The standard advice is for young people to use Roth accounts and for older folks to use traditional accounts. To which I say hooey. From 18 to 55 your age has little bearing on your tax situation. Choosing whether to use a pretax (traditional) of after tax (Roth) account is entirely determined by your current and projected tax situation. Lets look at some of the factors that influence whether to use a traditional versus Roth accounts for retirement savings. Both types of account exist for both 401k and IRA accounts.
The Argument for Roth Accounts
When something wells up as popular advice I try to understand how it got to be that way. For the case of young people should contribute to a Roth account advice it makes sense in some scenarios. In general younger folks aren’t earning as much as they will be later in their careers. So they have less taxable income to shield from taxes at this point in their lives than they will later. If the last dollar earned is taxed at 10% or 15% paying low taxes now, allowing the funds to compound in the account, and then having tax free withdrawals later might just be a good plan.
The Argument for Traditional Accounts.
Does the advice to use a traditional IRA later in your career hold out? Yes, if you are earning a higher income. If the last dollar earned is taxed at 25% then it makes sense to shelter that income from taxes in a tIRA. But, not everyone earns more as they progress in their career. And young folks in high demand specialties can be raking it in. Making the pretax option a good one early in their career.
For this example lets assume we a looking at a single worker earning $45,000 a year. For 2016 they pay 10% on earnings from $0 to $9,275. Then pay 15% on earnings from $9,276 to $37,650. And 25% on earnings from $37,651 to $91,150. Their income tax liability is $9,275 * 0.10 + $28,375 * 0.15 + $7250 * 0.25 = $927.5 + $4256.25 + $1812.50 = $6996.25. The standard deduction for 2016 is $6,300 for our single filer so actual tax owed is $6996.25 – $6300 = $696.25.
Now let’s start stashing cash in pretax accounts and see how low this can go.
Giving us 45,000 – 18,000 – 5,500 – 3,350 = 18,150 for a tax liability of 9,275 * 0.10 + 8875 * 0.15 = 927.5 + 1331.25 = 2258.75 well below the standard deduction so no income tax is owed.
To make things even better if your AGI in 2016 is not more than $18,500 for a single filer then you qualify for the savers credit. There are a few other stipulations such as you can’t be a full time student, a dependent on someone else’s tax return, and must be age 18 or older. Let’s assume our example person meets these criteria. In this case %50 of the contribution to a retirement plan or IRA up to $2,000 is returned as a credit. so that’s a $1,000 credit on the income tax return for lowering AGI.
Now our example person retires and starts taking distributions. But even pulling $25k annually from investments leaves a tax liability below the standard deduction. So the money was stashed pretax and later withdrawn without incurring tax liability.
Now we’ll run this example with the post tax Roth account. Total income for our single filer of $45,000. Total income tax owed $696.25. $5,500 is deposited in the Roth IRA. The future distributions will not be taxed, but taxes were paid now when the money was earned.
In 2016 for single taxpayers the phase-out range for traditional IRA accounts is $61,000 to $71,000 and it is $117,000 to $132,000 for the Roth IRA. These numbers are for MAGI so a single taxpayer with a MAGI under $61,000 can take full advantage of a tIRA and doesn’t qualify for a deduction with a MAGI above $71,000. And is only eligible for a partial deduction between $61,000 to $71,000. The take away is that at certain MAGI levels the tIRA and Roth IRA are no longer available and that the limit for the Roth is higher than the traditional. The above numbers assume all parties are covered by a workplace retirement plan. There is a different table with higher limits for those not covered by a workplace retirement plan. These numbers get updated each year so check the IRS website for current numbers.
If your taxes are higher now compared to what they will be when taking distributions traditional pretax accounts are the clear winner. If your taxes are lower now compared to what they will be when taking distributions the Roth account can edge out the traditional. My crystal ball is cloudy so I don’t know how the rules will change in the future. So, I tend to take all the tax advantage I can now with traditional accounts. I used to split my contributions between traditional and Roth accounts. Since it isn’t an all or nothing decision. Even though I don’t contribute to the Roth any more having it available will give me flexibility when it comes time to start taking distributions. Since I will have the option of pulling from the traditional account on which I will owe taxes or from the Roth on which I will not.