls are notoriously cloudy!

One can introduce another perspective: the inflation adjusted 4% WR is "safe", but the median result of that strategy is a portfolio worth ~$6 million (see http://jlcollinsnh.com/2012/12/07/stocks-part-xiii-withdrawal-rates-how-much-can-i-spend-anyway/).  The first year RMD for that amount is ~$219K.  The marginal rate on $219K is likely to be higher than 15%, so...good luck predicting!


MVal

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Re: Deciding between Roth and Traditional IRA based on marginal tax rate?
« Reply #14 on: August 08, 2015, 10:19:12 AM »
Wow, seems like there is a lot of ways of looking at this. I think since I like the idea of being able to access my contributions anytime if I need to, I will go with the full Roth this year. If I do that, I will have about $13K in it. I think with five figures in the Roth, then I will feel comfortable with doing a traditional IRA next year. If I contribute as much as I can to my 401K and fully fund a tIRA next year, I think I will also be able to get the Savers Credit, but this year my eye is really on building liquid savings--after funding the IRA, I will still be on track to have over $10K in liquid savings at the end of this year. With that kind of padding, I will feel more secure about dumping all of my extra money into less accessible, but highly tax-advantaged investments like my 401K and/or tIRA.

I really have no idea what my tax bracket will be after I retire, or even 5 years from now, so I think I'll just alternate back and forth each year on traditional and Roth, or contribute the max 50/50, or some other kind of mix.

MDM

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Re: Deciding between Roth and Traditional IRA based on marginal tax rate?
« Reply #15 on: August 08, 2015, 10:55:25 AM »
I really have no idea what my tax bracket will be after I retire

You could try a retirement planner such as www.i-orp.com that estimates your future tax bracket for you.  Of course the estimate is no better than the inputs but it might be helpful....

MVal

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Re: Deciding between Roth and Traditional IRA based on marginal tax rate?
« Reply #16 on: August 11, 2015, 08:34:46 AM »
I really have no idea what my tax bracket will be after I retire

You could try a retirement planner such as www.i-orp.com that estimates your future tax bracket for you.  Of course the estimate is no better than the inputs but it might be helpful....

I think I'm going to have to crack a couple more books to understand how to fill this thing out. There's a few values I'm not sure what they mean.

MDM

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Re: Deciding between Roth and Traditional IRA based on marginal tax rate?
« Reply #17 on: August 11, 2015, 09:18:03 AM »
I think I'm going to have to crack a couple more books to understand how to fill this thing out. There's a few values I'm not sure what they mean.

Folks here may be able to help - examples?

BarkyardBQ

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Re: Deciding between Roth and Traditional IRA based on marginal tax rate?
« Reply #18 on: August 11, 2015, 03:45:28 PM »
It doesn't seem to accept 41500 as a tax deferred retirement account option... when you have a 457+403+IRA shouldn't that be acceptable?

edit: got a usable error,  (e.g. 1 Million = 1000)
« Last Edit: August 11, 2015, 03:49:10 PM by zdravé »

TomTX

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Re: Deciding between Roth and Traditional IRA based on marginal tax rate?
« Reply #19 on: August 16, 2015, 06:41:34 AM »
...
A few things you might want to read:
http://www.bogleheads.org/wiki/Traditional_versus_Roth
...
+1

This is a great link.  If you read through all of it, and all of the links referenced therein, you'll find many different calculations and situations that prevent giving a concise, 100% accurate, answer.  This quote from near the beginning of that article, however, does as good a job as any:
"The main reason to prefer one type of account over the other is the comparison of marginal tax rates. If your marginal tax rate now is higher than your estimated marginal tax rate at retirement, then the traditional account is better; if it is lower, then the Roth account is better."

You do have to look at the WHOLE tax picture. A couple of items often overlooked:

The really weird (punitive) taxation of Social Security benefits when you have other income combined with RMDs @ age 70.5 tends to shift the balance toward Roth @ the 15% bracket, IMO .

State/City income tax: If you're paying State income tax now, but don't expect to in retirement (ie, working in NYC, retiring to Florida) - the balance shifts toward Traditional. Conversely, if you work in a state with no income tax and intend to retire to a state WITH an income tax that taxes Traditional IRA/401k withdrawals (ie, working in Texas, retiring to Hawaii) this shifts the balance toward Roth.

Personally, I work in a state with no income tax (Texas) and have a mix of Traditional and Roth. I intend to convert most of the Traditional to Roth before hitting RMD age. Once the house is paid off, free cash flow is either going into 401k to hit the EITC, or conversions to Roth. In retirement,  I'll also be drawing a pension which is expected to put me into the "OMG this sucks" range of Social Security taxation.