Let’s look at the only reasons to ever contribute a Roth IRA in this post. A Roth IRA is a tax-advantaged retirement account where you contribute post-tax contributions. The contributions get to grow tax-free and the withdrawals are tax-free too.
“Disadvantages Of A Roth IRA: Not All Is What It Seems” ignited a flurry of responses from people who have already been contributing to a Roth IRA. Anybody who followed my advice since the post was first published during the Obama administration has been rewarded handsomely. Income tax rates declined under the Trump administration.
With Joe Biden as President, at the margin, investors should be more wary because there’s a likelihood that taxes will go up again. Taxes must be raised to pay for all the stimulus being spent to combat the virus. Further, Biden has said he will raise taxes on households making more than $400,000.
As a result, the relative appeal of contributing to a Roth IRA now has increased.
The income threshold to contribute to a Roth IRA for 2023 is $153,000 for singles and $228,000 for married couples. The income thresholds usually go up every year.
Hard To Trust The Government To Contribute To A Roth IRA
One of the main things people have learned is that the government manipulates individuals into forking over more money than they otherwise should due to gross mismanagement of their own budget.
Massive deficit due to record stimulus spending during a coronavirus pandemic? Let’s announce this huge “benefit” to allow people to convert their pre-tax retirement funds into a Roth IRA! We’ll raise the specter of higher tax rates to get more people to bite.
The reality is doing a Roth IRA conversion is probably a waste and time for most people. Because most people won’t make more in retirement than while working, meaning future tax rates for most will go down, not up.
It’s sometimes daunting to go against the government because they employ some of the smartest people on Earth to keep themselves in power while keeping the rest of us dependent on their largess. But I’m here to help you fight back and live a better life.
Know The Latest Tax Rates Before Contributing To A Roth IRA
If you contribute to a Roth IRA or convert your pre-tax retirement accounts into a Roth IRA, you aren’t going to be damned to hell. You’re just not maximizing your wealth over time if you are in a federal income tax bracket higher than 24% and contribute to a Roth IRA.
For those of you who already have a Roth IRA account, what you are about to read probably makes so much sense you might feel a little bad. But don’t worry. The number one solution when you are in a hole is to stop digging and slowly climb out.
The Only Reasons To Ever Contribute To A Roth IRA
1) You’ve maxed out your 401(k) already.
If you’ve contributed $22,500 to your 401(k) for 2023, then go ahead and contribute to a Roth IRA if you are eligible for tax diversification purposes.
Contributing to a Roth IRA is more tax-efficient than simply investing in a taxable brokerage account. Roth IRA money compounds tax-free and all contributions and earnings can be withdrawn tax-free once you’ve kept your Roth IRA open for more than five years.
Related: How Much Should You Have Saved In Your 401k By Age
2) You’re in the 22% marginal income tax bracket or lower.
If you earn under $95,375 as a single or $190,750 as a married couple, you are in the maximum 22% marginal federal income tax bracket I recommend for contributing to a Roth IRA. A 22% federal marginal income tax bracket is a reasonable rate to pay up front.
Feel free to contribute up to $6,500 to a Roth IRA now because you will be completely creamed by the IRS in the future as your income and marginal federal income tax rate increases.
If you’re in the 24% marginal income tax bracket, contributing to a Roth IRA or converting to a Roth IRA will likely be a wash.
3) You’re going to make over $153,000 or your spouse is getting a big raise.
After you make over $153,000 as an individual or $228,000 as a married couple for 2023, you can’t contribute to a Roth IRA. You can contribute the max if you earn $138,000 or less as an individual or $218,000 or less as a married couple. It is still unknown how the government comes up with such arbitrary amounts, independent of location.
Don’t they know that San Francisco is much more expensive than Des Moines? Contributing to a Roth IRA is particularly useful for those who are on the hunt for sugar mammas or sugar dads. If your prey actually proposes, then contribute as much as you can during the engagement before it’s too late.
4) You think World War III is on the horizon.
If you think world leaders no longer respect the United States’ might and plan to invade, conquer, and bomb neighboring countries around the world, you should consider:
1) Withdrawing all your money and keeping it under a mattress.
2) Making sure your savings accounts are no larger than $250,000 for an individual or $500,000 for a married couple to comply with the FDIC guarantee amount. Have multiple banking relationships to protect yourself from a bank run.
3) Selling equities and keeping cash or Treasury Bills for liquidity
4) Contribute to a Roth IRA because the government will likely raise taxes on everyone to fund a long war.
I still think if you make under $200,000, you’re relatively safe. However, with an expense as large as World War III, the government may have no choice but to raise taxes on people paying 25% or less.
5) You feel tremendous guilt for not paying your fair share.
Let’s say you’re having a guilty conscience for not paying enough taxes because you either cheated on your taxes for years, run a cash only business with two sets of books, mooched off the government longer than you should have, or feel so bad taking advantage of all the loopholes, then go ahead and contribute to a Roth IRA.
I’ve spoken to a lot of the 47% who don’t pay income taxes during my time off from Corporate America. A couple have admitted they feel bad that 100% of the tax burden is paid for by only ~53% of the people. Some of my 47% friends have side jobs that are cash only and never pay taxes.
6) You’re undisciplined and expect to have a lot of problems in your life.
You may have the best intentions of saving for your retirement, but you know that you have poor discipline when it comes to money. Perhaps your experiences as a relapsing cigarette smoker or drinking alcohol have given you doubt about never needing to raid your retirement accounts.
Maybe you’ve got outstanding debts that must be paid or else goons will visit you in the parking lot and break your kneecaps. Who knows.
The “good” thing about a Roth IRA is that you can withdraw the money you put in penalty free, just not the earnings. The only times you might be able to get away with the early withdrawal penalty before 59.5 is if for college expenses, medical expenses greater than 7.5% of your adjusted gross income, or paying for a first-time home purchase (up to $10,000).
7) You have inside information knowing that Roth IRAs will get favorable treatment.
Let’s say you work in the US Treasury and overhear that the government plans to pilfer all 401(k) and traditional IRA accounts by raising taxes on withdrawal rates and extend the penalty free age of withdrawal from 59.5 to 69.5.
You’ve seen draconian measures executed with bank deposits in Greece in 2013 so you have no doubt America can do the same. You also hear that anybody who contributes to a Roth IRA will get a one-for-one dollar match and get two votes to raise taxes on others to benefit yourself. Clearly you should contribute all you can to a ROTH IRA until the government changes its mind again.
Be aware the Tax Cut and Jobs Act that resulted in lower taxes will expire on December 31, 2025. Therefore, for tax diversification purposes, you may want to shift more assets from tax-deferred to the tax-now Roth IRA before January 1, 2026.
8) You live in one of the no state income tax states.
Federal income tax is one thing, state income tax is another. If you live in Texas, Washington, Florida, Alaska, Nevada, South Dakota, Wyoming, or New Hampshire, it is less of a sin to contribute to a Roth IRA because you aren’t paying any state income taxes.
Everybody else should figure out a way to retire in one of the seven no income tax states and then start withdrawing pre-tax retirement funds.
Related: States With No State Tax Or Inheritance Tax
9) Someone is paying you to promote a Roth IRA.
Money makes people do anything. If some organization is going to pay you to promote the Roth IRA then I guess you’re better off than others who don’t have the same money making opportunities.
If you can earn more promoting the Roth IRA than what you can earn from the returns of your Roth IRA, then you would be a fool to ignore all the wrong reasons for contributing to a Roth IRA in order to pad your bank account.
Be especially aware of financial advisors or CFPs who aggressively push the Roth IRA without providing other benefits besides tax free growth and gains. Make sure pitchmen practice what they preach.
10) You are an income tweener.
If your income is between the tax deductible IRA max ($68,000 income limit to contribute the max) and Roth IRA max ($153,000 income limit to contribute the max) and you can afford it, making a Roth contribution could make sense.
For those over the Roth income max, you can do a “backdoor” Roth contribution – by making a non-deductible contribution to a traditional IRA and then converting it to a Roth.
11) You’ve got a working child.
If you’ve got a child who is working for someone else or for your business, then you might as well contribute to a custodial Roth IRA. The child will pay no taxes up to the standard deduction of $12,550. Further, your child will learn about the importance of saving and investing for his or her future.
There is no age limit to open up a custodial Roth IRA for you child. So long as your child is earning income doing work, he or she is eligible.
Contributing To A Roth IRA Isn’t The Worst Thing In The World
Mathematically speaking, the most taxes you will pay on a $6,500 contribution is roughly $1,440 (24% tax bracket). You can’t contribute to a Roth IRA once you’re in the 32% federal income tax bracket due to the $153,000 individual income limit threshold for 2023.
It is really unlikely that you will earn more in retirement than while you were working. Interest rates have plummeted, which means it requires a lot more capital to produce the same risk-adjusted income. Therefore, we should all lower our safe withdrawal rate in retirement to be more aligned with the times.
You will unlikely earn enough in retirement to pay higher than a 24% marginal federal income tax bracket. This would require an individual to make over $182,101 a year or a married couple over $364,200 a year in retirement to pay the 32% marginal federal income tax rate in 2023.
However, to generate $182,101 / $364,200 a year in income from your retirement portfolio at a 4% rate of return would necessitate having $4.55 – $9.1 million.
Yes, I do believe many personal finance readers will become multi-millionaires in retirement. But most Americans will not. The retirement numbers don’t lie.
If the choice is between not saving anything at all and saving in a Roth IRA, then definitely save in a Roth IRA even if you haven’t funded your 401(k). But the best sequence is to max out your 401(k) and traditional IRA first before paying more taxes up front.
Diversify Your Retirement Sourcs
Today,I have come around to contributing to a Roth IRA because I’m now a father of two kids. So much of one’s perspective changes after becoming a parent.
When I reflect back upon my time working minimum wage jobs as a teenager and then working jobs in college and a year after college, I regret not contributing to a Roth IRA. If I did contribute a Roth IRA back then, I would have over $100,000 in a Roth IRA account today.
I plan to put my kids to work at some point, pay them the Roth IRA contribution limit, teach them about online entrepreneurship, and also teach them about the importance of saving and investing for the future. Being able to pay 0% tax to contribute to a Roth IRA and then withdraw the money tax-free in the future is a no-brainer.
Joe Biden and Kamala Harris are likely going to raise taxes for higher income earners and keep taxes the same for the rest. Pay attention to tax laws and tax rates going forward.
For those of you in a marginal tax bracket above 24%, doing a Roth IRA conversion to try and save on taxes when you’re in retirement is probably not going to save you money. But if you are in the 0%, 10%, 12%, and 22% marginal income tax brackets, it’s not a bad idea.
Diversify Your Investments Into Real Estate
If you want to dampen volatility and build wealth at the same time, invest in real estate. Real estate is my favorite asset class to build wealth.
The combination of rising rents and rising capital values is a very powerful wealth-builder. By the time I was 30, I had bought two properties in San Francisco and one property in Lake Tahoe. These properties now generate a significant amount of mostly passive income.
In 2016, I started diversifying into heartland real estate to take advantage of lower valuations and higher cap rates. I did so by investing $810,000 with real estate crowdfunding platforms. With interest rates down, the value of cash flow is up. Further, the pandemic has made working from home more common.
The Two Best Real Estate Investment Platforms
Fundrise: A way for accredited and non-accredited investors to diversify into real estate through private eFunds. Fundrise has been around since 2012 and has consistently generated steady returns, especially during volatile times. For most people, investing in a diversified eREIT is the easiest way to gain real estate exposure.
CrowdStreet: A way for accredited investors to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities with lower valuations and higher rental yields. They also have potentially higher growth due to job growth and demographic trends. If you have a lot more capital, you can build you own diversified real estate portfolio.
Recommendation To Build Wealth
Whether you have a Roth IRA or a traditional IRA, I would sign up for Personal Capital to run your retirement funds through their Investment Checkup tool for free.
You’ll get a snapshot of how much in portfolio fees you’re paying a year and how you can optimize your portfolio based on your risk tolerance. I found out I was paying $1,700 a year in fees I had no idea I was paying!
Run your numbers through their Retirement Planning Calculator. It uses real data that you’ve linked to produce as realistic a future financial scenario as possible to see how you’re doing. You can adjust the various expense and income variables to see the different results.
Check out a sample output below and see if you can get to excellent shape as well!
The Only Reasons To Ever Contribute To A Roth IRA is a Financial Samurai original. Financial Samurai has been around since 2009 and is one of the leading personal finance sites in the world. Join 60,000+ others and sign up for his free weekly newsletter to never miss a thing.
This is the first time ever I disagree with Sam. I speak with retirees all the time and 99.9% of them favor the ROTH and wish they had contributed more to the ROTH in their working years because the taxes are killing them on withdrawals. The low tax rates we see now are set to expire on Jan. 1, 2026. Too many retirees are finding themselves either in the same tax bracket and some even higher now that they are retired between RMD’s, social security, annuities and pensions. It’s a myth that you will be in a lower tax bracket in retirement for many. To add insult to injury, too much provisional income counted in retirement also affects IRMMA payments and may also prevent your from qualifying for subsidized ACA. I think the ROTH 401K is the way to go.
Financial Samurai says
Thanks for your comment. And I agree about the desire to diverse retirement income sources due to taxes. I highlighted many reasons in the post to contribute to a Roth IRA.
Your point about low taxes rates potentially expiring on Jan 1, 2026 is precisely why I wrote this new post:
Shifting Retirement Assets From Tax-Deferred To Tax-Now By 2026
Thanks for sharing your thoughts!
There are other advantages to the Roth including a lack of mandatory distributions, passing it on to heirs, etc. So it’s not as black and white as you wrote before. Roth 403(b) in particular aren’t subject to the income limits the IRAs are and this could be done once you contribute the full $57K minus the $19.5K employee contribution limit. Again for me it is about tax diversification. Even if you do have tens of millions of dollars in retirement at age 70, it’d help to have at least some fraction of that be tax free so you can make large withdrawals if needed without feeling pain.
Partial Roth conversions from a traditional IRA are an alternative to using the 72t SEPP to turn tax deferred income into nontaxable income without paying any taxes or an early withdrawl penalty. The way I like to use my early retirement is to be a mega tax optimizer as opposed to a mega wealth generator. The goal of my working career was to store as much income as possible in tax deferred accounts, and the goal in retirement is to get all that money out without paying any federal or state taxes. I moved about $440K last year from tax deferred to available or spendable categories last year, paying $0 Fed and $0 California tax, and I am happy as a clam with that!
I’m very familiar with Roth conversion ladders and all kinds of tax optimization tricks such as those GCC shares. But can you share more info on how on earth you moved $400k of tax-deferred pretax over in a year without paying tax? I can’t think of any way that could be done that wouldn’t also have cost you a lot of money in other ways.
I was referring to my focus on mega tax optimization with that figure. About $370K of that was a capital gain on a primary residence I held for six years. The other $70K came from multiple tricks due to married filing jointly status, but heck, avoiding the Federal component of taxation is simple for under $70K just from the long term capital gains or qualified dividends exclusions! The state portion is actually easy to hide anyway in California since the tax structure is *so* progressive compared to other states.
Quick follow up on my comment about my focus on tax optimization over wealth generation.
First, you can generate as much wealth as you want in tax deferred accounts, especially with Solo 401(k) that let’s you choose *any* investment vehicle. So wealth generation is always doable and important, but not my focus.
Second, at some point I realized that someone making $47K retired could live *exactly* the same lifestyle (if not better) as the majority of people who make $100K working. Since I am content with a $120K lifestyle with no need to “live large” I decided to focus more on maximizing every dollar I made vs making as much wealth as possible.
That, in a nutshell, is why I am a FIRE guy that focuses on optimizing taxes instead of generating wealth.
Besides, generating wealth requires a lot more effort than optimizing taxes. :-)
David Lovato says
My company offers a mega-backdoor roth (in-plan after tax 401k conversions to a roth 401k) which lets me put away the IRS maximum of $56k. I see no reason not to do this because my earnings will grow tax free, I’m already maxing out my pre-tax 401k, and I can use the roth 401k as an emergency fund (well, my contributions). I see no reason not to do this, even though I would like to start using the 30k or so I’m putting into my roth 401k into a house eventually.
The Expostriate says
I understand your points in this system, but don’t believe they account for all situations. You make some statements that I am sure are true for many, if not most, of your readers. However, by the shear fact that I am a reader, they’re not true for all. I am an expat reader. You probably have more readers than me in my situation. Thus, I have to disagree that these are not the only reasons to ever contribute to a Roth IRA.
In your post:
1. “You’ve maxed out your 401(k) already.”
As an American citizen who lives and works abroad, I don’t have a 401(k). You could argue it is maxed out because the amount I can contribute is zero, but, really, I haven’t contributed anything to it either.
2. “You’re in the 24% marginal income tax bracket or lower.” And “You’re just not maximizing your wealth over time if you are in a federal income tax bracket higher than 24%.”
I am currently in the 22% bracket, but have not been far away from the 24% bracket the past couple of years. Even if I enter the 24% bracket, I think it is still to my benefit to enter the Roth IRA as an expat American in Germany. Right now, I can take a tax credit on my German income taxes, and then put the money into a Roth IRA. I get no deduction benefit from putting it into a Traditional IRA.
If and when I make enough in dividends, capital gains, and other distributions from my investments, I can just exclude all of my German earned income and contribute to the Roth as if I only had 6k in US income.
Correct me if I am wrong, but being an expat almost guarantees a Roth IRA is a better choice than a traditional IRA. The only situation I could see that being otherwise is if you can still exclude your foreign income under the foreign earned income exclusion while earning enough dividends, capital gains, and other investment distributions to be under the US income max for the traditional IRA deduction while being able to really take advantage of the tax deduction.
3. “You live in one of the no state income tax states.”
I’m guessing that you meant with this section: “you don’t have to pay state income taxes.” I do not live in one of the states with no income taxes, but I also don’t live in any state. Years ago, I formally renounced my residency in that state and have that state’s confirmation. I no longer pay state taxes, only federal taxes. And there are ways to reduce federal income tax liability substantially, if not completely. For those interested, I wrote about two of the primary ways to do so: the foreign earned income exclusion (expostriate.com/foreign-earned-income-exclusion/) and foreign tax credit ( expostriate.com/foreign-tax-credit/).
Bill in NC says
We won’t be converting tIRA to Roth IRA…our income is low and will be so in retirement, so any taxes on tIRA withdrawals will be low.
OTOH all our kids are going into the military after college, so they will be putting their retirement savings into the Roth TSP since their tax brackets will be low at first (plus they get generous non-taxed “allowances”) but they’ll be in much higher tax brackets later in their careers.
It wouldn’t matter if they are going to be in higher tax brackets. what matter is in their retirement income tax ratio. SO it would be better for them to use traditional..
Here’s another reason for people to invest in the Roth: After 35+ years spouse and I have saved in the tax deferred 401ks and as a result, wee have over $2.5 million in the tax deferred accounts. Now… we recently read the writing on the walls… Unless we do some major converting in retirement, Uncle Sam is gonna take an enormous chunk of our tax deferred savings when RMDs kick in at age 72. So, we wised up and changed our paychecks to 100% Roth 401ks until we retire. We are definitely going to have to create a drawdown strategy or Roth conversion strategy between our retirement at age 61 and RMDs at 72. So there, you have it! Another great reason for investing in the Roth!
Originally I was like you and I worried about RMD’s. However, a while ago I decided to create a spreadsheet to see what my RMD’s would look like if invested in my 401k and had a $2.5 million balance when I turned 70.5. The spreadsheet was created before the RMD was raised to 72, but it still gives you a general idea.
Here’s my sheet:
Historically, the average rate of return on investments while in retirement is about 5% since the investments are mostly moved into safer vehicles while in retirement which means lower rates of returns but more stable returns. Also, historically, since the early 1920’s, inflation has averaged 2.9% per year.
As you can see in the spreadsheet, I ran out the numbers year by year showing what my RMD would look like each year.
To the right you’ll see what my taxes will look like the first year in RMD’s and also what my highest RMD tax would look like.
My max RMD occurs when I turn 84 years old in which I’d be required to take out $108,596. Using a gross of 108,596 you can see that my effective tax rate would be 16.09% after my standard deduction and my AGI is funneled through the different tax brackets.
I’m not sure what marginal tax bracket you’re in right now, but I’m in the 24% marginal tax bracket right now. Meaning any money I invest in a ROTH is going to be taxed at 24%. Ouch!
However, as you can see from my spreadsheet, if I invested in a 401k instead and had a $2.5 million balance when RMD’s start, my first year of taxes would be 14.66% and my highest RMD year would be 16.09% in taxes.
I’d much rather pay taxes later at a lower rate even when forced to take RMD’s on my traditional 401k vs paying ROTH taxes now. For me the taxes would be about 50% more, 24% for a ROTH now vs 16% later on for a traditional 401k with RDM’s.
Hope that helps people understand RMD’s a little better.
Great spreadsheet. However, at the beginning of RMD, you’re paying a 14.66% effective rate on $79k after your standard deduction.
With a ROTH you are paying 24% (your marginal rate) only on your $6000 contribution which is $1440. In 40 working years you’ve paid ~$57,600 in taxes. Have you done the spreadsheet of the max allowed ROTH and how much total taxes are paid when you reach age 70.5 (or 72)?
With a ROTH, you pay no taxes on earnings and compounding. I’m thinking it’s great when you’re young and at some age it transitions to where it’s no longer profitable to pay the taxes up front, unless you are planning to let someone inherit it.
I understand what you’re saying and I’ve had a lot of talks with people relating to that as well.
You’re thinking of taxes now vs later in absolute dollar amounts. In that way you are correct.
With that said however, the way you should be thinking about taxes is what percentage of my income am I paying in taxes. Yes, you’ll pay more dollars quantitatively in retirement in taxes on a 401k, however your nest egg is also a lot larger with a 401k in retirement and your taxes are a smaller percentage of your retirement income later in retirement than they are now with a ROTH.
If you want a more complete concrete example, I created this a while back comparing the Roth to a Traditional 401k.
You’ll notice, that yes, you’ll pay more taxes (in raw dollars) on a 401k in retirement, however, again, your 401k nest egg is a lot larger than the ROTH and you need to look at what percentage of your income you’re paying in taxes and what your net income is in retirement after all the taxes are paid. That’s what matters to me. The bottom line is which investment gives me the highest take home pay in retirement after all the taxes are paid. I personally don’t care if I pay more in taxes (raw dollars) later in a 401k if my net take home after those taxes are paid is greater than what I would have had if I invested with a ROTH.
The example linked shows the full circle picture of the retirement vehicles as it pertains to our actual tax code. And more importantly, it shows who actually has more money to live on per year after all the taxes have been paid. In this case, Sam (401k) has more money to live on each year than Dave (ROTH).
Hope that helps!
For giggles, I just updated/created a new spreadsheet for the 2020 tax brackets and standard deductions. See below:
As the original one indicated, Sam and Dave are both saving 15% of their income for retirement. The first tab shows this comparison.
However, I expanded on this. Why?
Because Sam and Dave are not like most Americans.
The average American is only saving 6.9% of their income for retirement. The second tab shows what Sam and Dave’s situation would look like if they are an average Americans saving 6.9% for retirement.
I also went the other extreme, what if Sam and Dave were absolute rock stars and wanted to max out their 2020 contribution at $19,500. The third tab shows this comparison. As an fyi though, only 13% of Americans maxed out their 401k’s in 2017 (I can’t find 2018/2019 data).
In the end, all three tabs show the same thing. The 401k is more advantageous than the Roth and Sam has more money to live on per year than Dave does after all the taxes are paid.
Other things to think about, these scenarios show Sam and Dave contributing for 40 years. Which the typical American also isn’t doing. I could easily create a spreadsheet where they’re only investing for 30 years instead. But the same thing would happen: A shorter period of time investing means a lower retirement balance, which means less money taken out every year in retirement which means an even lower effective tax rate on their 401k withdraw in retirement. So even when time is taken into consideration, the 401k comes out on top.
Thanks for the second and third spreadsheets!
It’s a win-win for the individual and Uncle Sam.
Amazing that in 40 working years Dave would pay just $105,600 in Federal income tax whereas in 25 retirement years Sam would pay over $340,200… yet Sam will have higher income throughout retirement.
It’s a bit of a shame that the stretch IRA was removed as part of inherited IRAs. I was relieved to learn that the QCD age stayed at 70-1/2 and was not increased to 72 like the RMD age. I turned 70-1/2 this year.
Froogal Stoodent says
Thanks for sharing your spreadsheets! Great stuff!
I’d say the only real fly in the ointment is that you’re assuming the tax codes stay unchanged. That’s not an assumption I’m prepared to make, as I explained in my comments on this Financial Samurai post: https://www.financialsamurai.com/disadvantages-of-the-roth-ira-not-all-is-what-it-seems/.
I think it makes the most sense to tackle an uncertain future by diversifying your approach: I use a trad. 401(k), a Roth IRA, and a brokerage account. Each has advantages and drawbacks, and I’ll be okay regardless of whether or not the tax code changes.
Maybe my approach is not optimized, but it keeps my options open. And I won’t be quite so fuming mad when Congress changes something in a way that screws over one of these groups.
The issue with your spreadsheet is that you’re comparing two different result. I would adjust Roth’s effective tax calculation to total taxes paid / total fund. That way it’s apples to apples. The reason why this step is necessary is that you’re ignoring the benefit of ROTH account, which is tax-free cap gain. Without it, you’re comparing contribution + cap gain in traditional vs Contribution in roth.
Thanks for the spreadsheet but what happens when the government raises tax rates in the future. I’m currently in the 24% tax bracket and will also have SS and a federal annuity in retirement. Both will be taxed. Shouldn’t I have a Roth to off set all the taxable income I will have in retirement? I’m still 20 years away from retirement.
Jake Shivers says
I’m confused by your position, can you help me better understand?
If you contribute $5,000 to a Roth, you’ve already paid taxes on that money. It grows tax free, and you get to spend it in your golden years. The only alternate option would be to invest that same money elsewhere (I max out my 401k), and pay capital gains on the earnings.
Am I misunderstanding something?
Yes because you’re paying taxes on a ROTH investment at your Marginal tax rate, which is your highest tax bracket. If you invest in a regular 401k, the withdraws are treated as normal income so you get to take a standard deduction and then the money is taxed in tiers. This is considered your effective tax rate. Your effective tax rate is always lower than your marginal tax rate. If you don’t believe me look at your tax summary for the past year.
For example, My marginal tax rate last year was 24%, however my effective tax rate was 12%.
Every dollar I put into a ROTH would be taxed at 24%. Ouch!
I agree with the author 100%. The vast majority of the people reading this will retire on less income per year in retirement than they had while they were working. In fact, most financial advisors suggest 80% income replacement is a good goal to strive for. And in that case the regular 401k is definitely better. If you’re one of the unicorns that can retire on significantly more money in retirement than they had while working, then it would be beneficial to diversify.
The sad reality is that the vast majority of the public won’t even hit 80% income replacement and their retirement fund is severely underfunded. So why would you want to pay high taxes right now on a ROTH when you can pay lower taxes later on a regular 401k? That doesn’t make sense.
Max Briggs says
I think it depends on where you are at in your career. It is true that most people will retire in less money than they make at the end of their career, but most people will retire making far more than they did at the beginning of their career.
So early in your career it probably makes sense to co tribute to a Roth and then transition more and more of the contributions into a traditional as your income increases.
I also suspect tax rates in general will go up, so having some money in a Roth to mitigate tax risk is nice, but I know that’s speculative.
Max Briggs says
Another point is that if you contribute $10k to a traditional and $10k to a Roth the Roth will win 100% of the time because the withdrawals are tax free. The only way the traditional can compete is if you also invest the tax savings. So for example you contribute $12k to your traditional instead of $10k to your Roth, because Both reduce your take home pay by the same amount.
Of course if you invest $10k into a Roth and $10k into a 410k the Roth will win, everyone knows that because you’re investing MORE money in the ROTH that way. That’s a no brainer. That’s also not an apples to apples comparison because your take home pay right now suffers because you’re paying the taxes on your $10k ROTH investment from your take home pay.
How is that a fair comparison of which one is better?
If you want a true apples to apples comparison, you need to take your Roth investment of $10k, pay the taxes on it and then invest the remaining amount. If you’re in the 24% tax bracket that means that you’re investing $7600 into your Roth and paying $2400 in taxes or you’re putting $10k into your traditional 401k. That is the only way to get a true apples to apples comparison because your take home pay stays the exact same right now. If your take home pay is the same now, then you can compare which is better in the future.
There are a lot of people claiming the ROTH is better, but I have yet to see anyone run an apples to apples comparison with actual Math calculations comparing them using real income and realistic inflation and rates of return.
I have, I have tons of spreadsheets just like the Samurai does which proves the traditional 401k is better for most people. If you don’t believe me, then give me your stats and I’ll run a scenario for you. I am a tax, math and excel nerd, I have run hundreds of scenarios so I know that for most people the traditional is better.
Max Briggs says
I understand equal contributions isn’t an apples to apples comparison. I only made the comment for other readers that might not be aware that you have to also invest the tax savings in order to receive the benefit of the traditional 401k.
My larger point is still valid though. I have a financial blog of my own where I run the numbers for several different scenarios. Financial samurai doesn’t let you post links in the comments but if you’re interested I can probably find a way to show you the article with the math. But if you’ve run your own spreadsheets you probably already know the big picture.
If you are looking for a specific example where the Roth makes more sense I would offer this one, which applied to me:
Young married couple has a combined household income of $100k. Both have a very reasonable expectation of making $250k combined when they retire (Government jobs with defined pay scales). The difference between their current tax rate and their anticipated future tax rates dictates that they should contribute to a Roth. However as they start to realize their raises, their current tax rate gets closer to their retirement tax rate they should transition their contributions to the traditional.
I’m interested to see what your spreadsheet would say about that scenario.
Mine show Roth as the clear winner.
I agree that for many people, especially with flat income profiles traditional is better.
The one thing that you’re not taking into consideration is inflation.
I mean if I’m making $100k right now, I’d suspect 30 years from now I’ll probably be making around $250k as well. Using some online calculators (https://www.cchwebsites.com/content/calculators/AnnualReturn.html), this works out to a 3.1% raise per year, which again, is more than the national average raise of 2.7% per year. So if you’re getting a 3.1% raise each year you’re doing better than the average person out there.
We can break this problem down two different ways: We can forecast what the tax brackets will be in the future based off inflation OR we can back track $250k to see what it would be worth today based off inflation and then compare it to our current tax brackets.
Lets take the first option: Adjust the tax brackets each year for inflation.
So if the couple makes $100k right now that puts them in the 22% tax bracket. Right now, inflation is about 2% per year and the brackets get adjusted every year based off inflation. For 2019, the 22% tax bracket maxes out at $168,400 for a couple. If we adjust this up 2% every year for inflation, in 30 years from now, the 22% tax bracket will be maxing out at $306,692. So in this case, even though the couple is making $250k/year when they retire, they’re still squarely in the 22% tax bracket.
Now lets look at it from the second point of view and adjust our $250k backwards based off inflation over 30 years.
Here is an online calculator to figure out present value based off a future value and inflation. If we enter $250k as our future value, 2% as inflation, and 30 years as the length, we can see that $250k 30 years from now would be worth about $138k right now. As we saw above, the 22% tax bracket for 2019 tops out at $168,400. So at $138k, we’re still squarely in the 22% tax bracket.
Technically, there’s also a third way to do it….
As I’ve posted above, the math formula is (1 + ror ) / (1 + inflation) – 1. This gives you what the inflation adjusted raise would be. From above, if you start at $100k and end at $250k 30 years from now that’s about a 3.1% raise per year, which again, is above the national average of 2.7%. But anyway, plugging the numbers into the formula, we see that (1 + 3.1% raise) / (1 + 2% inflation) – 1 = 1.078%. So the couple you mentioned is basically getting an inflation adjusted raise of 1.078% per year. $100k * 1.078% per year for 30 years gives the couple an inflation adjusted income of about $138k/year 30 years from now, which is basically what we found in option 2 above. It’s good to see that we did the math two different ways and the math came out the same!
No matter which calculation option you choose (1, 2, or 3), the couple still ends up squarely in the 22% tax bracket making $250k 30 years from now. Given your scenario, this couple never leave the 22% tax bracket.
Max Briggs says
My example is one of a starting teacher salary and a GS-11 government employee. Expectations of promotions to GS-15 and maxed out MS degree teacher salary put their combined pay scales at $100k in the early years and $250k in the late years BEFORE cost of living adjustments. If you’d like to project the COLA adjustments into the future and take a guess at how tax rates will move you are welcome to do so. However, I think it is just as useful to assume that inflation adjusted tax rates will be roughly the same then as they are now and apply the current tax rate for the $250k household income to the decision. Essentially doing all of the math in today’s dollars. If COLA’s do not keep pace with inflation, or if tax codes don’t then you are correct the math will change. But I think that it’s fair to say that the situation described above will result in a much higher marginal tax rate in retirement than at the beginning of employment, so I stand by the analysis.
Also, the 2.5x multiplier is in line with typical progression of incomes according to various data sources on income quintiles by age. (Not linking because again I don’t think it is allowed). So not only do I think that the Roth is the best option for that couple early in their career, I also think that there are more people in that boat than you might expect. It’s probably not the norm, but it’s probably not uncommon.
Here is my situation that I think proves the benefit of a Roth IRA. I make too much to make a deductible contribution to a traditional IRA. Therefore, I make a non-deductible trad contribution and then a conversion to a Roth. I make marginal tax rates on this contribution regardless if it is into the trad or Roth. If I were to leave it in the traditional then I would owe taxes in withdrawal AND have an RMD, right? I’d be taxes twice.
Am I right in this thinking?
Steven Hoover says
After $6 trillion in new spending to combat Corona Virus I like my odds that my Roth will payoff in the long-run…
Max Briggs says
I have done a lot of math on the Roth vs 401k vs brokerage analysis and I don’t view Roth’s nearly as unfavorably as the author seems to. Generally speaking, I would say that most early career people make much less than they will make when they are in their prime earning years when they retire and therefore a lot of people are in much lower tax brackets than they will be in retirement. It therefore makes a lot of sense for those people to contribute to a Roth. I agree that as your income gets close to your expected retirement income it starts to make sense to transition to traditional, but this could take 10-20 years. I also like that it takes income tax risk off the table, so if the total return from a traditional and a roth are close, I would argue the roth is better because you are immune from income tax increases. I also believe that with the social security/medicare/medicaid insolvency and coronoavirus responses all likely to require additional tax dollars it is fair to assume that someone’s taxes are going up, although I admittedly don’t know whose, or when.
Max, make sure you are taking inflation into consideration. You may start out making $50k/year and then 20 years later you’re at $100k/year. That sounds awesome because you’re making twice as much money as you did when you started. However even at a modest 2% inflation like we have now, that $100k would only be worth $67k in present terms money, so really in 20 years you went from $50k to $67k. That’s a 1.5% increase per year after inflation (3.5% a year with inflation). FYI, the average pay increase last year was 2.7%, so at 3.5% you’re considered better than average for wage increases but your income really isn’t exponentially growing.
I do agree a ROTH is good if you expect exponential income growth,for instance going from $50k to $100k in 2 years, but if you’re an average person getting a 2.7% raise each year, the Roth doesn’t make much sense.
But for what it’s worth, the one area I 100% suggest a Roth for is if you make under the standard deduction every year. For a single person that would be $12k. So if you make under $12k, I 100% say invest in a ROTH since you will pay $0 in taxes on that investment right now.
Max Briggs says
I don’t know that the pace of growth or inflation matters nearly as much as how much you make. For one, tax brackets aren’t inflation adjusted, so whether my wages are keeping pace with inflation or outpacing it my tax rate is still going up. Also even if the growth is slow it just means that you would transition your money from one to the other more slowly it would change which vehicle you choose.
The rate of inflation most definitely is important. If not, then please show me where I can find fuel for $0.25/gallon? How about a brand new house for $30k? Recent inflation has been around 2%. However historically, inflation has averaged closer to 3% since the 1920’s. Inflation most definitely matters!
Secondly, I have no idea where you’re getting your information from, because yes, the tax brackets are most definitely adjusted every year for inflation. Just look at the bracket maxes for the past two years. The max 24% rate topped out at $82,501 in 2018 and it maxed out at $84,201 in 2019. Which, btw, is basically a 2% inflation rate like I said before. If you got a 2% raise last year and inflation was also 2% last year, you effectively didn’t get a raise as your buying power stayed the exact same. And since the tax brackets got adjusted up 2% last year, that means you’re not jumping any tax brackets either.
For giggles, since we’ve already established that the tax brackets are adjusted each year for inflation and that in 2019, the 24% tax bracket maxed out at $84,201, if that max is adjusted every year by 2% inflation, then in 20 years from now the 24% tax bracket will max out at $125,571. So making $84k now would be equivalent, tax wise and buying power wise, to making $125k in 20 years. Your wages went up 50% over that 20 year period ($41k), but your real buying power hasn’t done anything! And tax-wise, you’re still at the top of the 24% tax bracket, you haven’t moved anywhere even though you’re making 50% more than you did 20 years ago!
There’s a math formula to figure out what the true raise would be after accounting for inflation:
(1 + pay raise rate) / (1 + inflation rate) – 1.
So if inflation last year was 2% and the average raise last year was 2.7%, then your actual raise after inflation would look like this:
(1 + 2.7%) / (1 + 2%) – 1 = 0.69%.
So even though the average raise was 2.7% last year, the inflation adjusted raise was only 0.69%. If you made $50k last year and got a 2.7% raise, your real raise after inflation is considered would only be $345 ($50k * 0.69%). You’re not exactly exponentially jumping tax brackets when your real raise only went up $345 last year after inflation was taken into consideration.
Lets drag this out further, if you made $50k/year and you got 2.7% raise every year and inflation was 2% every year, your $50k income in 40 years would be $65,887 after being adjusted for inflation. So even though you’re getting 2.7% raises every year, you never left the 22% tax bracket after 40 years of working. If you make $100k/year you’d currently be in the 24% tax bracket. Using the same 2.7% raises and 2% inflation, in 40 years your inflation adjusted income would be $132k. You’re still in the 24% tax bracket! Again, you didn’t move anywhere!
As I said above, inflation most definitely makes a very real difference and if you’re not accounting for it in your calculations then it’s going to bite you!
Lastly, the formula above is good for calculating rates of returns for investments as well. If you get a 10% rate of return on your investments and inflation is 2%, your real rate of return is (1+10%) / (1 + 2%) -1 = 7.8% after inflation is taken into consideration.
Tyson Coolidge says
I like what you said about using a Roth IRA if you make less than $84,200 a year. My sister has been telling me about how she wants to make sure that she’s preparing properly for retirement. I’ll share this information with her so that she can look into her options for using a Roth IRA.
What is your opinion on gifting to a ROTH IRA for another person under the assumption they would not have contributed to an IRA otherwise?
Andrew Mika says
In general, contribute to a Roth if you are currently in a lower or the same tax bracket now than what you anticipate in retirement. If using it as a legacy play for your kids, you are then comparing your current tax bracket to you kid’s anticipated bracket when you and your spouse die. If the stretch IRA is shortened for non-spouses such as your kids, having to empty a large regular IRA can increase their taxes tremendously. One more reason to use a Roth is that you can in a sense shelter more of your money. Most illustrations show contributing $6000 to a traditional vs $4500 to a Roth because of the 25% tax bracket. But you can put $6000 in it. The more you can shelter from taxes forever, the better, as long as your retirement tax bracket is the same or more.
The reason people compare $4500 in a Roth to $6000 in a Traditional is because that is a true apples to apples comparison. Meaning your take home pay right now stays the exact same.
If you try comparing putting $6000 into a Roth and $6000 into a 401k, of course the Roth would win because you’re putting in way more money! That’s because you’re paying your taxes on your Roth contribution from your take home pay and not taking it out of the investment. Meaning you’re take home pay right now is not the same between the two investments. That is not an apples to apples comparison.
If you want a true apples to apples comparison, you need to take the taxes out of the investment right now which is why they illustrate $4500 into a Roth vs $6000 into a 401k.
Also, assuming your income is steady, why would you want to pay 25% tax on your ROTH right now (marginal tax rate), when you can pay less in taxes later on? Your 401k withdraws are taxed as normal income meaning you get to take a standard deduction, and then the remaining AGI goes through the various tax tiers to come up with an effective tax rate. Think about this way, because of the standard deduction, if you’re single, the first $12,000 of your 401k withdraw is 100% tax free! You’re effective tax rate is ALWAYS lower than your marginal tax rate. ALWAYS!
Jim Amerman says
Maybe this was mentioned already, but it appears that you are comparing Roth Contributions to deductible Traditional IRA contributions. In many cases the T.IRA is better, but in many cases income is too high to take the deduction. Then the backdoor Roth is a great choice, as opposed to saving to a taxable account with cap gains on the growth. Gift to your kids who work so they can contribute to Roth accounts – the taxes saved really adds up when you start early.
Also, finessed Roth Conversions can save a ton in future taxes when there’s a significant dip in your marginal tax rate (sabbatical year, large loss, after retirement but before social security and RMDs, etc.). For HNW, the savings can easily be over a million.
I am not paid to promote Roth accounts, but I do see that the vast majority of people who could benefit significantly from Roth IRAs (which is a higher number than you would think) are not taking advantage of them.
11) You’re a US citizen living and earning entirely outside the US.
My understanding is that if you earn within the brackets, this is pretty much the only tax sheltered US vehicle open to you… and you have to elect to take the Foreign Tax Credit (form 1116) instead of the Exclusion (2555). No?
Unless I missed it, you left off one very good reason to contribute to a Roth:
it is more favorable to inherit a Roth than to inherit a Traditional IRA, and I expect to leave much of it to my nephew after I’m gone. Under current stretch rules, he’d be able to get a nice chunk of change tax free stretched out over perhaps the final 40 years of his life.
Financial Samurai says
Hmmm, could you elaborate more on this? Could be a good point!
There’s also a debate on how much one should give. Check out: Three Things I Learned From My Estate Planning Lawyer Everyone Must Do
Mike, he would also get a nice chunk of change from a Traditional IRA stretched over 40 years except that he would owe taxes on each distribution. In the beginning, distributions would be quite small if he’s young.
OTOH if he doesn’t read Financial Samurai, he just might treat himself to a Ferrari!
My husbands in the service E-6 10 year pay. I don’t work and we have 2 kids. I find contributing to the traditional TSP to be our best option. It allows us to benefit from the Earned Income Tax credit which is huge! Not only do we benefit from the EITC but also it allows us to take a larger Retirement savers credit. Tax planning is key here! If you can shelter 8k a year in a traditional TSP/401k and get back 3-4k because of it in your income return do it! We saved in the roth for years until I started tax planning.
I am 29 but have only ever had a Roth IRA since I started contributing – about $9,000.
I have access to a 401k at work, which I am using and maxing out my employer matching.
I feel a traditional IRA is smarter at my age due to the greater amount of money one can contribute (being pre-tax money) versus a Roth’s taxed money. It can compound quicker than taxed contributions.
Is it smart to convert my Roth to a Traditional IRA, if that’s even possible?
Or should I keep the Roth and contribute to a new Traditional IRA?
At least until we begin WWIII…
I feel that I have a fairly good grasp on all the of concepts at work here, and I have a scenario where I would be a fool not to max out my and my spouses Roth options. Admittedly, my situation is quite unique. My wife and I will be adopting 3 children from foster care later this year. The children will qualify for an adoption subsidy from the state and are thereby considered “special needs”, which means that we can claim the full amount of the adoption credit for each child, a total credit of $41,520 even though our adoption expenses will be minimal. Our gross income is about $93,000. I believe that we will fail to use the entire credit during the current year or the 5 years of carryover. This means that for six years our tax rate will be $0. I am using all available ways to eat up this credit. I plan to sell our rental in the last year of the carry forward in order to do so without paying any capital gains taxes. I plan to sell and rebuy stock to reset our basis. I plan to fully fund our Roth IRAs to the limit. Any other options I should consider to use the credit to it’s max benefit?
I am over simplified things but calculating rough estimate taxation is always going to have some push backs. Lets say same amount of earning power contribution to both Roth and Traditional account. Since Roth IRA is limited to $5,500 annually (for the most part), Traditional contribution should be $5,500 / (1 – effective tax rate). For this calculation, lets use average growth of 6% annually for both accounts. We can calculate the ending balance after 30 years as follows: N=30 I/Y =6% PV=0. Lets also assume effective tax rate would be 20% on average.
This makes Traditional PMT equals to ($5,500 / (1-25%) or $7,333 annually and Roth PMT equals to $5,500. The ending balance for Traditional account would be $579,760 and Roth IRA would be $434,820. Since we already know Roth IRA paid $1,833 for 30 years, This means total tax paid in Roth IRA account equals $55,000. This makes Roth IRA effective tax to be $55,000 taxes paid / $434,820 ending balance = 12.65%
If the effective tax bracket is now at 20%, Roth IRA effective tax percentage drops to 9.49%
If the effective tax bracket is now at 33%, Roth IRA effective tax percentage increase to 18.69% These are the rates Traditional IRA or non company matched 401K needs to beat.
Please bear in mind, traditional account is a tax deferred account not tax free account. The cost of living may be going up, you may need gap insurance to cover expenses Medicare doesn’t provide etc. On average, you need 70% to 80% of your annual income in retirement. This means, even with the standard deductions on your distributions in traditional account, you effective tax bracket would only be slightly lower than your pre-retirement effective tax rate. Unless, of course, you are already near bottom of your marginal tax rate bracket.
Nerdwallet also conducted this type of analysis and Roth IRA wins in most scenarios. Regardless which vehicle you picked, just remember time, compound interest and low cost investment are your friend.
Alex, I agree with some of your math, and disagree with other parts. We’ll assume, as you say, $5500/year into a Roth vs $7333/year into a Traditional IRA since, as you say, you’re paying taxes at your 25% marginal tax bracket now for a ROTH.
I even agree with your math where you’re indicating in 30 years you’d have:
$579,760 in a Traditional IRA
$434,820 in a Roth
Here is where I digress from you however. Look at a real world example. You don’t ever pull out the entire Traditional IRA balance in year 1 of your retirement. Instead most financial planners suggest using the 4% rule for withdraws. Meaning you can take out 4% of the balance each year (adjusted for inflation) and in theory you should have enough money to last you about 30 years in retirement. This 4% rule is independent of if the money is in a Traditional IRA or a Roth as it’s applied evenly.
So if you take 4% out of your retirement account balances calculated above you’d be able to pull out:
$23,190/year for a Traditional IRA (Still need to pay taxes)
$17,392/year for a ROTH (Tax Free)
Now lets calculate the taxes owed on that pesky Traditional IRA. Assuming I’m a single tax filer:
Gross is $23,190
I get a standard deduction of $12,000 in 2018
So my Adjusted Gross Income (AGI) is $11,190 ($23,190 – $12,000).
Plugging $11,190 into the current 2018 tax brackets and you’d have to pay $1,152 in Federal taxes on the Traditional IRA withdraw.
$1,152 (taxes) divided by $23,190 (Gross income) means the effective tax rate for my Traditional IRA account in retirement is 4.97%
Subtract your taxes ($1,152) from your gross ($23,190) and you’d have a net of $22,037 after you pay taxes on a Traditional IRA.
So lets figure out the yearly difference between the Roth and Traditional IRA after all the taxes are paid:
$22,037 (Traditional IRA after I pay taxes) minus $17,392 (ROTH) equals $4,645.
So I’d be paying 4.97% in taxes and have an extra $4,645 to spend each year in retirement if I use a Traditional IRA instead of a ROTH. That’s almost a 27% difference!
Hands down, the Traditional IRA wins in this real life tax scenario!
The big takeaway is that your effective tax rate is always lower than your marginal tax rate which is why a Traditional IRA is better than a Roth IRA in most situations.
A few issues with your real life tax scenario. The first glaring hole is the limitations on IRAs are the same so you cant contribute $7333 to the traditional. I know Alex originally proposed this but you used it in your real life scenario. So assuming you plan to max out an IRA you would have the same balance after 30 years in either account. Yes one cost more to fund because your using after tax dollars but the does not infer you can contribute more to the other account.
Also the 4% rule is very sound but the point Alex made was you will need 70-80% of your pre-retirement income to retire. Which unless your making due with at a minimum $33,128… you will need more. Which means when your calculating your yearly income you need to include your other sources of income that don’t come from your IRA into the tax mix.
For example you might only be pulling $23,190 from the IRA, you will most likely have other income (unless you are actually living off 33K a year, but if that were the case you wouldn’t be paying into a ROTH at 20% anyways). In this case you dont simply plug 23K into the tax bracket, instead you would see what additional taxes you would pay on the 23K when added to your other income.
When you take into consideration that at the end of 30 years the accounts both have the same amount of money but one is already taxed…. you will see you can save more with a ROTH. Then consider you will pay taxes on the full amount in a traditional IRA over just the contributions with the Roth. In the model above you only did a year where as the real life model would be taxed year after year for 20 to 30+ years, where as the ROTH would continue grow tax free.
Not saying ROTH is better than the Traditional in every way, but I am saying this is not a good real life scenario.
So IF you max out an IRA (using 2018 contribution limits) and can live solely off 4% of that IRA, the yearly difference is
$22,037 (Traditional IRA after I pay taxes) minus $23,190 (ROTH) equals ($1,153).
NOTE: Those are your numbers…. I didn’t check the math.
Don’t forget that social security is also taxable income during retirement. That needs to be added into the effective tax rate formula.
dunno if anyone commented on this but you also have to take out your retirement in the increments you have it stored in your retirement accounts (ie 90% 401k and 10% Roth, then that is how you are able to with draw it). You can’t maximize tax savings by taking more from one account one year and another the next account.
Alex, I agree with some of your math, and disagree with other parts. We’ll assume, as you say, $5500/year into a Roth vs $7333/year into a Traditional since, as you say, you’re paying taxes at your 25% marginal tax bracket now for a ROTH.
I even agree with your math where you’re indicating in 30 years you’d have:
$579,760 in a Traditional
$434,820 in a Roth
Here is where I digress from you however. Look at a real world example. You don’t ever pull out the entire 401k balance in year 1 of your retirement. Instead most financial planners suggest using the 4% rule for withdraws. Meaning you can take out 4% of the balance each year (adjusted for inflation) and in theory you should have enough money to last you about 30 years in retirement. This 4% rule is independent of if the money is in a 401k or a Roth as it’s applied evenly.
So if you take 4% out of your account balances calculated above you’d be able to pull out:
$23,190/year for a Traditional 401k (Still need to pay taxes)
$17,392/year for a ROTH (Tax Free)
So now lets calculate the taxes owed on that pesky Traditional 401k assuming I’m a single tax filer:
Gross is $23,190
I get a standard deduction of $12,000 in 2018
So my Adjusted Gross Income (AGI) is now at $11,190 ($23,190 – $12,000).
Plugging $11,190 into the current 2018 tax brackets and you’d have to pay $1,152 in Federal taxes on the Traditional 401k withdraw.
$1,152 (taxes) divided by $23,190 (Gross income) means the effective tax rate for my Traditional 401k account in retirement is 4.97%
Subtract your taxes ($1,152) from your gross ($23,190) and you’d have a net of $22,037 after you pay taxes.
So lets figure out the yearly difference between the Roth and Traditional 401k after all the taxes are paid:
$22,037 (401k after I pay taxes) minus $17,392 (ROTH) equals $4,645.
So I’d be paying 4.97% in taxes and have an extra $4,645 to spend each year in retirement if I use a Traditional 401k instead of a ROTH. That’s almost a 27% difference!
Hands down, the 401k wins in this real life tax scenario!
The big takeaway is that your effective tax rate is always lower than your marginal tax rate!
I retired in 2008. Recently, I have been contributing $6,500 yearly from my bank Savings account to a Roth IRA for the past 4 years ($26,000 total) and has grown to approx. $34,000.
Recently, someone informed me that I cannot contribute to a Roth IRA since I am no longer working.
Also in 2008, 1) some of my retirement money approx’ly $40K was converted to IRA with a stockbroker and is currently about $50K.2) I have 403b invested approx. 85% in domestic stocks and 15% in international stocks for several years, which gaine approx. 16+% until Feb. 2018. Early in February, I converted my 403b to 60% bond, 35% domestic and 5% int’l stocks. I plan to hold it until early next year.
I would appreciate very much if anyone could give advice re 1) As a retiree, can I contribute to a Roth IRA (yearly $6,500) using my bank Savings Account? If not, what to do? 2) Should I convert my $50K w/ stockbroker from IRA to Roth IRA? and 3) Did I make the right decision to convert my 403b to 60% bond, 35% dom. 5% intl. stocks?
Thanks advance for any advice.
i am in similar situation and wondering who was the “expert” (or IRS instruction) that said you cannot contribute to a Roth IRA if you are no longer working?
Google “irs ira”. You will find the IRS definition of “Compensation for Purposes of an IRA”.
I forget where it’s specified, but I know that you cannot contribute more to a Roth IRA (or traditional IRA) than your earnings for that year; thus, it’s necessary to still be working. With the Roth IRA, there is no age limit on contributions, so it’s just the earnings requirement that would prevent people.
Dividend Driven says
I max out my Roth IRA at the beginning of the year as a birthday present to myself. As a single person I do wish they would at least double the amount you can contribute annually. For me I see the most important benefit of a Roth IRA is having the ability to control the money during retirement – meaning there are no required minimum distributions so you can allow the money to continue compounding.
Vrushali Pande says
I am a single working mom making $72k annually. I have a dependent daughter and file as the head of the household. Which IRA would be a good option for me?
Richard Costa says
The question of Roth versus traditional really comes down to whether you believe you will invest wisely, and what tax bracket you will be in when you retire. If you don’t invest wisely, are looking at a meager return on investment and you expect you will be in a low paying job most of your life then yes the traditional IRA is for you. If you invest wisely, pay attention to the stock market, and expect to be reasonably successful in life, then the Roth is for you. Consider this, if somehow you hit it big with a stock or two, double your investments, do you want it tax free when you retire or get whacked on the taxes? It’s a no-brainer for most people…..Roth!
I 100% disagree with your analogy! She’s not taking her whole 401k out in one lump sum in retirement! She’s taking it out slowly over the course of her retirement. The overwhelming majority of people will retire on an annual amount at or less than their last year of work. For arguments sake, lets say she’s making $75 (adjusted for inflation) when she retires. If she contributes right now, every dollar she invests in a ROTH will be federally taxed at her marginal tax rate which is 22%. However later in retirement when she takes out $75k/year from her traditional 401k she’ll get to subtract off her standard deduction of $12k so her AGI is $63K. Then she’s taxed progressively on that $63k. Using the current tax brackets, her effective rate tax rate will be 13.07%. She’s saving almost 9% in federal taxes by using a traditional 401k over a ROTH. If you live in a state that taxes income, then you’d see even more savings by using the traditional 401k. I would 100% hands down rater invest in a traditional 401k and pay 13.07% in taxes when I retire versus paying 22% in taxes now.
As the author indicated. The only time it makes sense to use a ROTH is if you’re in the 10% or 12% bracket now and expect to jump to at least the 22% later on. Even once you hit the 22% marginal bracket, you’d first want to use the 401k to get your AGI down to the 12% bracket, and then after that use the ROTH for the rest. Once you’re solely in the 22% tax bracket or above, it makes no sense to use a ROTH!
Hey Financial Samurai,
Came across this article and I am having some problems digesting the tax rational for contributing to a Traditional IRA vs Roth. I did my own math and came up with the conclusion that a Roth IRA is a better vehicle than a Traditional IRA.
Scenario assuming today’s tax brackets for single filer:
*100K Pre-Retirement Income…..(932+4,294+13,488+2268 = Tax Paid of 20,982)
*100K Pre-Retirement Income with 5,500 Traditional IRA contribution is 94,500 MAGI
(932+4,294+13,488+728 = Taxes Paid 19,442)
Tax Savings of 1,540
Assuming Tax Rates Never Change
*100K Post-Retirement Income from Traditional IRA = 20,982 taxes paid = Income of 79,018
*100K Post-Retirement Income from Roth IRA = 0 taxes paid = Income of 100,000
By contributing to the Traditional IRA I save 1,540 today, but I pay 20,982 later.
By contributing to the Roth IRA it costs me 1,540, but I pay 0 later.
In this scenario, the Roth IRA is the most attractive offer. Am I missing something?
Mark Kowaleski says
I love this site and have posted here a few times. This advice does not make sense. Any investment instrument that gives tax flexibility is worth considering. My challenge in my retirement cash flow, as for many, is a huge undesired wave of RMD from our TSP and Roll-IRAs – this produces income that, quite frankly, we do not need or want after age 70. With ROTH we can isolate income after age 70 and withdraw ROTH only when and if needed – with zero tax implications. This way we can max out our withdrawals from TSP/IRA to maximize income in the early years when we are healthy and able-bodied. Most folks with sizable retirement money (greater than $1M) will get pounded with taxes due to RMD after age 70. ROTH is also tax free inheritance to the beneficiary, so this solves the dilemma of parents desiring to leave a financial legacy to their children vs. spending down all of it on themselves. If I live to 100 and I don’t need the ROTH balances, my daughter gets all of it tax free. It is a win-win all around. The other huge benefit with any type of IRA is that you can invest with zero paperwork for taxes for gains and losses – we have made a small fortune in our Roth IRAs that are competely free of dealing with captital gains. I see zero downside to maxing out ROTH IRA if it is available to you. Lastly, any money in any IRA is not typically counted for college financial aid – it is a great way to shelter your money. My order of priority is:
1) max out TSP/401K to point of matching contributions
2) max out ROTH IRA
3) max out rest of TSP/401K
4) pay off mortgage (equity not included for college EFC)
5) pay off student loans, etc. if you have these debts.
I started the Roth as an emergency fund. I did not have the emergency fund everyone said I should have (3 months worth of expenses, 6 months, whatever) so I thought I would hedge: if there is an emergency I can withdraw the contributions, if there is no emergency then I have another retirement account. Besides, the rates I could get from a savings account were insulting. The emergency never happened (or hasn’t happened yet) and even after I reached the recommended emergency amount I kept contributing. Maybe after a while I should have switched contributions to a regular IRA but I liked the flexibility of having some money taxed and some deferred (from a 401k). My decision wasn’t the best but I feel pretty good about it, as I could have just spent the money.