Great Debates: Retirement Account Redux

Welcome back fight fans, to the first grudge match in Great Debate history.  Yes, although we already fought this issue out a while back, it’s come up quite a bit in the media lately, and with 2010 being the year that anyone can convert their traditional account into a Roth without regard to the usual income limits, the arguments are only likely to increase in the future.  To help you decide which is the better choice, let’s look over the situations where each account really shines (as well as when we can’t tell):

Traditional Accounts Are Best If:

Tax Rates Drop in the Future: This should be pretty obvious; with traditional IRAs/401(k)s, you get a tax break now but pay taxes in the future.  If taxes come down between now and when you retire, you’ll have benefited by delaying long enough to see the tax rates decrease.

We Switch to a Non-Income Tax System: Similarly, if we as a country stop taxing income and start taxing something else, like spending, for example, traditional accounts again win out.  Switching over to spending based tax system (like the Fair Tax) would mean that your money avoided taxation on the way into your retirement account, and could be withdrawn without penalty and reinvested, only be taxed when it was spent.  A Roth account, on the other hand, is filled with money that’s been taxed at least once, and now faces substantial spending taxes, making it a double loser in this situation.

Sail Boats, those scream retirement, right?
Sail Boats, those scream retirement, right?

(Side Note: in researching the above linked Fair Tax article, I called the Fair Tax organization and explicitly asked about what happens to Roth accounts under this system (since the benefits to traditional accounts were already listed on the Fair Tax website).  The answer I got was that, in short, Roth account holders were going to be hung out to dry if the Fair Tax is implemented.)

Tax Rates Stay the Same in the Future (Or Increase Slightly): This one is probably going to require a little bit of explanation, so hold on to your seats.  It has to do with the difference between marginal tax rates and overall tax rates.  The money you put into your traditional account comes off the top of your income pie, so to speak.  If you were still collecting that money, you would have to pay taxes equal to the highest tax bracket you are in (or a weighted average of the highest and next highest, if the contribution reduces your taxable income enough to move you from one tax bracket down to the next lower one).  So, with $50,000 in income, you’d be in the 25% tax bracket (as of 2010), and you would save 25% of $5000 ($1250) in tax expenses with a traditional account.

However, when you take money out of the account, you are going to be pulling out a much larger amount of money, spread across a wider range of tax brackets.  Because we have a progressive tax system, where your first dollar of income is taxed at a lower rate than you last dollar (aka, the dollars you were putting into your retirement account), your average tax rate is much less.  To pull out $50,000 as a taxpayer filing singly, you would have to pay $6393.75 on that income, or 14.2%, given the current tax brackets and standard deductions.  Same tax rates, much lower rate coming out than going in (as a result of which dollars you specifically added).  As a result, there’s also a bit of leeway at to how high tax rates can rise before it becomes a better deal to pay taxes now at your marginal rate, since taxes can go up a reasonable amount without pulling the average tax rate in retirement above the level of the highest marginal bracket during your working life.

Roth Accounts Are Best If:

Tax Rates Increase Dramatically in the Future: Just as tax decreases would be a boon to traditional accounts, tax increases benefit Roths.  Note the ‘dramatically’ qualification in this point, though; for many people in the middle income brackets (and even more in the upper income brackets), tax rates would have to rise substantially (ten to fifteen percentage points in every bracket, for example) for the taxes paid on withdrawals to be equal to your highest current income tax bracket.

Your Income Rises Substantially From Your Current Income: The lower your current income, and the more it rises in the future, the better a Roth looks.  If you end your career in a tax bracket several steps higher than your current one, there is a good chance that making investments in a Roth now will enable you to benefit from your lower tax bracket and save on taxes in the future.  This is one reason why Roths are particularly recommended for us young whippersnappers; our tax burden is likely to be much higher, even if tax rates stay the same.

We Just Can’t Tell If:

We Switch to a Flat Tax: If we go from a graduated tax system to a flat tax, how good it will be for each type of account depends on your current marginal bracket and the flat tax rate.  If the flat tax is higher than your top marginal rate, having a Roth will be better; if the flat tax is lower, then the traditional account is better.  (As a side note, if the flat tax is lower than your highest marginal tax rate but higher than the average rate you would pay under the current system, then the traditional account is still better, but you’ll be paying more than you would under the current tax system.)

Roth Accounts End Up Being Taxed: This entire discussion is predicated on the withdrawals from Roth accounts being tax free in the future.  If this is not the case, then the case for traditional accounts gets much stronger.  It’s not a slam dunk for traditional plans, though; if Roth withdrawals are taxed at a different, lower rate than ‘normal’ income, it’s possible (although harder) for Roth accounts to be the better deal.

Conclusions

You might notice a common thread for these points; they all depend on knowledge of the future which, unless you are a witch (and thus, weigh less than a duck), you can’t know for certain.  We can make educated guesses; given our large and increasing budget deficit and future obligations for Social Security and other programs, my assumption (one shared by many financial writers) is that taxes are only going to go up in the future, making Roths an attractive proposition.

What do I intend to do?  Basically, try to diversify my accounts; perhaps traditional accounts will save me more, perhaps Roth accounts will, it’s best to attempt to hold some money in both types of accounts, so that I can attempt to optimize my tax situation in the future.  Having money in a traditional account to withdraw until you fill the lower tax brackets, and money in a Roth for withdrawals beyond that point, allows you to lower your average tax rate without having to lower the money you have available.

How much to hold in each account?  That’s a tough one.  Before, I would have recommended mostly Roth accounts, but after reading some of the comments on Financial Samurai’s site and considering the effects of marginal tax rates, I’m leaning more towards traditional accounts.  (Going back to our $50,000 a year earner, to pay the same 25% as the marginal tax rate, he or she would need to pull $185,000 from a traditional account; even if tax rates go up substantially, you could still spend less on taxes with a traditional account.)  A mix of of two-thirds to three-quarters traditional accounts with the remainder as Roth accounts should provide plenty of tax savings now with a nice amount of tax-free income in the future to fill out my income needs without too much tax liability.

Now, as to conversions, particularly this year, given the ability of everyone to convert.  If you are currently invested entirely or mainly in traditional accounts, it might be worthwhile to convert; just remember that the more you convert, the more taxable income you will have.  The more taxable income you have, the higher your marginal tax rate (and overall taxes), and the less likely that future tax rates will make the conversion worthwhile.  In short, don’t convert so much as to greatly boost your taxes now; you’ll be setting a high bar for tax rates to clear.  Better to keep your traditional accounts than to pay out the nose for the privilege of conversion.

The most important thing to do though, is to save now, and take advantage of either type of account if possible; it’s better to use a less ideal retirement plan than delaying things to try to figure out the perfect one for your situation.  You’ll definitely be better off, even if when you retire, the tax circumstances mean your (primary) type of account was not the ‘best’ one.  If you’re really, really worried about your retirement savings, there’s a simple and easy way to ensure your retirement is more secure: save more money, in any type of account.  The more you save, the better off you will be in the future.  Good luck, and happy retirement investing!

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