Roth vs. Traditional: 3 Things You Didn't Know That May Push You To A Roth Account Over Traditional Even If You’ll Pay Higher Taxes Now.
The Roth vs. Traditional Debate is one that is long and drawn out on many sites across the internet. The typical argument comes down to what you think your tax rates will be now versus in retirement.
If you’re not familiar with this argument, it goes something like this:
If your marginal tax rates are lower now than expected what is in retirement, one should favor the Roth account.
But, If your marginal tax rate is higher now than what is expected in retirement, one should favor the traditional account.
The idea here is that the final decision rests on what will help you keep the most money after investment growth and taxes.
Well, today I’m going to attempt to give you reasons that will outweigh strictly looking at the numbers since we can’t predict tax rates in the future anyway.
For those not fluent with the difference between Roth and Traditional accounts, the big difference is in how the money is taxed now and in retirement.
Money saved in a Traditional account (401k or IRA) is saved before tax. What this means is that the money goes in before taxes are applied. You do not pay tax today. If you put 10% of your paycheck into a traditional account, a full 10% of your salary goes in. This money will be fully taxed when withdrawn in retirement. By putting money in before tax, you essentially have more dollars working for you.
Money saved in a Roth account (401k or IRA) is taxed now, at your current rates, but is forever protected from taxes in retirement or after age 59.5 when you can start withdrawing it without penalty. (Unless Obama gets his way. He has brought up legislation to tax these accounts, but even if it did go through, most legislation like this is not done retroactively so I don’t feel there’s much to worry about.)
Ok, so here are a couple reasons I feel it may be worth it to (GASP!) pay higher taxes now to get more Roth money stashed in your accounts.
1. Money withdrawn from Traditional retirement accounts can affect your other retirement benefits.
Since money from Traditional accounts increases your income level for the year, this can not only affect the tax you pay on Social Security, but your Medicare premiums may also be adjusted depending on your income level. You pay more in Medicare premiums when your income rises.
While this may seem like a relatively high threshold, it comes into play nonetheless, and when you withdraw money from a Traditional account, this money is included in your income for the year. Furthermore, once you reach age 70.5, you lose control of whether you have to take distributions or not.
With a Roth IRA account, you don't have the Required Minimum Distribution (RMD) rule. Keep in mind, employer Roth accounts currently do have the RMD rule, but it’s easy to defeat this by rolling over your account to a Roth IRA.
2. If you have to tap into your retirement account early, Roth accounts are much more flexible.
Look, I would never recommend tapping your retirement account for emergencies, but, it does happen. When you consider the consequences of tapping a Traditional account versus a Roth, there’s a clear benefit to having Roth available.
Say, for example, you face a period of unemployment or emergency that drains your 3-6 month emergency fund I recommend you have. What’s going to happen if the only money you have is in your retirement account?
Here are your two scenarios:
You tap your traditional account. First of all, your withdrawals are generally taxable. Add to that, what if this happens in a year where you’re still working? Say you’ve already used up the lower tax brackets. Well, now you’re paying your top tax rate on what you take money out. If you do this before you’re 59.5 years old, you could be hit with a 10% penalty tax for taking an early distribution from your retirement savings.
There are some exceptions to this such as if you were to have heavy medical expenses. There isn't a general hardship exception in the law. But, many people get hit with this penalty at the worst possible time.
If you’re in California for example, if you make $51,530 - $263,222 you’re in the 9.3% state tax bracket. If you make $37,650-$91,150 you’re in the 25% federal tax bracket.
Say you make $75,000 annually and you need to take a withdrawal and you lose your job October 1st. Well you’ve already made $56,250 for the year so if you took an early distribution, you would be paying 25% federal tax, 9.3% state tax and if you’re under 59.5 years old you could be hit with a 10% penalty. This totals 44.3% in taxes. Well if you took an early distribution, of $50,000 you would only be left with $27,850.
So you went from $50,000 to $27,850 of available money? Sounds crazy right.
Let me take this to the next level. Say you didn’t ever take that money out because you had enough emergency savings. Well if you were 35 years old with 30 years until retirement age and you were to let that $50,000 compound at 8%, well your early distribution would have cost you $503,132.84. OVER A HALF A MILLION DOLLARS!
It sounds absolutely insane when you think about it.
What would have happened if you would have taken this money from a Roth account?
Yes, if you take it out you lose the compound interest in the last example, but in regards to taxes and penalties, you save yourself a bunch of headaches.
No matter when you pull money from your Roth account the portion treated as coming from your contributions will be free of tax and also free of the 10% penalty. If you were to pull the amount counted as earnings, yes you would have to pay income tax and potentially an early withdrawal penalty, but usually, this is a small portion if any.
3. If you’re in the same tax bracket now as you will be in retirement, it’s a break even in usable dollars.
What a lot of people don’t talk about is that if you’re in the same tax bracket now as you will be in retirement, you will end up with the same amount of money so it’s a draw. If you consider the points I previously shared, then the benefit of a Roth account is not in usable dollars, but in flexibility of the account.
Here’s an example for the numbers people.
Assume you’re in the 25% tax bracket and you contribute $4,000 to a Traditional account which gives you a $1,000 tax saving or you contribute the same amount after tax into a Roth so you contribute $3,000.
Keeping after-tax costs the same, you invest in the exact same investments. Say you leave the money invested long enough for it to triple.
Well in the Traditional account you would have $12,000 and in your Roth account, you would have $9,000.
If you wanted to take this money out, and you were still in the 25% tax bracket, if was in the Roth you would be able to take out the full amount of $9,000 without taxes. If you were to pull the $12,000 out of the Traditional account, you would pay 25% of that to taxes and end up with the same $9,000.
So, in this case, it’s a break even.
Now, I know what you’re going to say if you’re a student of this argument. Most likely, it’s something like, “well with a traditional account you start by filling up the 0%-15% tax brackets first so technically your effective rate would be less than 25%. And you would be right.
And this argument holds up for a while until you hit 70.5 years old and now RMD’s (required minimum distributions) come into play.
And yes, you still may come out ahead, but what if we’re planning for long-term wealth transfer?
And since distributions from Traditional accounts are considered income for Social Security purposes, the waters can get a little more muddy than just considering effective tax rates.
We’ll dig into this in Roth vs. Traditional Part 2.
What are your thoughts so far? Are you on-board with the Roth argument yet or do I still have some work to do to win you over?
Jason J. Hamilton