Why More People Should Probably Use Pre-Tax Retirement Accounts Instead of Roths

Anyone saving for retirement has probably had to decide between saving in a Roth account versus a traditional retirement account.

The biggest reason people recommend saving in a Roth account is if you think you'll have a higher income in retirement than you do now. But if you're already saving for retirement, and you intend to maintain the same quality of living, your retirement income shouldn't exceed your current income.

Moreover, comparing your current income to your potential retirement income isn't exactly the right comparison. Instead, you need to compare the tax rate you'll pay on a Roth contribution today versus the tax rate on traditional retirement account withdrawals in retirement. It's very often the case that you'll pay a lower overall tax rate on withdrawals from a traditional account than you'll pay on Roth contributions today even if you have a higher income in retirement.

Marginal tax rates versus effective tax rates

Before you can understand why it likely makes more sense to use a traditional retirement account versus a Roth account, you must first understand the difference between marginal tax rates and effective tax rates.

  • Marginal tax rate: the tax rate on your next dollar of income. People that say they're in the 22% income tax bracket are describing their marginal tax rate.
  • Effective tax rate: your total tax bill as a percentage of your income. This number is always lower than the marginal tax rate due to the progressive nature of the U.S. tax system.

Jason Hall did an excellent write up on marginal and effective tax rates that goes into more depth.

For every dollar you contribute to a traditional retirement account, you're reducing your taxable income and saving on taxes at your marginal tax rate. The corollary is that each dollar saved in a Roth account is effectively taxed at your marginal tax rate because you could've saved it in a traditional account.

That's very important to understand, so you might want to reread that last paragraph.

You'd have to spend a lot more in retirement for Roth to make sense

A single person making $60,000 per year is in the 22% tax bracket after taking the $12,000 standard deduction. In order to reach a 22% effective tax rate on a traditional IRA withdrawal, he'd have to have an income of $195,105 in retirement, assuming the same tax code as today.

The math works a little bit better for someone in the 12% tax bracket. Someone making $50,700 per year is right at the top of the 12% bracket after taking the standard deduction. Still, they'd have to withdraw $52,605 from a traditional IRA in retirement for the math to work out in favor of a Roth IRA. That's a 16.4% increase in spending during retirement after factoring out the $5,500 saved in a Roth account during working years.

So, it really depends on how much you spend in retirement. I'm a firm believer of living the life you want as long as you can save for your future at the same time. I don't expect my retirement expenses to increase over my current living expenses. As some expenses like healthcare increase, my housing cost will effectively decrease due to inflation and eventually move a lot closer to $0 after paying off my mortgage.

Assuming you maintain the same standard of living in retirement, your taxes will be lower if you choose a traditional retirement account over a Roth account, all else being equal.

Don't tilt the math in favor of Roths

Many Roth proponents also like to point out that you can effectively save more in a Roth account than a traditional account, since you're saving the taxes too. And that's technically true, but what if you just saved your tax savings from using a traditional retirement account in a taxable account?

The U.S. government really wants people to invest, so it has very favorable long-term capital gains tax rates. There's even a very generous 0% tax bracket for long-term capital gains. As long as your total taxable income is below $38,700 if your single or $77,400 if you're married, you pay no taxes on long-term capital gains. It's very likely the taxes on your capital gains in retirement will be lower than the taxes on Roth contributions during your working years.

When to use Roths

While I think most people will be better off saving in traditional retirement accounts, there are always exceptions.

If you already have a marginal tax rate of 0%, then you should definitely save money in a Roth account. This actually happened to me recently, when I had a year of relatively low income, saved enough in my traditional 401(k), and had other deductions and credits that resulted in a $0 tax bill. If you have a lot of kids, for example, and you get a lot of tax credits for them, a Roth could work out better for your situation.

At the 10% marginal tax rate, it's a very close call and the tax benefits for traditional contributions are practically nothing for most people. It might make sense to lock in the 10% rate as a hedge against potential tax increases in the future.

If you don't qualify for a traditional IRA deduction, you should put your money in a Roth account. The IRS phases out the IRA deduction as your income increases. The government also prevents you from contributing directly to a Roth IRA if your income gets too high. You can still, however, execute the backdoor Roth with after-tax contributions to your IRA. If you can execute the megabackdoor Roth, you should definitely take advantage of the opportunity.

Saving in a Roth account is better than saving in a taxable account. You'll be able to buy and sell stocks without worrying about capital gains and you'll be able to withdraw the gains tax free regardless of your income in retirement.

Ultimately, every person's situation is different. This article aims to provide a framework for making the Roth versus Traditional decision: compare your marginal tax rate today versus your effective tax rate in retirement. It might require you to do some homework to figure out your financial situation, but it can save you thousands of dollars in taxes over the long run.

For me, it usually makes sense to max out my pre-tax retirement accounts before looking at Roth contributions.

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