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

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Anyone who's saving for retirement has probably had to decide whether to save in a Roth account or a traditional retirement account.

Experts commonly recommend that you save in a Roth account if you expect to have a higher income in retirement than you do now. That's because you pay taxes today on Roth contributions but don't pay taxes on withdrawals in retirement, and higher incomes are generally associated with higher taxes. However, if you're already saving for retirement, and you intend to maintain the same standard of living when you leave the workforce, then your retirement income won't likely exceed your current income.

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Moreover, there's more to the equation than the difference between your current income and your potential retirement income. A traditional 401(k) or IRA may allow you to save more and thus grow your retirement savings faster, especially if you're investing primarily in stocks.

Don't tilt the math in favor of Roths

One could argue that saving taxes at your marginal tax rate today on a contribution of $5,500 (the maximum IRA contribution in 2018) is worth less than the tax savings on your withdrawal during retirement. After all, you're likely to withdraw a lot more in a year than your annual contribution.

For example, a person -- let's give him a smart name like, I don't know, Adam -- with a net income of $65,000 per year is firmly in the 22% tax bracket. If Adam maxes out his Roth IRA contributions, he's effectively paying $1,210 in taxes each year that he could have kept out of the government's hands by saving through a traditional IRA instead. But if Adam needed $30,000 from his Roth IRA each year in retirement, then he'd save at least $1,970 in taxes on those withdrawals, assuming tax rates remain the same when he's retired.

Indeed, one of the benefits of a Roth account is that you're never taxed on the growth of your contributions.

But in that exercise, we've tilted the math in favor of the Roth account.

The right way to compare traditional and Roth contributions

When Adam saves $1,210 in taxes by using a traditional IRA, he doesn't just blow that cash on stuff he doesn't need. Since he's smart, he puts that money in a taxable brokerage account. Assuming he invests those tax savings each year until he retires 25 years from now, and the money earns an average return of 7% annually, he'll have an additional $76,500 to his name. When it's time to pay taxes on his traditional IRA withdrawals in retirement, he'll have plenty of money to do it with.

Granted, Adam will have to pay taxes on the gains in his brokerage account. But 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 Adam's total taxable income is below $38,700, assuming he's still single, or $77,400 if he got married, he'll pay no taxes on long-term capital gains in his brokerage account.

What you'll find is that the math almost always works out in favor of a traditional retirement account compared to a Roth account as long as 1) you invest your up-front tax savings, 2) your standard of living won't dramatically increase in retirement, and 3) federal income tax rates stay more or less the same (which is not a given, but nobody can see the future).

When to use Roths

While I think most people are 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 in your situation.

At the 10% marginal tax rate, it's a close call, and the tax benefits of traditional contributions are practically nothing for most people. It might make sense to save in a Roth account and thereby lock in the 10% rate (or even the 12% rate) as a hedge against potential tax increases in the future.

Also, if you expect to have significant additional income in retirement outside of your retirement accounts and long-term capital gains, you may want to use a Roth account to lock in income at the lowest tax brackets if you can.

If you don't qualify for a traditional IRA deduction, then you should definitely put your money in a Roth account. The IRS phases out the traditional IRA deduction as your income increases, and there's little benefit to a traditional IRA without the tax deduction.

The government prevents you from contributing directly to a Roth IRA if your income gets too high, but you can still execute the backdoor Roth contribution with after-tax contributions to your traditional IRA. If you can pull off the megabackdoor Roth, you should definitely take advantage of the opportunity after maxing out your your tax-deferred contributions.

Finally, remember that saving in a Roth account is still better than saving in a taxable account. You'll be able to buy and sell stocks without worrying about taxes on capital gains and dividends, and you'll be able to withdraw your 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 IRA versus traditional IRA decision. You may need to do some homework to get a complete picture of your financial situation, but it can save you thousands of dollars in taxes over the long run.

For me -- a guy who's very similar to our example Adam -- it usually makes sense to max out my pre-tax retirement accounts before looking at Roth contributions.

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