Two Pieces of Unconventional Wisdom in the Traditional vs. Roth IRA Debate

There are some flaws in the conventional wisdom surrounding the traditional vs. Roth IRA debate that may be costing you money.

The conventional wisdom says that when deciding between a traditional IRA and a Roth IRA, you should compare your tax bracket now to your expected tax bracket in retirement and make your decision according to the following rules:

If you expect your tax bracket to be higher in retirement, contribute to a Roth IRA. You sacrifice the deduction today for tax-free withdrawals in retirement.
If you expect your tax bracket to be lower in retirement, contribute to a traditional IRA. The current tax savings will outweigh the tax hit later on.
If you expect your tax bracket to be the same in retirement as it is today, you’ll end up with the same amount of money no matter which account you use.

This logic typically leads younger investors to a Roth IRA, given the expectation that their income will increase over time. It also leads investors in lower tax brackets to a Roth IRA, given that it would be hard for their tax bracket to decrease.

But there are two key points that are missing from this conventional wisdom, both of which make the traditional IRA look more favorable, even for young investors and even for people in lower tax brackets.

Understanding them could result in more retirement income for you down the line, and maybe even an earlier retirement date.

Missing Piece #1: Evaluating the Right Tax Rates

The first missing piece requires a quick understanding of the difference between two different tax rates:

Marginal tax rate: This is the tax rate you pay on your last dollar of income. When you look up your tax bracket, what you’re really looking up is your marginal tax rate. Someone in the 25% tax bracket paid 25% of their last earned dollar to the government in taxes.
Effective tax rate: This is the average tax rate you pay on every dollar of income. Because we have a progressive tax code, different dollars are taxed at different rates. Someone in the 25% tax bracket is partially not taxed, partially taxed at 10%, partially taxed at 15%, and partially taxed at 25%. So their effective tax rate is lower than their marginal tax rate.

The traditional vs. Roth IRA debate typically focuses on marginal tax rate. The argument is that unless you plan on being in a lower marginal tax bracket in retirement, a Roth IRA like makes the most sense since it will at worst break even.

But this this argument ignores two things:

Contributions to a traditional IRA today will likely save you money at your marginal tax rate. Since the contribution limits are relatively small compared to the tax bracket ranges, it’s unlikely (though possible) that the contribution will span multiple tax brackets.
On the other hand, you may be withdrawing tens of thousands of dollars per year in retirement, and those withdrawals could absolutely span multiple tax brackets.

Given those two points, it usually makes more sense to make the traditional vs. Roth decision by comparing your marginal tax rate today to your effective tax rate in retirement. If your effective tax rate in retirement will be lower than your marginal tax rate today, a traditional IRA is likely the better choice.

This makes the traditional IRA case a lot more compelling, simply because the effective rate is often lower than the marginal rate, unless there’s a significant increase in income over the years.

Let’s look at an example.

Mark and Jane are 32 with one child. They make $70,000 per year, putting them squarely in the 15% tax bracket (marginal rate).

They’re setting up their retirement savings and they know that because of the tax deduction, they could afford to max out their traditional IRAs with $11,000 in combined pre-tax contributions. But they could only contribute $9,350 (post-tax) to their Roth IRAs, since they wouldn’t get the 15% tax break on those contributions. (Essentially, because it’s tax-deferred, they can contribute 15% more to a traditional IRA without affecting their take-home pay.)

Assuming that their income remains about the same and that they make those same annual contributions every year until they retire at 67, here’s how much income they would have available to them in retirement in each scenario (Social Security benefits were estimated here and taxes here):

Roth IRA

Roth IRA Income = $35,469
Social Security Income = $27,720
Taxes = $0
Total Annual After-Tax Retirement Income = $63,189

Traditional IRA

Traditional IRA Income = $41,728
Social Security Income = $27,720
Taxes = $4,229
Total Annual After-Tax Retirement Income = $65,219

This couple is in the 15% tax bracket both now and in retirement. According to the conventional wisdom, they should have ended up with the same amount of money either way.

But they have $2,030 more in annual retirement income using the traditional IRA because of the difference between marginal tax rate and effective tax rate.

Their $11,000 contribution today saves them 15% in taxes, while their $41,728 withdrawal in retirement is taxed at a 10.13% effective tax rate. That 4.87% difference generates the extra income.

It won’t always work out like this, but you should run the numbers yourself before assuming that the conventional wisdom is correct.

Quick note: This same logic applies when deciding between regular 401(k) contributions or Roth 401(k) contributions.

Missing Piece #2: The Opportunity to Convert

The second point that’s often missed in the traditional vs. Roth IRA debate is the fact that you can convert money inside a traditional IRA to a Roth IRA at any time, without any income limits.

This is what allows high-earners to get money inside a Roth using the “backdoor Roth IRA” strategy, but it also allows everyday people more control over when they take the tax hit of contributing to a Roth.

There are plenty of scenarios in which you might deal with a temporary decrease in income. Changing jobs. Switching to a single income. Starting a business. Unemployment. Early retirement. Going back to school.

Any of those situations may push you into a lower tax bracket, which could be an excellent opportunity to convert some of your traditional IRA money to a Roth IRA and gain some big tax savings.

Let’s say that you’re currently in the 25% tax bracket. An $11,000 contribution to a traditional IRA today saves you $2,750 in taxes, meaning that without adjusting anything else in your budget you would only be able to afford an $8,250 contribution to a Roth IRA.

But what if in a couple of years you go through one of those transitions and you drop into the 15% tax bracket? Well, now you could convert that $11,000 to a Roth IRA, pay $1,650 in taxes on the conversion, and save yourself $1,100 compared to making the Roth IRA contribution earlier.

Contributing to a traditional IRA now gives you more flexibility to control when and how you take the tax hit, potentially allowing you to capitalize on lower earnings years by converting money to a Roth.

On the other hand, contributing directly to a Roth IRA today locks in your current tax rate, removing the opportunity to save money by converting later on if your income decreases.

Making a Smarter Decision

None of this is to say that contributing to a traditional IRA is always the right move. The Roth IRA is a great account and can be used effectively for a lot of different financial goals, including retirement.

It’s just to say that the traditional IRA is often better than conventional wisdom makes it out to be. If know you how to evaluate it the right way, you may find yourself with an easier path to retirement.

Matt Becker is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents take control of their money so they can take care of their families. His free book, The New Family Financial Road Map, guides parents through the all most important financial decisions that come with starting a family.

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