The higher the income, the higher the tax. Right?
What if you could flip that on its head? In fact, what if you could pay tax when your income is lower, but pay no tax when your income is higher?
Sounds impossible, but that’s exactly what the Roth IRA allows us to do.
Here’s the playbook for grabbing the gold!
What Is A Roth IRA?
You’re in the process of building wealth. You expect to have more tomorrow than you have today. And ideally, you plan to have more than you’ll ever need by the time you retire.
But there’s a problem.
A Traditional 401(k), 403(b) or IRA allows you to deduct contributions from your taxes in the current year when they are made. While that’s fine for now (we saved a little in taxes), the government is eventually going to come for its due when you make withdrawals in retirement.
A Roth does not allow a tax deduction in the year you make the contribution, but the government won’t come back for taxes when you decide to withdraw in retirement.
In other words, you won’t save taxes this year for contributing to a Roth, but you won’t ever have to worry about paying taxes on anything you draw from that account after age 59.5.
Traditional vs Roth: What’s the Difference?
So what’s the difference if you pay taxes then or now?
Well the goal of investing, and one which is extremely likely to be met if done properly, is that money will grow faster than the rate of inflation.
Take Shelly for example. She is 35 years old, married filing jointly in 2024, and together she and her husband earn a household income of $100,000. If they take the standard deduction of $29,200, we account for FICA taxes (Social Security and Medicare), and ignore possible state taxes, her effective tax rate comes to about 15.6% this year.
Now imagine they want to make a $7k contribution each to some sort of Roth account: it could be a 401(k), 403(b) or IRA, depending on what’s available.
Doing this won’t change their effective tax rate at all this year.
Alternatively, if they choose to make those same contributions to a Traditional form of these accounts, then they can deduct this amount from their federal income tax. State tax deduction rules vary, and FICA tax still applies.
So in this case, it brings their effective federal tax rate down to about 14%, saving them approximately $1,680 (12% x $14,000).
Nice! But is there an opportunity cost here? Like most answers in finance: it depends!
If Shelly plans to retire at 62, she has 27 years to let that $14,000 grow. At an estimated 7% average return per year, that original $14,000 becomes $86,994 at age 62. All of that is going to be taxable at her marginal income tax rate eventually when she withdraws it.
Sure tax brackets will likely increase for inflation, but inflation doesn’t average 7% over 27 years unless we’re all in big trouble! The likelier inflation rate is in the range of 2-4%, and we can estimate that’s about the rate that tax brackets will adjust.
Is a Traditional or a Roth Better?
If Shelly and her husband continue making $14,000/year contributions for the next 27 years, averaging 7% per year, then starting with nothing they will have accumulated about $1,043,000.
Assuming they draw an average of 5% from their portfolio every year, that income will be $52,150. Combined with their Social Security checks, which could easily be another $35,000 or so, their total income figure could be around $87,000 income per year.
The question is: what will be the tax rate for that income in 2050 when they retire? All we can do is make a guess.
But we can reasonably infer that if they make $100,000/year today, and take $87,000/year income in 27 years from now, their tax rate will probably be lower in retirement than it is today. With that best guess, then they would choose to go with the Traditional IRA, get the tax benefit now while they’re subject to a higher rate, and pay the taxes later at a lower rate.
But what if, on the other hand, they already have $200,000 in that same account. They’ve been contributing already for years since their early 20’s. Now that ending value at age 62 comes to about $2,285,000. Using the same math, a 5% withdrawal rate of $114,000 plus Social Security of about $35,000 comes to an income of nearly $150,000.
Now the answer isn’t so simple. It’s quite possible that their tax rate in retirement could be more than it is today, in which case they would want to use the Roth option to avoid that higher tax rate.
The Roth IRA Escapes the RMD
But what if they don’t need $150,000 in retirement? What if they only need to withdraw, say, $80,000/year from their retirement portfolio?
The government thought of that too! And so they implemented what’s called the Required Minimum Distribution (RMD).
The RMD is a required annual percentage that an individual is required to withdraw from his or her Traditional 401(k) or IRA starting at age 73. That’s because the government wants to make sure they get paid!
Let’s take this example further. If they only withdraw $80,000/year from a portfolio worth $2,285,000, then still assuming a 7% rate of return, their portfolio would be worth over $3,500,000 by her age 73.
Assume they’ve saved this in a Traditional 401(k), 403(b) or IRA, or some combination of these. Using current RMD tables, their first year of required withdrawals at age 73 would be $132,000. And the percentage required of their account value would only go up, year by year, after this.
This is where the higher tax rate can easily come into play.
The government forces their hand.
But if they’ve saved this in a Roth, then they can forget the RMD. It doesn’t apply. The government doesn’t care, because they don’t stand to get paid from it. Taxes were paid long ago.
Conclusion
So which one is right for you?
Ask yourself these questions:
- Do you expect taxes to be higher or lower in retirement versus today (don’t forget the RMD)?
- How do you feel about the uncertainty of not knowing exactly what taxes will look like in the future?
- Can you afford to pay taxes today, or would a tax deduction make a significant impact on your ability to afford your lifestyle?
If you expect higher taxes today than in retirement, this would favor the Traditional option. If you expect higher taxes in retirement, this would favor a Roth.
If you don’t like uncertainty about future taxes, this would favor using the Roth. At least you know what you’ll be paying if you pay today!
If the deduction doesn’t make all that much difference to you in the current year, this would favor the Roth. Otherwise, if you’re strapped for cash, and you’ll take every bit of help you can get, you may prefer the Traditional route.
And lastly, I get that there are a lot of calculations in this piece. If math isn’t you’re strong suit, or you simply want to get a second opinion, consider inquiring with a financial advisor or a tax accountant.
In the end, it’s all about turning normal on its head: pay less in taxes when you’re making more!