One of the most frequent questions I hear from investors is ‘should I contribute to tax-deferred accounts, like a Traditional -401k, Individual Retirement Account (IRA), or Simplified Employee Pension (SEP) or should I contribute to my Roth -401k or IRA?’
Before we get there, let’s do a quick refresher on both options.
You put pre-taxed money in these accounts and they grow tax deferred. At some point in the future, when you take a distribution, you pay taxes. In most cases, with employer-sponsored plans, your contributions go directly into the plan without paying any income taxes.
Typically, with Traditional and SEP IRAs, the money deposited into these accounts has already been taxed. For example, at end of the year you deposit $5,000 into your IRA. That $5,000 was after-tax money deposited into your savings account from your pay check. Because you deposited after-tax money into a pre-tax savings account, when you do your taxes, you’ll report the contribution. You’ll reduce your taxable income by the amount of the contribution and reduce the amount you owe in taxes.
You put after-tax dollars into Roth accounts and the money grows tax free. At some point in the future, when you take distributions, the distributions are tax free, with a few caveats.
With Roth IRAs, money deposited into these accounts has already been taxed. Contributing to a Roth will not reduce your taxable income, like the Traditional IRA. Despite that, you’ll still want to report your Roth contribution to your tax preparer. Contributions are not reported on your tax returns, but you should keep track of your basis, which is the amount of money you’ve contributed to the account(s).
Which Should I Choose?
In the process of deciding between the two vehicles, your future income tax bracket should be considered. There are three possible outcomes for your future income tax rate.
1. There is no change from today
2. It’s higher than today
3. It’s lower than today
Your Income Tax Rate in the Future is the Same as Today
Let’s discuss the easiest first. From a tax perspective, if you don’t expect your income tax rate to change, deciding between a Roth and a Traditional IRA is somewhat irrelevant. That may sound counterintuitive. Whether you pay 30 percent in taxes today or you defer the taxes and pay them in retirement, one way or the other you’ll pay 30 percent in taxes.
Your Income Tax Rate in the Future is Higher than Today
Generally, if your income puts you in the 10 – 22 percent Federal tax bracket, I’d consider a Roth IRA. It’s not a one-size-fits-all recommendation, but it’s a good rule of thumb.
While I’m not predicting the direction of tax rates, based on historic rates, global rates, and our political climate, I’d assume it’s more likely that rates will go up than down in the future.
Your Income Tax Rate in the Future is Lower than Today
If you believe your tax rate will be lower in the future, consider funding your Traditional IRA. Let’s assume you’re single and make between $204,101 and $510,300 or are married making between $408,201 and $612,350. This income would put you in the second to highest Federal tax bracket, 35 percent.
To maintain these incomes on the low end of the tax brackets, $204,101 and $408,201 respectively. The following chart shows how much money you would needed at retirement assuming a four percent withdrawal rate after 30 years of investing.
If you expect to meet or exceed the funding demands required to put you into the same expected tax rate, there are additional considerations and planning opportunities you should consider. I’ll discuss those in a future blog titled “Should I Choose a Traditional or Roth for High-Income Earners.”
You can’t predict future tax rates. In a recent post, I discussed thinking about planning decisions like this in three- to five-year increments. You’re more likely to know what your taxable income with be in three years than trying to predict what it’ll be in 30.
Current and future tax rates are not the only factors you should consider in your decision-making process. Future income potential, flexibility wanted, legacy planning, the type of savings vehicles you have available, future income needed, and retirement location should also be factored into your decision.