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To Roth or not to Roth? That is the Question

by
Zacc Call

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To Roth or not to Roth? That is the Question

The basics

Traditional: Your contributions are made with pre-tax funds. Typically, contributions are done through 401(k) payroll deductions or deductible individual retirement account (IRA) contributions. You will be taxed on withdrawals.

Roth: Your contributions are made with post-tax funds. Newer 401(k) plans are starting to offer Roth payroll deductions. Depending on your income, you may make a Roth IRA contribution. You will never be taxed on withdrawals if you remember to follow some rules.

The Math Myth

The math myth I am regularly told that it will save you “Scrooge McDuck” quantities of wealth if we pay the taxes up front and make Roth contributions. Who wouldn’t want to swim backstrokes in a multistory money bin of gold coins? Maybe I stretched it a little and they really say, “the account will be so much larger later and Roth IRAs avoid taxes on a larger amount.” The logic seems sound. Not so fast: that logic does not match the math.

Make these assumptions:

• You are paying 22 percent federal tax plus 5 percent state tax. In 2018, this applies to a couple making between $77,400 and $165,000 of net income and a single person making between $38,700 and $82,500.

• You can save $10,000 per year of your pre-tax income.

• You average 8 percent growth per year on your investment for 15 years.

• You are in the same tax bracket when you withdraw the funds in retirement 15 years later.

Either way, the result is $23,157. For a moment, set aside the awe-inspiring magic that patience just turned $10,000 in to $23,157 at a very reasonable rate of return and pause to notice that it didn’t matter whether you chose the traditional or Roth scenario. So why the ado?

The reasons you should still care:

1. You expect your tax rate to drop.

2. You expect your tax rate to rise.

3. You already max out your contribution limits and want to ultra-fund the accounts.

4. You want to tax diversify to prepare for retirement marginal tax bracket management (my geeky personal favorite).

Let’s take a look at each.  

1. You expect your tax rate to drop.

This is common for those who live below their means. Roger and Jean (names changed) recently retired. He is a doctor and has been making $400,000 per year for many years. They have been incredible savers and only live on $65,000 per year. Their taxable income – and therefore tax rate – will be significantly lower in retirement. The pre-retirement tax rate would be 32 percent at$400,000. The post-retirement tax rate would be 12 percent. This is an extreme example, but it shows the numbers well:


In a high to low changing tax rate situation, traditional contributions clearly win $27,915 to $21,571.  

2. You expect your tax rate to rise.

The current tax brackets are scheduled to revert to 2017 levels in 2026. In other words, if you are in the 22 percent bracket now, your rate would likely go back to 25 percent in 2026. We are experiencing historically low tax rates right now. If you feel that rates will rise or that your income will rise, your results change.  

In a low to high changing tax rate situation, Roth contributions clearly win $24,743 over $23,791.  

3. You already max out your contribution limits and want to ultra-fund the accounts.

If you are under 50 years old, in 2018, your 401(k) contribution limit is $18,500. Add $6,000 to the limit for those over 50 as a “catch-up” contribution. A contribution of $18,500 to a Roth 401(k) is equivalent to a contribution of $25,342 to a traditional 401(k) assuming a 27 percent total tax burden to get the funds out.  

$25,342 minus 27 percent tax ($6,842) equals $18,500

If you have the discipline, a high tax bracket individual should max out traditional 401(k) contributions, avoid the high-er tax now, and invest the tax savings of $6,842 into a general brokerage account. If you won’t make the last step happen, max out the Roth contributions.  

4. You want to tax diversify for better marginal tax bracket management.

“Marginal tax bracket management” may be the most boring line of script the writers of a sitcom could conjure up for an accountant to say before being snubbed by the popular lead character. I do not disagree; however, the thought of paying an average tax rate of 8-12 percent on $150,000 of annual income in retirement gives me goosebumps. Yes, I realize which character that makes me in the sitcom example.  

Marginal tax bracket management is watching the tax bracket lines closely and slotting the right type of income in each bracket as you withdraw in retirement. You must have funded multiple tax structures in your saving years. Imagine if you were able to fill the 10 percent and 12 percent brackets with Social Security and IRA withdrawals. You avoid the 22 percent bracket by taking your next income from selling positions at along-term capital gain. You experience a 15 percent long-term capital gain rate applied only to the growth. Then you avoid the 22 percent and 24 percent brackets by using some Roth dollars and possibly paying for a few healthcare expenses with HSA money. Assuming you take a standard deduction ($24,000 in 2018), your brokerage accounts had doubled in value, and half of the $50,000 (in blue above) was capital gain, this couple would experience roughly a 6.5 percent effective federal tax rate on $150,000 of annual income. Maybe it really is “Scrooge McDuck” multistory money bins.

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