Ruminating On Roth

It is the second week of April, so all minds naturally turn to taxes.  And one of the things that often comes up is Roth (both IRA and 401(k)).  The decision on whether to use a Roth versus a Traditional retirement account is never as straight-forward as it seems.  So here are some thoughts that I have when I do the comparison, either for contributions or conversions.

Pay Me Now or Pay Me Later

The IRS will eventually get its money from you.  You will either pay taxes when you put the money in (Roth) or when you take the money out (Traditional).  At the first level the math is simple.  If your tax rate is lower now than it will be in the future chose the Roth.  Make the opposite decision if you tax rate will be lower in retirement.  But, determining your tax rate now may be harder than you think.  Will contributing to a deductible Traditional IRA/401(k) now lower your Adjusted Gross Income (AGI) and make you eligible for credits or deductions you wouldn’t normally get?  If so, the effective reduction in your taxes will be higher than your marginal rate.  You need to do the second and third level analysis.

It Is All About Maximizing Income In Retirement

Distributions from Roth accounts are not considered income for tax purposes.  Distributions from Traditional accounts, on the other hand, are.  If you will not have a Pension in retirement and only have your savings and Social Security then a Roth may make more sense.  That is because if you have “too much” income (and it is not that much), your Social Security Income will be taxable.  However, if the other major portion of your income comes from a Roth account, you won’t have that much “income” and your Social Security will not be taxable…more money in your pocket.

You Also Want As Much Matching As Possible

If you invest through a Traditional 401(k) it is possible to get $1 of matching for less than $1 of income ($1 of income contributed to a Traditional 401(k) reduces taxes by some amount resulting in less than $1 in income for $1 in matching).  On the other hand, you need earn more than $1 in income to get $1 of matching in a Roth 401(k).  You can think of it this way:  Income – Taxes = $1 = $1 matching.  By the way, employer matching goes into a Traditional 410(k) not a Roth  (Uncle Sam is going to get his cut eventually).

You Should Think About Your Legacy Plans.

Roth IRAs do not have Minimum Required Distributions.  All 401(k) and its cousins 403(b) and TSP (including Roth) accounts and Traditional IRAs have Minimum Required Distributions.  Therefore a Roth IRA can be an extremely effective, tax efficient way to pass on assets to the next generation.

There are obviously other factors in the decision (eligibility for Roth IRAs as one example), but these are some of the things I think about when it comes to Roth IRA/401(k)/403(b)/TSP versus Traditional decisions.

About the author

Curt Sheldon, EA, MBA

One Comment

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  • This is a good discussion. I especially like the inclusion of qualifying for tax credits as a criteria. One other aspect that I rarely see mentioned is the different between marginal and effective tax rates and how that should be factored in.

    For example, let’s say you’re currently in the 15% tax bracket. The conventional wisdom is that you should go Roth because you’re in a “low” tax bracket. But by forgoing the Traditional in favor of the Roth, you are choosing to pay 15% taxes on that entire contribution. Let’s say that when you withdraw that money, you are still in the 15% bracket. The difference is that because of our progressive tax code, not all of your withdrawal will be taxed at 15%. Your effective rate will be lower than 15%, because some will not be taxed and some will be taxed at 10%. So you would have paid more taxes with the Roth, even though you’re in the same tax bracket.

    There are nuances there that are important to evaluate, but it’s a point that often gets overlooked. People simply base their entire analysis off the marginal rate now vs. retirement, but I think that’s missing a key component.

    Thanks for the helpful info. They certainly don’t make any of this easy for us lowly taxpayers!

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