mptfan wrote: ↑
Wed Mar 05, 2008 11:07 am
For those in their peak earning years, it is usually better to maximize tax deductible plans (401k, 403b, SIMPLE IRA, SEP IRA, deductible traditional IRA) before investing in non-tax deductible plans (Roth IRA) because:
1) You get an immediate tax reduction equal to your marginal tax rate. If you are currently in your peak earning years, you are probably in a high marginal tax bracket, say 25% or higher, and you will save 25% or more of every dollar you invest in a tax deductible plan. Then, when you retire and begin withdrawing that money, you will pay taxes based on your lower AVERAGE tax rate (aka effective tax rate) in retirement, not your marginal tax rate in retirement. Your average tax rate is almost always lower than your marginal tax rate. If you pay state income tax, your savings are even more dramatic. People who suggest that a Roth IRA and a 401k are a wash if you will be in the same tax bracket in retirement simply don't understand this.
2) Your fixed expenses in retirement may be lower than they are now (no mortgage, no tuition bills or other child related expenses, no car payments, no work related expenses). You will also no longer need to save a chunk of your income for retirement. Therefore, when you retire, you will likely be able to maintain the same standard of living on less income, which means you will be in a lower marginal tax bracket in retirement. If you want to live a more extravagant lifestyle and withdraw money into the higher tax brackets, so be it, you will have that choice. To that extent, and to that extent only, the Roth may prove to be a better choice in the future, but that does not prove that a Roth is better choice as the first option for your investment money now.
3) By contributing to tax deferred plans, you can reduce your current adjusted gross income (AGI) below the threshold at which you can fully take advantage of certain tax credits or tax deductions, such as the child tax credit, or the earned income credit, or the student loan interest deduction, or other credits. If you did not fully take advantage of tax deductible investment plans (and instead contribute to a Roth IRA), your AGI would be correspondingly higher, and you would lose some tax credits, or, the amount of certain tax credits would be reduced. By contrast, investing in a Roth does not lower your AGI.
4) While I agree with the consensus that tax rates will likely be higher in the future, I think it's somewhat naive to have faith that congress will never tax Roth withdrawals, no matter how desperate our government may be in the future for tax revenue. There is a lot of tinkering that can be done in the future, such as reducing the eligibility to take tax free withdrawals, limiting the amount of annual tax free withdrawals, etc. It can (and I think it will) happen.
5) You will retain the option of converting some of your tax deductible funds to a Roth IRA at lower marginal tax rates in the future. For example, you may decide to retire before you are eligible for social security benefits, and withdraw taxable savings to pay your expenses until social security begins. By doing this, you will be using "return of capital" which is not taxed as income, and you may find yourself in a very low tax bracket for a period of time, maybe even a zero tax bracket, and you can use up your lower tax brackets during that time period to convert tax deferred IRAs to a Roth IRA and pay tax on that money at your then lower tax rates. By contrast, funds contributed to a Roth IRA can never be converted to a traditional deductible IRA.
6) Almost everyone will die with some money. Some will die with a great deal of money, especially those of us who plan carefully and consider safe withdrawal rates. I have even heard some suggest that they do not plan on touching their principal during retirement, and some have stated that they continue to be net savers even after retirement. Therefore, given the fact that we will likely die with some significant amount of money left over, we will never have to pay taxes on that chunk of money which was tax deferred. Our heirs will have to worry about paying the deferred taxes on that money. So, I much rather save the taxes now, allow my money to grow tax free, and defer a significant chunk of that tax liability beyond my grave to my heirs. I refuse to voluntarily pay more taxes now so that my heirs will enjoy the benefit of paying less taxes when I'm dead.