Should I Fund a Roth or a Traditional Account?

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Should I Fund a Roth or a Traditional Account?

Which retirement account to fund, a traditional or Roth account, is a difficult decision to make. The tax bill of the present makes a Roth account feel costly. But, as with many financial decisions, such gut feelings deceive us.

Regardless of whether the account is an IRA or 401(k), the difference between funding a Roth and a traditional account is when you pay your income tax. For a Roth contribution, you pay tax on the money now. For a traditional contribution, you pay tax on the money later.

The trick is that the money you are paying tax on is not the same.

A Roth contribution must come from your income and neither increases nor decreases your tax owed. You pay income tax on your earned income, as you always do, and then use a portion of that income to fund your Roth.

A traditional contribution also must come from your earned income but grants you a tax deduction that effectively defers earning that income until later. Instead of taking that money as income today, you contribute to your traditional IRA or 401(k), invest the money, let it grow, and then, in retirement, take distributions from the account as though it were earned income then.

Funding your traditional IRA just one year for $5,500 at age 25 and letting that investment appreciate over your working career could result in the account growing to over $280,000 at age 70. Fully funding the account every year could result in an account worth over $5.2 million at age 70.

That means rather than paying tax on $5,500 each year, as you would if you funded the Roth, you would have to pay tax on withdrawals from a five million dollar portfolio. Required minimum distributions will force you to take money out during your lifetime and pay tax as though it were income. Even after your death your heirs will suffer having to pay the same tax as a result of inherited IRA rules.

Even if you stretch your withdrawals over many years, ultimately, all of the growth along with the original contributions in the traditional IRA will be taxed. And the longer the funds appreciate in the traditional account, the more tax you will be required to pay.

If you are in an identical bracket at the time of your withdrawal, then this greater tax is a wash. It won’t matter whether you pay the tax early and have less value to compound or pay the tax later on the compounded value.

You can see this in a simple example. Imagine two single sixty-year-olds who both earn $40,000 each year, fund their IRA for $6,500, and take advantage of normal exemptions and deductions. The only difference is Ms. Roth funds her Roth IRA and Mr. Traditional funds his traditional IRA.

The first year, Ms. Roth places $6,500 in her Roth, making her earned income $40,000. She pays a tax of $4,001 and her IRA value grows to $7,085.00.

Meanwhile, Mr. Traditional the first year places $6,500 in his Traditional, making his taxable income $33,500. He pays a tax of $3,026 (a savings of $975 over Ms. Roth) and his IRA value grows to $7,085.00.

At face value, Mr. Traditional has more money in his accounts. Both their IRAs are worth the same ($7,085) but, assuming Mr. Traditional saves and invests his tax savings of $975, his savings account could be worth $1,062.75 at the end of the year while Ms. Roth won’t even have opened a savings account.

But face value is deceptive. Let’s pretend after that one year, Mr. Traditional and Ms. Roth (now age 61) need to withdraw money from their IRA.

Ms. Roth simply withdraws the money from her IRA and receives the full account value ($7,085.00) to her checking account.

Mr. Traditional withdraws the money from his IRA and has to pay the tax he deferred. This increases his earned income for the year by the withdrawal ($7,085) and, at his top marginal rate of 15%, this means he owes $1,062.75 (15% of $7,085) in taxes from his distribution. To pay the tax, he needs to liquidate his savings account (worth $1,062.75), leaving him with $7,085.00, just like Ms. Roth, in his checking account.

This is how, if at the time of your distribution you are in the same bracket as you were during your contribution, then which account you fund could be a wash.

That being said, this simplistic example is difficult to replicate in real life.

If Mr. Traditional had saved but not invested his tax savings (a common decision), then when it came time to pay the $1,062.75 in taxes, he would have only had $975 and been short $87.75, making Ms. Roth have more money. Many families fail to keep the cash in their taxable accounts fully invested and appreciating at market rates of return.

Furthermore, if they had been in a higher bracket, earning $95,000 and in the 25% tax bracket for example, the math works even more against Mr. Traditional.

The first year, Ms. Roth contributes $6,500 to her Roth, leaving her earned income at $95,000. She pays a tax of $16,981 and her IRA value grows to $7,085.00.

Meanwhile, Mr. Traditional places $6,500 in his Traditional the first year, reducing his taxable income to $88,500. He pays a tax of $15,356 (a savings of $1,625 over Ms. Roth) and his IRA value grows to $7,085.00. Then, Mr. Traditional saves and invests his tax savings, which grows to $1,771.25 by the end of the year.

After that one year, Mr. Traditional and Ms. Roth (now age 61) need to withdraw money from their IRA.

Ms. Roth, as in the other example, simply withdraws the money from her IRA.

Mr. Traditional withdraws the money from his IRA and has to pay the tax he deferred. At his top marginal rate of 25%, this means he owes $1,771.25 (25% of $7,085) in taxes from his distribution. To pay the tax, he needs to liquidate his savings account (worth $1,771.25). The difference is that, because he is in the 25% tax bracket, he has a 15% capital gains tax. This means, he needs to pay tax on the growth of his savings account.

With a cost basis of $1,625, this means he needs to pay $21.94 (15% of $146.25) in capital gains taxes, making him receive only $7,063.06 (instead of Ms. Roth’s $7,085.00).

Mr. Traditional’s tax savings accrue capital every year. Because the government taxes these gains, his investments will yield less value for him than Ms. Roth’s, even when they both remain in the same tax bracket. Mr. Traditional gets taxed both on the growth in his traditional account as well as the capital gains on his savings account where he is accruing the money to pay the taxes on his traditional account.

Small differences like these upset the balance of being in the same bracket, often in favor of funding a Roth.

Most people however won’t remain in the same tax bracket but rather get semi-regular raises to keep up with inflation and because of merit and achievement in their firm. These raises push them gradually into higher and higher tax brackets. Then, when they retire they collect Social Security and often drop down into a lower tax bracket.

Imagine two couples, Mr. & Mrs. Roth and Mr. & Mrs. Traditional. Both couples get marred at age 25, earn $60,000 collectively, receive raises 2% above inflation, and each fund their IRAs ever year ($5,500 each, $11,000 total) until retirement at age 60. At 65, they file for Social Security and receive checks totaling $30,000.

The only difference between the families is which account type they fund.

At age 25, they are in the 15% bracket with a collective income of $60,000.

At age 56, Mr. & Mrs. Roth move into the 25% bracket and, just before retiring at age 60, they are earning (in today’s dollars) $104,012.92 and in the 25% bracket.

Mr. & Mrs. Traditional are earning the same amount but, thanks to funding of their Traditional account, are able to remain in the 15% their whole working career. You would think that this scenario would favor Mr. & Mrs. Traditional. They have successfully used funding a tax deferred account to keep them in a lower tax bracket. But deferring their tax owed is not the same as avoiding their tax altogether.

After retirement, both couples move into the 10% bracket. They remain there even when Social Security starts at age 65. All this time their IRAs continue to grow.

At age 70, Mr. & Mrs. Traditional are forced to start withdrawing required minimum distributions (RMDs) from their account. These start small, but, after three years at age 74, they are pushed into the 25% tax bracket with an RMD of $68,000 in today’s dollars.

This higher bracket also causes Mr. & Mrs. Traditional to be subject to a capital gains tax bracket of 15%, forcing them to pay tax regardless of from which account they draw funds.

Mr. & Mrs. Roth, still in the 10% income tax bracket and with their retirement assets in a Roth IRA, do not have either of these problems.

Because so much of their wealth is post-tax, by age 90 Mr. & Mrs. Roth would have approximately $6.5 million more after all taxes have been paid ($500,000 in today’s dollars) than Mr. & Mrs. Traditional.

Each person’s situation requires extensive analysis, but in general tax planning favors funding your Roth over funding a traditional account.

Photo used here under Flickr Creative Commons.

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David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. Favorite number: e (2.7182818...)

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