The whole Roth vs. Traditional IRA

Have a question about your personal investments? No matter how simple or complex, you can ask it here.
Middle
Posts: 236
Joined: Tue Feb 08, 2011 7:15 pm

The whole Roth vs. Traditional IRA

Post by Middle » Thu Feb 17, 2011 6:22 pm

I have always struggled with that question of "do you think you will be in a higher tax bracket later?" If I knew that, I'd probably also know when this current bull run was going to run out.

But I did convert to Roth back in 1999 and now have my Roth, a small traditional IRA and a 401k. My instinct is that it might not be a bad idea to maintain some kind of balance between the Roth and IRA/401k as a sort of hedged bet on what will be better for my retirement tax situation (still 20+ years away). So this year I contributed to my Roth account in place of trad IRA. Seem logical considering we don't know what the tax situation will be in 20+ years? Let alone my own.

no_name
Posts: 572
Joined: Sat Apr 24, 2010 12:55 pm

Post by no_name » Thu Feb 17, 2011 6:25 pm

get both.

fishndoc
Posts: 2323
Joined: Wed Apr 11, 2007 11:50 am

Post by fishndoc » Thu Feb 17, 2011 6:36 pm

I agree with the concept of "tax diversification".

Also, remember you can effectively put away more $ per year in a Roth: $2000 in a Roth is $2000 (you pay tax now); $2000 in an IRA is actually less than than (x% is owned by the federal government, depending on tax rates when you withdraw).
" Successful investing involves doing just a few things right, and avoiding serious mistakes." - J. Bogle

User avatar
Kevin M
Posts: 8869
Joined: Mon Jun 29, 2009 3:24 pm
Contact:

Post by Kevin M » Thu Feb 17, 2011 6:49 pm

fishndoc wrote:Also, remember you can effectively put away more $ per year in a Roth: $2000 in a Roth is $2000 (you pay tax now); $2000 in an IRA is actually less than than (x% is owned by the federal government, depending on tax rates when you withdraw).


Not a fair statement at this low level of contribution. If you can afford an after tax reduction in pay of $2,000 (i.e., for a Roth Contribution), then you can afford to contribute more than that to a traditional IRA because of the tax savings. As has been shown in many posts, assuming no change in tax rates, you end up with the same after tax dollars in the end.

Of course if you can afford to max out your Roth IRA, or even approach the max, your point is valid, assuming you don't have additional tax-deferred choices in which to invest the tax savings from a traditional IRA contribution.

Also, your point is valid for those who don't think clearly about pre-tax and after-tax dollars, and just decide to put $2,000 in one or the other, regardless of tax implications.

Kevin

Bob's not my name
Posts: 7347
Joined: Sun Nov 15, 2009 9:24 am

Post by Bob's not my name » Thu Feb 17, 2011 7:43 pm

You don't provide any of the key pieces of information that would allow us to comment on the wisdom of your decision. Although future tax code changes are unknowable, there are still criteria upon which to base your decision, including 401k quality and company match and whether you're maxing it out, your state and state bracket and how your state taxes tIRA contributions and withdrawals, your federal tax bracket, your retirement expectations (age and whether you're likely to retire to a different state or end up there later, e.g., to be close to children), whether you are maxing the tIRA/Roth, whether you're married and if so what your spouse is doing wrt 401k/IRA, whether you'll have a pension, etc.

User avatar
nydad
Posts: 449
Joined: Wed Dec 01, 2010 11:10 am

Post by nydad » Fri Feb 18, 2011 10:33 am

Image

Historically, we are at very low rates. given the deficit, it's not unreasonable to consider much higher marginal tax rates at least at the top are within the realm of reason.

no_name
Posts: 572
Joined: Sat Apr 24, 2010 12:55 pm

Post by no_name » Fri Feb 18, 2011 4:01 pm

nydad wrote:Image

Historically, we are at very low rates. given the deficit, it's not unreasonable to consider much higher marginal tax rates at least at the top are within the realm of reason.


that's cool.

Bob's not my name
Posts: 7347
Joined: Sun Nov 15, 2009 9:24 am

Post by Bob's not my name » Fri Feb 18, 2011 4:37 pm

That's a baloney graph. Do you really think the tax code in 1920 looked as it does today? Find a graph of average tax burden. Even better, find a graph of average tax burden on retirees.

John Thacker
Posts: 17
Joined: Tue Sep 29, 2009 12:42 pm

Post by John Thacker » Fri Feb 18, 2011 4:43 pm

nydad wrote:Historically, we are at very low rates. given the deficit, it's not unreasonable to consider much higher marginal tax rates at least at the top are within the realm of reason.


And yet despite that the percentage of revenue revenue obtained by the federal government from income tax as a percentage of GDP has remained remarkably stable compared to the changes in marginal rates.

That's because higher marginal tax rates have often been accompanied with greater deductions and loopholes. Just look at the AMT, which results in more tax for many people despite having a lower marginal rate.

It will be difficult to address the deficit without reining in deductions as well.

While you have to worry about rates being raised, you also have to worry about the deficit being addressed by changes that remove deductions and favorable tax treatment. While it seems beneficial to put money into a Roth now if you expect tax rates to go up, it's also possible for Congress to change the tax laws by the time you retire so that your Roth distributions are subject to some tax. Instead of being taxed once at a much lower rate, you may end up being taxed twice.

For something that I think is more likely, it wouldn't entirely surprise me to see HSA changes that limit the ability to withdraw funds without penalty for medical spending that occurred years in the past.

Just another reason to diversify tax law change risk.

Marine
Posts: 9
Joined: Fri Feb 18, 2011 5:01 pm

Roth Versus Traditional

Post by Marine » Fri Feb 18, 2011 7:00 pm

I get this questions often. Should I invest in a Roth or Traditional IRA? The first thing investors should do is take advantage of the free company match in their 401K plan. After that they should consider maxing out their Roth IRA if they are eligible to contribute. The Roth has some big advantages over a Traditional. The biggest advantage is you can pull out your contributions at any time without taxes or penalties. You will have to leave your earnings in until you are 59 1/2 or 5 years. This makes a Roth an excellent savings vehichle. The traditional IRA requires you to keep your contributions in until you are 59 1/2. Otherwise you are taxed at your ordinary income rate plus 10% penalty. Ouch!

Bob's not my name
Posts: 7347
Joined: Sun Nov 15, 2009 9:24 am

Post by Bob's not my name » Fri Feb 18, 2011 7:36 pm

That's right! A Roth is tax-free! It's incredible. All you have to do is pay taxes at your top rate and it's tax-free. :roll:

User avatar
SSSS
Posts: 1888
Joined: Fri Jun 18, 2010 11:50 am

Post by SSSS » Fri Feb 18, 2011 8:14 pm

Income limits for deducting traditional IRA contributions are so low that those who would benefit from the deduction are not allowed to take it, and those who are allowed to take the deduction are not in a high enough tax bracket to benefit from it.

I think a lot of people get distracted by the arguments about hypothetical tax brackets 40 years in the future, then get an unpleasant surprise in April. What use is it watching the mountains in the distance if you trip over a small rock directly in front of you?

Bob's not my name
Posts: 7347
Joined: Sun Nov 15, 2009 9:24 am

Post by Bob's not my name » Fri Feb 18, 2011 8:21 pm

SSSS wrote:Income limits for deducting traditional IRA contributions are so low that those who would benefit from the deduction are not allowed to take it, and those who are allowed to take the deduction are not in a high enough tax bracket to benefit from it.
Except for IL residents, who get the best of both: deduction for tIRA contribution, immediately convert to Roth with no state tax on the conversion. Maybe other states work that way too.

More broadly applicable: spousal tIRA is definitely preferred over Roth for many MFJ who are eligible.

... and many people with a decent 401k should max that out -- not just to the match -- before resorting to a Roth IRA.

Bob's not my name
Posts: 7347
Joined: Sun Nov 15, 2009 9:24 am

Post by Bob's not my name » Fri Feb 18, 2011 8:26 pm

Kevin M wrote:I'm puzzled by the apparent bias toward using Roth IRAs, given that the choice between traditional and Roth should be determined by each individual's tax situation. The bias is apparent, for example, in the wiki, which recommends contributing first to 401(k)/403(b) to maximize employer match, then to a Roth IRA, then back to 401/403. I would think the recommended second priority should be traditional or Roth IRA depending on whether or not you expect to be in a lower tax bracket when you retire. I don't mean to single out the wiki, as I see the same apparent bias in most recommendations in BH forum posts and elsewhere.

I understand the many benefits of a Roth; e.g., no RMDs, tax-free withdrawals, ability to withdraw contributions without penalty, etc. I also appreciate the Roth tax diversification benefit for someone making significant traditional 401/403 contributions. However, for someone who is unlikely to build significant wealth by retirement, and is likely to have a lower marginal tax rate in retirement, the current tax deduction of a traditional IRA may be a more significant benefit.

Some BH posters have written blog posts on planning to fill up the lower tax brackets in retirement (which is an excellent consideration), and use this as an argument to use traditional 401/403 plans rather than Roth 401/403 plans. Doesn't the same argument apply to using a traditional IRA rather than a Roth in some situations; e.g., if one doesn't have a 401/403 (or pension), or for whatever reasons is unlikely to have significant income in retirement?

For many, it's likely that withdrawals from traditional IRAs won't be taxed at all. My Mom and her husband paid no federal or state income taxes for 2009 (first full year of retirement) despite receiving very healthy social security payments. Although they didn't have to take an RMD in 2009, their unused 0% tax space was over $16,500, which I estimate will just about be filled in 2010 by RMD and portion of SS that may be taxable. People in this situation get the tax deduction on traditional IRA contributions, and pay no taxes on withdrawals, so with respect to income taxes, the traditional IRA is superior to the Roth.

Hector
Posts: 826
Joined: Fri Dec 24, 2010 2:21 pm
Contact:

Post by Hector » Sat Feb 19, 2011 4:17 am

I think tax will go only up and roth is the way to go.

TT
Posts: 487
Joined: Sat Oct 17, 2009 7:27 am

Tax rates

Post by TT » Sat Feb 19, 2011 5:57 am

Bob's not my name wrote:That's a baloney graph. Do you really think the tax code in 1920 looked as it does today? Find a graph of average tax burden. Even better, find a graph of average tax burden on retirees.


Not a graph but all the data for tax rates:

http://www.taxfoundation.org/publications/show/151.html

From what I can decipher from this data from 1923 to 1931 maximum tax rate was 25%

Bob's not my name
Posts: 7347
Joined: Sun Nov 15, 2009 9:24 am

Post by Bob's not my name » Sat Feb 19, 2011 7:45 am

That's still only nominal marginal rates (but at least it shows all nominal marginal rates vs. the nakedly political, irrelevant for retirees, and erroneously titled "wealthiest Americans" chart). As John Thacker pointed out above, income tax burden has actually been fairly stable over time, it's only how we've been taxed that keeps changing. Simplistic statements that "tax rates are at historic lows" provide no guidance for the Roth vs. traditional decision.

Middle
Posts: 236
Joined: Tue Feb 08, 2011 7:15 pm

Thanks

Post by Middle » Tue Mar 01, 2011 4:02 pm

I think this might, for the most part, answer my question in that it is entirely unclear which will be better in the long run so why not do both.

And to clarify, as someone had earlier asked for more details, I am nearly maxing out my 401k contributions. But I have a taxable account with more than 6 months salary that I have lately been using some of to make either IRA or Roth IRA contributions. My 401k has what I believe to be "okay" choices (only one index fund but the others average ER of 1%). Married file jointly.

Right now there is a little more money in the Roth than the 401k but the 401k through contributions has obviously been making fast progress. So I thought maybe to shift some taxable account money to Roth might be prudent. But even assuming those both maxed, the 401k will end up being much larger than the Roth (also assuming that I stay employed).

Thanks again for the input.

User avatar
Justin618
Posts: 204
Joined: Fri Mar 02, 2007 10:37 am
Location: accumulation phase

Post by Justin618 » Tue Mar 01, 2011 4:55 pm

The Case Against Roth 401(k)
http://thefinancebuff.com/case-against-roth-401k.html

This qualifies as required reading for anyone contemplating a Roth conversion, Roth 401k, Roth vs. Traditional IRA, or anyone conflating marginal tax rates and effective tax rates.

Justin
"Investing is simple, but not easy" - Buffett.

Silence Dogood
Posts: 699
Joined: Tue Feb 01, 2011 9:22 pm

Post by Silence Dogood » Tue Mar 01, 2011 5:36 pm

Would it be legal for Congress to change the tax benefits of the Roth IRA?

I have a Roth IRA but my only concern is that Congress will change the rules by the time I retire (I'm 20).

kirent
Posts: 529
Joined: Tue Sep 28, 2010 1:06 am

Post by kirent » Tue Mar 01, 2011 5:46 pm

Silence Dogwood wrote:Would it be legal for Congress to change the tax benefits of the Roth IRA?

I have a Roth IRA but my only concern is that Congress will change the rules by the time I retire (I'm 20).


It's possible, hence the need to diversify between Roth and Traditional holdings.
Disclaimer: I am not a financial or legal expert and all information I provide is given for entertainment purposes only, at your own risk and with no guarantees of accuracy.

zapper
Posts: 50
Joined: Tue Feb 20, 2007 4:08 pm
Location: Alexandria, VA

Post by zapper » Tue Mar 01, 2011 5:47 pm

Silence Dogwood wrote:Would it be legal for Congress to change the tax benefits of the Roth IRA?

I have a Roth IRA but my only concern is that Congress will change the rules by the time I retire (I'm 20).



Of course it's legal, they make the laws. It is also a very real posibility.

Silence Dogood
Posts: 699
Joined: Tue Feb 01, 2011 9:22 pm

Post by Silence Dogood » Tue Mar 01, 2011 7:11 pm

stives wrote:
Silence Dogwood wrote:Would it be legal for Congress to change the tax benefits of the Roth IRA?

I have a Roth IRA but my only concern is that Congress will change the rules by the time I retire (I'm 20).


It's possible, hence the need to diversify between Roth and Traditional holdings.


This causes me great anger.

zapper wrote:
Silence Dogwood wrote:Would it be legal for Congress to change the tax benefits of the Roth IRA?

I have a Roth IRA but my only concern is that Congress will change the rules by the time I retire (I'm 20).


Of course it's legal, they make the laws. It is also a very real posibility.


I was hoping it would be considered some sort of contractual agreement that couldn't be broken.

Bob's not my name
Posts: 7347
Joined: Sun Nov 15, 2009 9:24 am

Post by Bob's not my name » Wed Mar 02, 2011 6:20 am

I often see this argument that maybe they'll tax Roth withdrawals. I don't believe I've ever seen the argument that maybe they'll start giving tax breaks on tIRA withdrawals. I think this is the more likely of the two possibilities, and would have the same effect of tilting the equation in favor of traditional.

Bob's not my name
Posts: 7347
Joined: Sun Nov 15, 2009 9:24 am

Post by Bob's not my name » Wed Mar 02, 2011 6:20 am


halfnine
Posts: 707
Joined: Tue Dec 21, 2010 1:48 pm

Post by halfnine » Wed Mar 02, 2011 12:37 pm

I suspect if they do anything they won't tax the Roth in the future, but instead they will include it as part of the cost basis when determining your tax rate on other income. Crudely eliminating most benefits of splitting contributions 50/50 to minimize one's retirement tax bracket.

Middle
Posts: 236
Joined: Tue Feb 08, 2011 7:15 pm

Post by Middle » Wed Mar 02, 2011 1:07 pm

Justin - thanks for the link on the argument against Roth for most people. It seems to be a compelling argument.

And as to the speculation regarding how Roth distributions might get taxed in the future, I just can't see the wisdom in thinking they might get taxed. There would be complete outrage. Just like I don't see the mortgage interest deduction just suddenly disappearing. I certainly think the mortgage deduction might get phased out before Roth distributions are taxed but both seem like nothing to base decisions on right now.

User avatar
nisiprius
Advisory Board
Posts: 34154
Joined: Thu Jul 26, 2007 9:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Post by nisiprius » Wed Mar 02, 2011 2:21 pm

Bob's not my name wrote:That's a baloney graph. Do you really think the tax code in 1920 looked as it does today? Find a graph of average tax burden. Even better, find a graph of average tax burden on retirees.
I can't speak for 1920 but I can speak for the 1950s-60s-70s and it is not baloney.

There really was a graduated income tax.

People really paid it.

It really mattered.

My dad had a highish but irregular income and went to a lot of work negotiating deals to spread his payments over several years. And when "income averaging" came in--I haven't heard about it in years, I think it's gone now, but there used to be an option to base your taxes on a ten-year moving average or something--it was a big deal for him.

I don't know what this urban legend is that there was never effectively a graduated income tax. There was. And, I might add, under presidents belonging to both parties. And while captains of industry were always bloviating about how the tax rate killed all of their incentive for working, they somehow managed to make it into the office anyway.

Of course they successfully avoided taxes then. Didn't then, don't now. In the sense that higher-income people paid less than the chart shows, I wouldn't doubt it.

When the 401(k) first came in, the assumption that you'd be in a higher tax bracket in your working years than in retirement was a no-brainer. Now, the 25% bracket is so wide, and the rate increases above that so gentle, that arguments based on likely tax brackets become imponderable.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

Bob's not my name
Posts: 7347
Joined: Sun Nov 15, 2009 9:24 am

Post by Bob's not my name » Wed Mar 02, 2011 3:02 pm

nisiprius wrote:People really paid it.

Of course they successfully avoided taxes then.
I'm not sure if we agree or disagree. Income averaging is one example of significant changes in the tax code. As for marginal rates, all the AGI-based phaseouts and the AMT make it easy for households making over $100,000 to have effective marginal rates over 40% and even over 100%. For 2010 the Making Work Pay, AOC, and Roth eligibility phaseouts overlapped.

User avatar
willthrill81
Posts: 2300
Joined: Thu Jan 26, 2017 3:17 pm
Location: USA

Re: The whole Roth vs. Traditional IRA

Post by willthrill81 » Sat Jan 28, 2017 12:20 pm

I know this thread is quite old, but the topic still seems to come up frequently: traditional IRA or Roth?

While there are many factors potentially at work, I think that just about everything can be summed up in two sentences.

If your effective tax rate in retirement will be lower than your marginal tax rate when you make an IRA contribution, the traditional IRA is better. Otherwise, the Roth is better.

For clarification, "better" in this case means more after tax income in retirement.

Granted, it's impossible to know with certainty what your exact effective tax rate will be in retirement. But to the extent that history is our guide, we can get some very useful help. For instance, at our current tax situation, you would need close to $400k of taxable (earned) income in retirement before you were paying 25% of your income in taxes (i.e. effective tax rate). So if your marginal rate is currently 25%, and you don't anticipate having $400k per year of taxable income in retirement, then a traditional IRA is better. Very few retirees have that level of income; most have significantly less income than during their working years.

Now someone might say that if you can max out a traditional or a Roth that you're better off with a Roth. That would only be true if your investments were strictly limited to IRAs, but they obviously are not. You can easily take the tax savings from a traditional IRA and invest those in tax efficient ETFs in a taxable account and still be better off in the end than with the Roth.

It's worthwhile to note as well that your effective tax rate in retirement will be impacted by all of your income, not just what comes from your IRAs. Social Security income, 401(k) proceeds, and income earned during retirement will obviously affect your effective tax rate in retirement.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

Bob's not my name
Posts: 7347
Joined: Sun Nov 15, 2009 9:24 am

Re: The whole Roth vs. Traditional IRA

Post by Bob's not my name » Sat Jan 28, 2017 12:51 pm

This is a very old thread, and I didn't re-read it. More recent threads have pointed out that it's marginal rate in both situations, since you are always deciding on an increment.

The central weakness of short (albeit correct) summations is that (1) most people know neither their current nor future tax rates and (2) it's necessary to consider your tax rate across your working years and your tax rate across your retirement years. For example, a retired couple with $400,000 of gross income could have an effective tax rate under 10% during a late-in-life tax year in which both are in assisted living -- depending on where you live, this can knock your taxable income to under $150,000. Another important consideration is early retirement may allow for major Roth conversions at very low effective tax rates. As for current tax rates, boglehead threads reveal that most workers don't know how to estimate taxable income and don't know how to include AGI-based taxes in their marginal rate calculation. This can go either way: many posters believe they're in a higher bracket than they actually are, and most posters don't consider AGI-based taxes, which causes them to understate their current marginal rate.

Also, most posters don't take state tax into account. State tax (most of which are relatively flat) can be a significant component of marginal rate for retirees (e.g., 15% federal and 8% state), while at the same time many states offer significant tax breaks for TIRA/401k withdrawals (this factor alone can make your marginal rate in retirement lower than your marginal rate when working, even if somehow your income doesn't go down when you quit working.

Finally, most posters don't do the math right in comparing Roth and traditional contributions. It's important to consider that if your marginal rate (federal nominal + AGI-based taxes + state) is 33%, a $10,000 Roth contribution is equivalent to a $15,000 traditional contribution).

So it's a ridiculously complicated choice.

User avatar
willthrill81
Posts: 2300
Joined: Thu Jan 26, 2017 3:17 pm
Location: USA

Re: The whole Roth vs. Traditional IRA

Post by willthrill81 » Sat Jan 28, 2017 3:56 pm

Bob's not my name wrote:This is a very old thread, and I didn't re-read it. More recent threads have pointed out that it's marginal rate in both situations, since you are always deciding on an increment. I would argue that the marginal rate in retirement is unimportant compared to the effective rate. If I have a choice between a 25% penalty on the money going into the piggy bank (i.e. marginal rate), but I could only pay 12% on the total money that I pull out instead (i.e. effective rate), the latter is better, regardless of the marginal rate when I pull the money out.

The central weakness of short (albeit correct) summations is that (1) most people know neither their current nor future tax rates and (2) it's necessary to consider your tax rate across your working years and your tax rate across your retirement years. For example, a retired couple with $400,000 of gross income could have an effective tax rate under 10% during a late-in-life tax year in which both are in assisted living -- depending on where you live, this can knock your taxable income to under $150,000. Another important consideration is early retirement may allow for major Roth conversions at very low effective tax rates. As for current tax rates, boglehead threads reveal that most workers don't know how to estimate taxable income and don't know how to include AGI-based taxes in their marginal rate calculation. This can go either way: many posters believe they're in a higher bracket than they actually are, and most posters don't consider AGI-based taxes, which causes them to understate their current marginal rate.

Also, most posters don't take state tax into account. State tax (most of which are relatively flat) can be a significant component of marginal rate for retirees (e.g., 15% federal and 8% state), while at the same time many states offer significant tax breaks for TIRA/401k withdrawals (this factor alone can make your marginal rate in retirement lower than your marginal rate when working, even if somehow your income doesn't go down when you quit working.

Finally, most posters don't do the math right in comparing Roth and traditional contributions. It's important to consider that if your marginal rate (federal nominal + AGI-based taxes + state) is 33%, a $10,000 Roth contribution is equivalent to a $15,000 traditional contribution).

So it's a ridiculously complicated choice.


I would argue that in most situations, it's not that complicated. People can look at their last year's tax return and a tax table to find out their marginal rate.

But even beyond that, the overwhelming majority of retirees (not Bogleheads of course) have a smaller income than they did in their working years, with the obvious exception of the early stages of their career when their income is probably the lowest it will ever be.

Consider a couple who are married filing jointly with a taxable income of $90,000. In 2016, this places them in the 25% marginal tax bracket. If they each contribute $5,500 to traditional IRAs for a total of $11,000, this will save them $2,750 of federal income tax this year, money which could (and should) be saved in an employer retirement plan (e.g. 401k, 403b) or a taxable account. By contrast, if they contributed $11,000 to Roth IRAs, there would be no immediate tax savings.

Let's say that after they retire, they still have the same living expenses, so they would need $90,000 per year from their traditional IRA. They would owe $11,905 of federal income taxes on that money. Yes, their marginal tax rate would still be 25%, but, more importantly, their effective tax rate would only be 13.2%. So they will pay only 13.2% federal income taxes on their retirement income (25% - 11.8%), whereas all of the money going into their Roth IRA was taxed at 25%.

So even though their marginal rate was the same, they were clearly better off with the traditional IRA.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

Bob's not my name
Posts: 7347
Joined: Sun Nov 15, 2009 9:24 am

Re: The whole Roth vs. Traditional IRA

Post by Bob's not my name » Sat Jan 28, 2017 4:22 pm

willthrill81 wrote:
Bob's not my name wrote:most workers don't know how to include AGI-based taxes in their marginal rate calculation.

Finally, most posters don't do the math right in comparing Roth and traditional contributions. It's important to consider that if your marginal rate (federal nominal + AGI-based taxes + state) is 33%, a $10,000 Roth contribution is equivalent to a $15,000 traditional contribution).
I would argue that in most situations, it's not that complicated. People can look at their last year's tax return and a tax table to find out their marginal rate.

Consider a couple who are married filing jointly with a taxable income of $90,000. In 2016, this places them in the 25% marginal tax bracket. If they each contribute $5,500 to traditional IRAs for a total of $11,000, this will save them $2,750 of federal income tax this year, money which could (and should) be saved in an employer retirement plan (e.g. 401k, 403b) or a taxable account. By contrast, if they contributed $11,000 to Roth IRAs, there would be no immediate tax savings.
We're in agreement that traditional is typically better. The marginal vs. effective issue is discussed in other threads (not by me).

However, your analysis ignores the factors I mention that strongly favor traditional contributions, including state tax, early retirement conversions, and late retirement tax exemption. The tax tables do not tell you your full marginal rate, because they conceal AGI-based taxes. These affect many (most?) taxpayers who are making these investment decisions (the child tax credit phaseout affects upper middle class families, and the AOTC phaseout, while narrow, applies a total 50% federal marginal rate to a family with two kids in college). And $11,000 of Roth IRA contributions (in a state without an income tax, with a 25% federal marginal rate) requires the paying of $3,667 in income tax. The couple could instead make $14,667 of deductible contributions to traditional IRAs and 401k's. Your math isn't incorrect but it makes an apples-oranges comparison that underserves the traditional argument.

User avatar
willthrill81
Posts: 2300
Joined: Thu Jan 26, 2017 3:17 pm
Location: USA

Re: The whole Roth vs. Traditional IRA

Post by willthrill81 » Sat Jan 28, 2017 4:27 pm

Bob's not my name wrote:
willthrill81 wrote:
Bob's not my name wrote:most workers don't know how to include AGI-based taxes in their marginal rate calculation.

Finally, most posters don't do the math right in comparing Roth and traditional contributions. It's important to consider that if your marginal rate (federal nominal + AGI-based taxes + state) is 33%, a $10,000 Roth contribution is equivalent to a $15,000 traditional contribution).
I would argue that in most situations, it's not that complicated. People can look at their last year's tax return and a tax table to find out their marginal rate.

Consider a couple who are married filing jointly with a taxable income of $90,000. In 2016, this places them in the 25% marginal tax bracket. If they each contribute $5,500 to traditional IRAs for a total of $11,000, this will save them $2,750 of federal income tax this year, money which could (and should) be saved in an employer retirement plan (e.g. 401k, 403b) or a taxable account. By contrast, if they contributed $11,000 to Roth IRAs, there would be no immediate tax savings.
We're in agreement that traditional is typically better. The marginal vs. effective issue is discussed in other threads (not by me).

However, your analysis ignores the factors I mention that strongly favor traditional contributions, including state tax, early retirement conversions, and late retirement tax exemption. The tax tables do not tell you your full marginal rate, because they conceal AGI-based taxes. These affect many (most?) taxpayers who are making these investment decisions (the child tax credit phaseout affects upper middle class families, and the AOTC phaseout, while narrow, applies a total 50% federal marginal rate to a family with two kids in college). And $11,000 of Roth IRA contributions (in a state without an income tax, with a 25% federal marginal rate) requires the paying of $3,667 in income tax. The couple could instead make $14,667 of deductible contributions to traditional IRAs and 401k's. Your math isn't incorrect but it makes an apples-oranges comparison that underserves the traditional argument.


Thanks for the clarifications. :beer We actually would have lost some of our child tax credit for 2016 had it not been for my wife's traditional IRA contributions. Unfortunately, I'm ineligible right now to make traditional IRA contributions.

I really think that many people prefer the Roth for emotional reasons. They think "Wow, after I pay taxes now, I'll never have to pay taxes later?! Great!" But there's obviously a lot more to it than that.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

User avatar
grabiner
Advisory Board
Posts: 20859
Joined: Tue Feb 20, 2007 11:58 pm
Location: Columbia, MD

Re: The whole Roth vs. Traditional IRA

Post by grabiner » Sat Jan 28, 2017 10:13 pm

Bob's not my name wrote:However, your analysis ignores the factors I mention that strongly favor traditional contributions, including state tax, early retirement conversions, and late retirement tax exemption. The tax tables do not tell you your full marginal rate, because they conceal AGI-based taxes. These affect many (most?) taxpayers who are making these investment decisions (the child tax credit phaseout affects upper middle class families, and the AOTC phaseout, while narrow, applies a total 50% federal marginal rate to a family with two kids in college).


There is also one important AGI-based phase-in for retirees: taxation of Social Security causes many retirees in the 15% bracket to have a marginal tax rate of 27.75% after they start taking SS. Therefore, it is usually best to invest in a Roth rather than a traditional account if you are currently in the 15% bracket, are not in any phase-out, and will have significant non-SS taxable income in retirement (from other contributions to traditional IRAs or 401(k)s, or from a pension); if you retire in the 15% bracket, your marginal rate will be 27.75% for much of your retirement. In the 25% bracket, I normally prefer traditional, as you are unlikely to be in a 27.75% marginal rate for your whole retirement.
David Grabiner

yourstruly
Posts: 1
Joined: Sun Jan 29, 2017 12:30 am

Re: The whole Roth vs. Traditional IRA

Post by yourstruly » Sun Jan 29, 2017 12:52 am

In retirement, the first $10k-$20k in income will be taxed at 0% based on your marriage status, the standard deduction, and exemptions. In order to generate $10k-$20k/yr in retirement requires between $200k and $500k depending on how many years you have before you die (based on a 4-5% portfolio safe withdrawal rate). A safe withdraw rate means you can withdraw ~4-5% of your portfolio per year over ~20 years without running out of money.

You want to put enough money into a Traditional retirement fund to get you to ~$300k in portfolio value to generate ~$15k / year tax free. You would pay 0% going in and 0% coming out if you funded this portion of your retirement from a traditional retirement account. It would be most efficient to put this money into your Traditional retirement account in your highest earning years in order to minimize the tax burden during those years. This would likely be the years immediately preceding your retirement. But it is important to fill up that 0% tax bracket prior to retirement. That would also mean investing in a ROTH early in life then when you hit the 25% tax bracket, switch to a Traditional account.

The next retirement tax bracket would be 10% and then you would want to compare 10% to your current marginal tax rate. If you are in the 15%+ tax bracket develop a strategy to fill up the retirement 10% tax bracket first. Then continue figuring out how each investment dollar is taxed at retirement compared to how it is taxed now.

Another consideration is that once each incremental invested dollar is taxed the same, put money into a ROTH because it is a more flexible if you need to withdraw contributions.

Another strategy could be to invest in a traditional until you drop to a marginal tax bracket you feel comfortable with (10%?), then put the rest in a ROTH.

User avatar
willthrill81
Posts: 2300
Joined: Thu Jan 26, 2017 3:17 pm
Location: USA

Re: The whole Roth vs. Traditional IRA

Post by willthrill81 » Sun Jan 29, 2017 11:12 am

yourstruly wrote:In retirement, the first $10k-$20k in income will be taxed at 0% based on your marriage status, the standard deduction, and exemptions. In order to generate $10k-$20k/yr in retirement requires between $200k and $500k depending on how many years you have before you die (based on a 4-5% portfolio safe withdrawal rate). A safe withdraw rate means you can withdraw ~4-5% of your portfolio per year over ~20 years without running out of money.

You want to put enough money into a Traditional retirement fund to get you to ~$300k in portfolio value to generate ~$15k / year tax free. You would pay 0% going in and 0% coming out if you funded this portion of your retirement from a traditional retirement account. It would be most efficient to put this money into your Traditional retirement account in your highest earning years in order to minimize the tax burden during those years. This would likely be the years immediately preceding your retirement. But it is important to fill up that 0% tax bracket prior to retirement. That would also mean investing in a ROTH early in life then when you hit the 25% tax bracket, switch to a Traditional account.

The next retirement tax bracket would be 10% and then you would want to compare 10% to your current marginal tax rate. If you are in the 15%+ tax bracket develop a strategy to fill up the retirement 10% tax bracket first. Then continue figuring out how each investment dollar is taxed at retirement compared to how it is taxed now.

Another consideration is that once each incremental invested dollar is taxed the same, put money into a ROTH because it is a more flexible if you need to withdraw contributions.

Another strategy could be to invest in a traditional until you drop to a marginal tax bracket you feel comfortable with (10%?), then put the rest in a ROTH.


I couldn't agree more.

People going all in for Roths apparently forget that a married couple pays no income taxes, 20106, on the first $20,700 of income ($8,100 exemption + $12,600 standard deduction). The next ~$10k is taxed at just 10%. For us, that $30k would cover most of our basic living expenses, and the effective tax rate on that money would only be around 3%. Our 'fun' money will be in the 15% bracket, but unless our investments do surprisingly well, I doubt that we'll ever make it to the 25% bracket in retirement. Considering that I'm in the 25% bracket now and am likely to remain there for a long time, it's a no brainer to invest all or nearly all of our savings in my 401(k) and my wife's traditional IRA. Unfortunately, I'm currently ineligible to contribute to a traditional IRA myself, so then I have to go with a Roth instead.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

User avatar
FiveK
Posts: 3138
Joined: Sun Mar 16, 2014 2:43 pm

Re: The whole Roth vs. Traditional IRA

Post by FiveK » Mon Jan 30, 2017 3:51 am

willthrill81 wrote:I know this thread is quite old, but the topic still seems to come up frequently: traditional IRA or Roth?

While there are many factors potentially at work, I think that just about everything can be summed up in two sentences.

If your effective tax rate in retirement will be lower than your marginal tax rate when you make an IRA contribution, the traditional IRA is better. Otherwise, the Roth is better.

For clarification, "better" in this case means more after tax income in retirement.
Unfortunately, the mistaken idea that one should use "effective" withdrawal rate does recur from time to time. Don't feel bad - it's a concept that looks correct at first glance - but it really isn't.

Some reading:
Traditional versus Roth - Bogleheads The wiki entry.
Fundamental Difference in Roth and Traditional 401k - Bogleheads.org The "OMG I get it!" post.
Deciding between Roth and Traditional IRA based on marginal tax rate?
Roth vs Traditional 401K - Page 4 - Bogleheads.org

And last but not least, from 9 years ago: Roth vs Traditional 401K - earliest Bogleheads thread. See posts from redbeard, Greenberry, and AzRunner.

Traditional is better for most people, just not as much better as "marginal vs. effective" would imply. "Marginal vs. marginal" gives the correct answer - assuming, of course, one gets those marginal rates correct. :)

dlw322
Posts: 44
Joined: Thu Mar 29, 2012 8:01 pm

Re: The whole Roth vs. Traditional IRA

Post by dlw322 » Mon Jan 30, 2017 8:45 am

Don't forget when one spouse dies the marginal tax rates will change substantially. That is assuming that income will be the same.

Another consideration is no RMDs, and if you plan on not spending it at all and leaving the money to your heirs.

User avatar
BogleMelon
Posts: 738
Joined: Mon Feb 01, 2016 11:49 am

Re: The whole Roth vs. Traditional IRA

Post by BogleMelon » Mon Jan 30, 2017 8:53 am

The way I look at it is as follow. I keep asking myself, is paying that percentage to uncle Sam is fair for me? if the answer is yes, then I go Roth, if no, then I go traditional/401K.
Currently I am in 15% tax bracket, i think this is fair. I am glad to pay my fair share then go to Roth.. Once I am in 25%, I see this as (too much), and will do traditional IRA (if eligible), or 401K if not.
Excuse my English, it is my second language! | | "One of the funny things about stock market, every time one is buying another is selling, and both think they are astute" - William Feather

Bob's not my name
Posts: 7347
Joined: Sun Nov 15, 2009 9:24 am

Re: The whole Roth vs. Traditional IRA

Post by Bob's not my name » Mon Jan 30, 2017 8:54 am

dlw322 wrote:Don't forget when one spouse dies the marginal tax rates will change substantially. That is assuming that income will be the same.
True, but this may happen late in life, when the surviving spouse is in assisted living and in the 0% tax bracket even with a six figure income.
dlw322 wrote:Another consideration is no RMDs, and if you plan on not spending it at all and leaving the money to your heirs.
Early retirees have significant conversion opportunity. Late retirement years are a second opportunity. I managed the finances of an elderly widow and was able to convert all of her (remaining) TIRA to Roth for the heirs, at a very low tax rate (most of it at 0%).

hulburt1
Posts: 245
Joined: Tue Jul 15, 2014 9:17 pm

Re: The whole Roth vs. Traditional IRA

Post by hulburt1 » Mon Jan 30, 2017 9:32 am

You need both..When you hit 70+ you will need to take money from IRA, SS and add all other incomes and it could be big. Roth you don't take out. We live on $60000 a year. but have 2m. At 70 this would be the amount we will be getting...me-Ira 50,000, pen. 11,000 SS 24000, Wife just about the same=about 150000. That why I am moving some in to a Roth. When I die my wife will be 124,000 and be in a big tax bracket. Am I missing something? I'm 63 wife 60 both work part time for fun.

User avatar
willthrill81
Posts: 2300
Joined: Thu Jan 26, 2017 3:17 pm
Location: USA

Re: The whole Roth vs. Traditional IRA

Post by willthrill81 » Mon Jan 30, 2017 10:27 am

FiveK wrote:
willthrill81 wrote:I know this thread is quite old, but the topic still seems to come up frequently: traditional IRA or Roth?

While there are many factors potentially at work, I think that just about everything can be summed up in two sentences.

If your effective tax rate in retirement will be lower than your marginal tax rate when you make an IRA contribution, the traditional IRA is better. Otherwise, the Roth is better.

For clarification, "better" in this case means more after tax income in retirement.
Unfortunately, the mistaken idea that one should use "effective" withdrawal rate does recur from time to time. Don't feel bad - it's a concept that looks correct at first glance - but it really isn't.

Some reading:
Traditional versus Roth - Bogleheads The wiki entry.
Fundamental Difference in Roth and Traditional 401k - Bogleheads.org The "OMG I get it!" post.
Deciding between Roth and Traditional IRA based on marginal tax rate?
Roth vs Traditional 401K - Page 4 - Bogleheads.org

And last but not least, from 9 years ago: Roth vs Traditional 401K - earliest Bogleheads thread. See posts from redbeard, Greenberry, and AzRunner.

Traditional is better for most people, just not as much better as "marginal vs. effective" would imply. "Marginal vs. marginal" gives the correct answer - assuming, of course, one gets those marginal rates correct. :)


I believe I 'get' the point you were trying to make in the second thread (already read the wiki entry, but didn't get it), but that's assuming that you already have money saved from another source which will impact your effective tax rate in retirement. It's absolutely accurate to say that something like a maxed out 401(k), SS, or a pension that will provide income in retirement besides your IRA will impact your effective tax rate in retirement.

But for someone who is pulling all (or even most) of their income from their IRA, I cannot see how it's accurate to say that all of your withdrawals would be taxed at your highest rate.

I've run this idea by a CPA (maybe he doesn't get it either, who knows) who agrees with me on this.

hulburt1 wrote:You need both..When you hit 70+ you will need to take money from IRA, SS and add all other incomes and it could be big. Roth you don't take out. We live on $60000 a year. but have 2m. At 70 this would be the amount we will be getting...me-Ira 50,000, pen. 11,000 SS 24000, Wife just about the same=about 150000. That why I am moving some in to a Roth. When I die my wife will be 124,000 and be in a big tax bracket. Am I missing something? I'm 63 wife 60 both work part time for fun.


This makes perfect sense to me.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

4th and Inches
Posts: 145
Joined: Mon Nov 12, 2012 8:53 pm

Re: The whole Roth vs. Traditional IRA

Post by 4th and Inches » Mon Jan 30, 2017 10:32 am

I fuss with the 401k above employer match vs Roth IRA conundrum all the time. If you were going to have a pension that would replace say 37.5% of your income or about $33,500 a year (not indexed to inflation, though increases can be possible) then wouldn't a Roth IRA generally becomes more attractive than extra 401k contributions?

CFR
Posts: 51
Joined: Sun Jan 22, 2017 1:35 pm

Re:

Post by CFR » Mon Jan 30, 2017 10:50 am

Justin618 wrote:The Case Against Roth 401(k)
http://thefinancebuff.com/case-against-roth-401k.html

This qualifies as required reading for anyone contemplating a Roth conversion, Roth 401k, Roth vs. Traditional IRA, or anyone conflating marginal tax rates and effective tax rates.

Justin


Wow, I just 1 week ago had that exact conversation with a fellow young engineer as to why she needed to NOT do the Roth! Explanating the "filling up the lower tax rate rungs" and all! :sharebeer
I believe for the majority of people, this is a strong argument against a Roth, and so I only doing a back door after my 401k Traditional is filled.

C.

User avatar
willthrill81
Posts: 2300
Joined: Thu Jan 26, 2017 3:17 pm
Location: USA

Re: Re:

Post by willthrill81 » Mon Jan 30, 2017 11:20 am

RFC wrote:
Justin618 wrote:The Case Against Roth 401(k)
http://thefinancebuff.com/case-against-roth-401k.html

This qualifies as required reading for anyone contemplating a Roth conversion, Roth 401k, Roth vs. Traditional IRA, or anyone conflating marginal tax rates and effective tax rates.

Justin


Wow, I just 1 week ago had that exact conversation with a fellow young engineer as to why she needed to NOT do the Roth! Explanating the "filling up the lower tax rate rungs" and all! :sharebeer
I believe for the majority of people, this is a strong argument against a Roth, and so I only doing a back door after my 401k Traditional is filled.

C.


That article sums up my argument much more eloquently than I could.

If you have income sources that can 'fill up' the lower income tax bracket 'buckets', then a Roth may make sense. Otherwise, it just doesn't for the overwhelming majority of folks.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

User avatar
willthrill81
Posts: 2300
Joined: Thu Jan 26, 2017 3:17 pm
Location: USA

Re: The whole Roth vs. Traditional IRA

Post by willthrill81 » Mon Jan 30, 2017 11:23 am

4th and Inches wrote:I fuss with the 401k above employer match vs Roth IRA conundrum all the time. If you were going to have a pension that would replace say 37.5% of your income or about $33,500 a year (not indexed to inflation, though increases can be possible) then wouldn't a Roth IRA generally becomes more attractive than extra 401k contributions?


It depends on what income you would need in retirement. Assuming that the current tax structure stays in place and you needed 80% of your current income in retirement, then you would still be in the 15% marginal bracket in retirement. In your case, it's probably close to a wash either way. However, if your current income rises to the point that you're in the 25% marginal bracket, then the extra 401(k) contributions are very likely the way to go.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

User avatar
FiveK
Posts: 3138
Joined: Sun Mar 16, 2014 2:43 pm

Re: The whole Roth vs. Traditional IRA

Post by FiveK » Mon Jan 30, 2017 1:38 pm

willthrill81 wrote:I believe I 'get' the point you were trying to make in the second thread (already read the wiki entry, but didn't get it), but that's assuming that you already have money saved from another source which will impact your effective tax rate in retirement. It's absolutely accurate to say that something like a maxed out 401(k), SS, or a pension that will provide income in retirement besides your IRA will impact your effective [and marginal] tax rate in retirement.
Glad that we agree!

But for someone who is pulling all (or even most) of their income from their IRA, I cannot see how it's accurate to say that all of your withdrawals would be taxed at your highest rate.
Again, we agree that not "all" withdrawals will be taxed at one's highest rate. To the 401k, SS, and pension funds, however, we must add "withdrawals based on previous tIRA contributions" as something already filling the bottom of the retirement taxable income.

Do you see how a previous year's tIRA contribution is identical to a previous year's 401k contribution in this regard?

Thus one should look at withdrawals from this year's IRA contribution as coming on top of the withdrawals from previous years' tIRA contributions (and all those other things, if present).

Note that TheFinanceBuff's articles also say "marginal vs. marginal" is correct. Two examples (taken from Taxes in Early Retirement):
Let t0 be the marginal tax rate now, and t1 be the marginal tax rate at retirement time.
Until you know you can generate from your Traditional 401(k) enough income to fill the lower brackets...

User avatar
FiveK
Posts: 3138
Joined: Sun Mar 16, 2014 2:43 pm

Re: The whole Roth vs. Traditional IRA

Post by FiveK » Mon Jan 30, 2017 1:45 pm

hulburt1 wrote:When you hit 70+ you will need to take money from IRA, SS and add all other incomes and it could be big. Roth you don't take out. We live on $60000 a year. but have 2m. At 70 this would be the amount we will be getting...me-Ira 50,000, pen. 11,000 SS 24000, Wife just about the same=about 150000. That why I am moving some in to a Roth. When I die my wife will be 124,000 and be in a big tax bracket.

Am I missing something?
I don't think so. Your choice is between paying tax at your current marginal rate if you do a Roth conversion now, vs. paying tax at your future marginal rate if forced to make excess tIRA withdrawals later.

User avatar
willthrill81
Posts: 2300
Joined: Thu Jan 26, 2017 3:17 pm
Location: USA

Re: The whole Roth vs. Traditional IRA

Post by willthrill81 » Mon Jan 30, 2017 1:49 pm

FiveK wrote:
willthrill81 wrote:I believe I 'get' the point you were trying to make in the second thread (already read the wiki entry, but didn't get it), but that's assuming that you already have money saved from another source which will impact your effective tax rate in retirement. It's absolutely accurate to say that something like a maxed out 401(k), SS, or a pension that will provide income in retirement besides your IRA will impact your effective [and marginal] tax rate in retirement.
Glad that we agree!

But for someone who is pulling all (or even most) of their income from their IRA, I cannot see how it's accurate to say that all of your withdrawals would be taxed at your highest rate.
Again, we agree that not "all" withdrawals will be taxed at one's highest rate. To the 401k, SS, and pension funds, however, we must add "withdrawals based on previous tIRA contributions" as something already filling the bottom of the retirement taxable income.

Do you see how a previous year's tIRA contribution is identical to a previous year's 401k contribution in this regard?

Thus one should look at withdrawals from this year's IRA contribution as coming on top of the withdrawals from previous years' tIRA contributions (and all those other things, if present).

Note that TheFinanceBuff's articles also say "marginal vs. marginal" is correct. Two examples (taken from Taxes in Early Retirement):
Let t0 be the marginal tax rate now, and t1 be the marginal tax rate at retirement time.
Until you know you can generate from your Traditional 401(k) enough income to fill the lower brackets...


I looked at those sources and can see why "marginal vs. marginal" would be correct IF your lower tax brackets have been filled with other income. Otherwise, it seems that "marginal vs. effective" is correct.

For instance, when I've run the numbers, even with maxing out my 401(k), HSA, and my wife's tIRA (I'm ineligible for a tIRA, so have to go with Roth), a reasonable WR will still place us in the 15% marginal bracket in retirement (planned for age 55). We won't have any income from other sources until SS, which I'll probably delay as long as possible. Further, I anticipate that my SS benefits will be lower than projected in 30 years. Given this situation and my current 25% marginal bracket, I can't see how a Roth would benefit me, even if I do creep into the 25% bracket in retirement.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

Post Reply