When I first learned about IRAs, I thought the Roth IRA would be a great choice for me. I’m a graduate student living off a stipend and hanging out in one of the lower tax brackets. I could just pay my relatively low taxes now, let my money grow inside the Roth IRA, and never have to pay taxes on any of my gains in retirement! Despite the fact that all of the above is true, I was pleased to eventually find out that I was actually wrong! The Traditional IRA is the better choice, even for me. This post will explain why.
Quick note: if you’re not comfortable with the basics of federal income taxes and how long term capital gains taxes work, you may want to pull up my Intro to Taxes post to refer to as you read this. Also, above certain income limits, you won’t be able to contribute to a Roth (sort of, we’ll talk more about this later!) and Traditional IRA contributions will not be tax deductible.
The seeds and the trees
A while back, the MD/PhD program at my university invited a financial adviser (more on those in a later post!) to speak to us about some personal finance basics. Between the free dinner at the talk and the fact that I was a budding finance nerd, I went and sat right in the front. Not surprisingly, he touched on the subject of Roth vs Traditional IRAs. He described money we contribute/invest as seeds that would eventually grow into trees. Would we rather pay tax now on the seeds (Roth IRA) or have to pay money on those huge trees later (Traditional IRA)?! This overly simplistic and pretty stupid analogy misses a few key points. So I figured it would be good to pick it apart a little bit like the intelligent people we are.
The Either/Or Scenario: 25% now or later
Let’s assume that we have four seeds. Let’s also assume that our current marginal tax rate1The tax rate you pay on your last dollar of earnings, aka the tax rate in the highest tax bracket you’re in. is 25%, and that we’ll also be taxed at 25% in retirement. If we go the Roth route and pay the 25% now, we’ll have three out of four seeds remaining, which will grow into three beautiful trees that we get to keep all to ourselves. If we go the Traditional IRA route, we get to keep all four seeds now, they’ll grow into four nice trees, and then we’ll be hit with the 25% tax. This will result in us having to pay one tree in taxes, ending up with guess what?! Three trees. So, assuming equal taxation before and after retirement, it doesn’t matter if you choose Roth or Traditional IRA.
Why your taxes are lower in retirement
So really, if the tax rate is the same, it doesn’t matter whether or not you pay taxes on the seeds or on the trees. But in almost all cases, the tax rate in retirement will be lower, and here’s why. Let’s take a look at the tax bracket chart for married couples filing jointly:
When you contribute to a Traditional IRA, you start with the last dollar that you earn–that is, the dollar taxed at your marginal (highest) tax rate depending on what tax bracket you’re in. So if I’m in the 12% tax bracket (woot woot!), I get to avoid paying 12% of my Traditional IRA contributions in taxes. Cool. Now fast forward to retirement. My income is $0 since I’m no longer working. If I go withdraw some money from my Traditional IRA, it gets taxed as income. But recall that the first $12,000 of income ($24,000 if you’re married) IS NOT TAXED!!! (Thanks to the standard deduction. Remember back when I said this would be important to keep in mind?). Above $12k/24k, you use the tax tables to calculate your taxes. For example, let’s say you want to withdraw $120,000 (because you happen to be terrible at defense and also because I’m making an extreme example) from a traditional IRA and/or 401k when you’re retired, and you are married. To get your taxable income, subtract the standard deduction of $24k. That leaves you with $96k. Taking a look at our handy chart, the tax due is $8,907 plus 22% of the amount over $77,400, which makes $12,999 in taxes. Dividing by our total income of $120k, that means that we pay an EFFECTIVE, or average, tax rate of about 10.8%. Recall that when we contributed, we avoided paying 12% in taxes. 10.8 is less than 12! So even though we were in a low tax bracket at the time of contribution, and a stupidly high tax bracket in retirement, Traditional was still the better choice. Essentially, if your effective tax rate in retirement is lower than your marginal tax rate when you contribute, which it will be, Traditional wins.
In reality, this what what will happen. First of all, your income in retirement will likely not be multiple times higher than it was when you were working like it was in my silly example. Also, since you are an intelligent and capable individual, you will likely make pretty good money at some point in your life. At that point, you’ll max out your contribution to retirement accounts and have extra money to save. You’ll stick that money in a regular old brokerage and use it to buy some Vanguard Total Stock Market index fund (VTI). When you retire, you’ll take out some money from your 401k/IRAs, but you’ll also supplement by selling stock in your taxable account. That will be taxed at a long term capital gains rate of 0% (assuming you’re in a reasonable tax bracket), thus lowering your effective tax rate even more. After considering these additional points, the Traditional IRA is by far the better choice.
But what if I want to retire early?
As it turns out, Traditional IRAs are an even better choice for early retirees, because you can CONVERT money from a Traditional to a Roth and access it 5 years later without tax OR penalty. Here’s how this would play out. Say you’re a 40 year old early retiree, and you’re married. First year, you convert money from Traditional to Roth. The conversion is taxed as income, but THE FIRST $24,000 OF INCOME WILL NOT BE TAXED (have I hammered this point home yet?). So you decide to convert $24,000 in your first year, and then sell, I don’t know, another $60,000 or so of stock from a regular brokerage account to fund your wasteful, luxurious retired life during that year as well. Since your long term capital gains rate at that income is 0%, you pay $0 in tax. You keep converting each year, and after 5 years you can take out the amount you’ve converted 5 years ago without penalty. Since this WON’T count as income, you can go ahead and keep your yearly Traditional to Roth conversions going even after you start taking old conversions out. And thus, you will never pay taxes in retirement!
Other financial bloggers have described this process simply and beautifully. Check out posts on this topic by Go Curry Cracker (summarized nicely by The Frugal Professor) and The Mad Fientist (including a really nice infographic) for more details.
Wow, what a world we live in! Ok, here’s the point(s):
Traditional > Roth because contributions are taxed at your MARGINAL tax rate, while withdrawals are taxed at your EFFECTIVE tax rate, which is 0% for the first 12k/24k of income.
Additionally, Traditional IRA money can be converted to Roth (for free up to 12k/24k per year), and then taken out after 5 years without tax or penalty for early withdrawal.
So, should you never ever open a Roth until you’re ready to convert? Not necessarily–the Roth still has the advantages noted in my last post ($10,000 house purchase withdrawal, access to principal), so it might make sense to open one, contribute a little bit, and then focus your attention on Traditional. Because in almost all circumstances, that will be the better choice.