Author Topic: Roth or Traditional IRA for best overall tax efficiency?  (Read 3701 times)

The 585

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Roth or Traditional IRA for best overall tax efficiency?
« on: December 09, 2016, 08:52:12 AM »
Hello! I'm currently making a $83,000 annual salary. I will be maxing out my pre-tax 401k contributions ($18,000), and also maxing out my pre-tax HSA contribution ($3,350).

However, I will also max out my Vanguard IRA, $5,500, in a Roth. Should I have been putting this $5,500 towards Traditional IRA instead? Would I qualify for the tax deductions in this situation? Or is it best off just putting this towards the Roth? I've heard my contributions for this year can still be converted from Roth to Traditional within this tax year, but wanted to get some advice on if this would be a good idea.

Thanks in advance!

caracarn

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Re: Roth or Traditional IRA for best overall tax efficiency?
« Reply #1 on: December 09, 2016, 08:55:43 AM »
The calculations I have always been taught on this (and that I use) is if your tax rate is lower now than it will be in retirement do the Roth.  If it is higher or the same now than it will be in retirement, do Traditional.  I make $160K and have always done Traditional because of that tax rate decision.  I will be in a lower tax bracket when I retire, so I certainly would rather pay on those earnings then at the lower rate.

The 585

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Re: Roth or Traditional IRA for best overall tax efficiency?
« Reply #2 on: December 09, 2016, 09:15:19 AM »
Thanks for the response. I agree, I'd definitely have a much lower taxable income rate at retirement. However, as for contributing to a traditional IRA, aren't there limits to being able to deduct contributions from taxable income? I would assume if you are making $160k, that would be past the limits to being able to deduct the $5,500 from a traditional IRA.

The deduction limits on traditional IRAs are what confuse me. If I wasn't able to deduct these contributions, I think I'd be better off just going with Roth or even taxable investments!

seattlecyclone

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Re: Roth or Traditional IRA for best overall tax efficiency?
« Reply #3 on: December 09, 2016, 09:38:49 AM »
Yes, if you can't deduct your IRA contributions, go with Roth. Roth is better than post-tax traditional in pretty much any scenario I can imagine.

Nothlit

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Re: Roth or Traditional IRA for best overall tax efficiency?
« Reply #4 on: December 09, 2016, 09:44:34 AM »
There are indeed limits. You might be right on the cusp. You'll have to do the math to figure it out...

robartsd

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Re: Roth or Traditional IRA for best overall tax efficiency?
« Reply #5 on: December 09, 2016, 10:40:03 AM »
The calculations I have always been taught on this (and that I use) is if your tax rate is lower now than it will be in retirement do the Roth.  If it is higher or the same now than it will be in retirement, do Traditional.  I make $160K and have always done Traditional because of that tax rate decision.  I will be in a lower tax bracket when I retire, so I certainly would rather pay on those earnings then at the lower rate.
There are only a few ways your tax rate would be higher in retirement:
  • You saved enough to increase your spending beyond your current taxable income
  • The government increased the tax rates
  • You moved to a higher income tax area
For most people all of these scenarios are unlikely (except for people who are temporarily scraping by at a lower standard of living before their careers take off).

That said, there are still reasons to contribute to Roth:
  • You count your Roth IRA contributions as part of your emergency fund enabling more tax advantaged savings
  • You plan to retire early and Roth contributions are part of a bridge to penalty free withdraw of tax-deferred savings
  • You exceed the income limits for deducting traditional IRA contributions or want to have no traditional IRA balance to facilitate backdoor Roth strategy later
  • You want to maximize tax advantaged savings space by paying the taxes with after tax money

If you're a single filer, you are getting close to the 61,000 MAGI limit for full destructibility of traditional IRA contributions. The single filer limit for Roth contributions is 117,000 MAGI (184,000 for married filing joint). If you ever exceed the Roth contribution limit, it would be best to have no balance in any traditional IRA so that you can execute a backdoor Roth contributions cleanly in the future. If you think you might exceed the Roth contribution limits in the future, I think you should stick with the Roth IRA; otherwise, as a single filer, you should be able to contribute to a Traditional IRA and deduct most, if not all, of the contribution. You'll have to sharpen your pencil, work out how much Traditional IRA contributions would be deductible for you (and decide what your threshold for partial-deductible Traditional IRA contributions is). Unless you have a specific reason for choosing Roth, I'd recommend Traditional.

The 585

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Re: Roth or Traditional IRA for best overall tax efficiency?
« Reply #6 on: December 09, 2016, 11:42:37 AM »
If you're a single filer, you are getting close to the 61,000 MAGI limit for full destructibility of traditional IRA contributions. The single filer limit for Roth contributions is 117,000 MAGI (184,000 for married filing joint). If you ever exceed the Roth contribution limit, it would be best to have no balance in any traditional IRA so that you can execute a backdoor Roth contributions cleanly in the future. If you think you might exceed the Roth contribution limits in the future, I think you should stick with the Roth IRA; otherwise, as a single filer, you should be able to contribute to a Traditional IRA and deduct most, if not all, of the contribution. You'll have to sharpen your pencil, work out how much Traditional IRA contributions would be deductible for you (and decide what your threshold for partial-deductible Traditional IRA contributions is). Unless you have a specific reason for choosing Roth, I'd recommend Traditional.

Thanks again for all the comments. Robartsd, in regards to your comments, I believe I'd fall under your case where I'll be exceeding the 61,000 MAGI Traditional IRA limit very quickly, likely next year. And since I'm only 26, I still have plenty of time in my career to exceed the Roth contribution limit as well. I'm completely sold on the idea of early retirement, and the backdoor Roth strategy in the future, so it may make sense for me to keep my Roth contributions and keep a clean and empty Traditional IRA... I hadn't thought about it that way. Thanks for the input!

SeattleCPA

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Re: Roth or Traditional IRA for best overall tax efficiency?
« Reply #7 on: December 09, 2016, 12:30:06 PM »
The calculations I have always been taught on this (and that I use) is if your tax rate is lower now than it will be in retirement do the Roth.  If it is higher or the same now than it will be in retirement, do Traditional.  I make $160K and have always done Traditional because of that tax rate decision.  I will be in a lower tax bracket when I retire, so I certainly would rather pay on those earnings then at the lower rate.

I believe the above is exactly right.

BTW, rarely does the math justify making a Roth contribution if you can instead make a deductible contribution. In fact, I can only think of four scenarios, all pretty  unlike for regular folk in regular situations:

http://evergreensmallbusiness.com/the-only-times-you-should-use-a-roth-style-account/

chucklesmcgee

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Re: Roth or Traditional IRA for best overall tax efficiency?
« Reply #8 on: December 09, 2016, 12:41:56 PM »
There are only a few ways your tax rate would be higher in retirement:
  • The government increased the tax rates
For most people all of these scenarios are unlikely


Why is it unlikely the government increases tax rates in the next few decades? Income taxes are at historical lows for most people, especially compared to a few decades ago. The US is nearly $20 trillion in debt and that situation seems unlikely to improve under Trump. We're also facing a constant drum-beat calling for a war on inequality and a demand for expanded welfare, free education and a single-payer healthcare system, all of which would point to higher taxes.


I'm not saying there will be higher taxes within the next 30 years or so, only it's not fair to say it's unlikely. There's a very real risk the US has a debt crisis, or descends into near-socialism and taxation begins to look much more like Canada or Sweden to provide those additional services. Investing in a Roth hedges against these outcomes.

robartsd

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Re: Roth or Traditional IRA for best overall tax efficiency?
« Reply #9 on: December 09, 2016, 12:52:40 PM »
Thanks again for all the comments. Robartsd, in regards to your comments, I believe I'd fall under your case where I'll be exceeding the 61,000 MAGI Traditional IRA limit very quickly, likely next year. And since I'm only 26, I still have plenty of time in my career to exceed the Roth contribution limit as well. I'm completely sold on the idea of early retirement, and the backdoor Roth strategy in the future, so it may make sense for me to keep my Roth contributions and keep a clean and empty Traditional IRA... I hadn't thought about it that way. Thanks for the input!
Funds in a Traditional IRA don't completely eliminate the possibility of a backdoor Roth but they do make it more complicated. Usually pretax funds in the Traditional IRA can be rolled into a 401(k) to clear the way for all the after-Tax funds to convert to Roth without tax implications. If there is no way to remove pretax funds in the IRA first, you could still make after-tax contributions and make a Roth conversion, but some of the conversion would be a pretax conversion incurring additional current year tax liability and some of the after-tax funds would remain in the Traditional account. Based on what you've described of your situation, I'd probably make the same choice to keep with Roth IRA contributions - it might not be the optimal choice tax wise, but it is close enough to (and much simpler than) more efficient options that I'd be fine with it. It's not what I'm doing personally because I don't expect to reach Roth contribution limits myself, so I'm currently making fully deductible Traditional IRA contributions.

robartsd

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Re: Roth or Traditional IRA for best overall tax efficiency?
« Reply #10 on: December 09, 2016, 12:59:42 PM »
Why is it unlikely the government increases tax rates in the next few decades? Income taxes are at historical lows for most people, especially compared to a few decades ago. The US is nearly $20 trillion in debt and that situation seems unlikely to improve under Trump. We're also facing a constant drum-beat calling for a war on inequality and a demand for expanded welfare, free education and a single-payer healthcare system, all of which would point to higher taxes.


I'm not saying there will be higher taxes within the next 30 years or so, only it's not fair to say it's unlikely. There's a very real risk the US has a debt crisis, or descends into near-socialism and taxation begins to look much more like Canada or Sweden to provide those additional services. Investing in a Roth hedges against these outcomes.
Fair point. However, I don't think that the bottom tax brackets will be changed much even if the higher tax brackets are increased and I expect most on these forums to be in lower tax brackets in retirement.

SeattleCPA

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Re: Roth or Traditional IRA for best overall tax efficiency?
« Reply #11 on: December 09, 2016, 02:37:14 PM »
To amplify robartsd's point...

We've mocked up tax returns in our CPA firm (no kidding for fun) and it's pretty easy to see how you can have $400K, $500K, even $600K in your IRAs and then not pay any income taxes on the draws.

Given that 90% of people retire with less than $500K in their retirement accounts, it seems reasonable to assume that most people won't pay a higher tax rate during retirement...

If it's too much to share this link, let me know, but it explains the math:

http://evergreensmallbusiness.com/why-you-dont-need-to-worry-about-taxes-in-retirement/

Slurgi

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Re: Roth or Traditional IRA for best overall tax efficiency?
« Reply #12 on: December 09, 2016, 02:50:43 PM »
I'm in an almost-identical situation to yours, with a slightly higher earned income, and was also looking at the same considerations, so maybe I can help. The link that Nothlit provided earlier is what applies to both of our situations.

In addition your salary, don't forget to consider any gains in any non-retirement accounts. Any dividends, earned interest (long-term savings, cashed-out EE bonds, etc.), and capital gains (if you sold or re-allocated assets) would also need to be added in, so keep that in mind.

The interesting question regarding the math here is whether the IRA contribution itself contributes to the MAGI, since we're in this weird boundary condition. My cursory internet research implies that it DOES count. Since ($83,000 - $18,000 - $3,300 - $5,500) == ($56,2000), assuming you don't have too much other income, you should be okay.   Edit: Shoot, this is wrong. I incorrectly remembered my previous conclusion, and should have looked it up before posting. IRA contributions are deducted from your AGI, but then added back in to determine MAGI.

Since we're on the razor's-edge, you may also want to look specifically at when you receive your paychecks and project what you'll actually earn in 2016. For example, if you're payed once-per-week on Friday, you'd receive 53 paychecks this year, whereas in a different year it might be 52.

After doing the math, and assuming I didn't make any mistakes, I found that I'll end up just slightly above the $61,000 number where the phase-out begins. Like you, I had originally contributed to a Roth IRA earlier in the year, and about a month ago re-characterized my contributions to be traditional IRA contributions. If you want, you can wait and see what your MAGI ends up at when you prepare your 2016 taxes, and can re-categorize those contributions at that time. You can technically do it any time before October 15th, but It'll be easier to do the recharacterization before filing your taxes, or you'll have to file an addendum.

Assuming "the 585" refers to the Rochester New York area, hello from the 'other' Rochester (in Minnesota) :).
« Last Edit: December 09, 2016, 03:14:58 PM by Slurgi »

Spork

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Re: Roth or Traditional IRA for best overall tax efficiency?
« Reply #13 on: December 09, 2016, 03:06:44 PM »

There are only a few ways your tax rate would be higher in retirement:
  • You saved enough to increase your spending beyond your current taxable income
  • The government increased the tax rates
  • You moved to a higher income tax area

Let me add one:
* inherited IRA with RMDs (especially if RMDs collide with your own traditional IRA RMDs).

 

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