In this article we’re going to discuss why the Roth IRA may NOT be your best retirement vehicle (and why it certainly shouldn’t be your only one.) If you’re not already familiar with a Roth IRA and how it compares to a Traditional IRA, please read this.
(Quick refresher: Traditional IRAs and 401ks allow you to avoid paying taxes on contributed income in the current year, but when you take the money out in retirement, you must pay taxes on it at your regular income rate.)
So, which one is better for you? If you expect your marginal tax rate to be higher in retirement than currently, it may make sense to put some of your money into a Roth IRA (Only after you max out your employers matching contribution on your 401k; never refuse free money!) Say you’re a student with a part-time job, and your marginal tax rate is 10%. Assuming you’re significantly wealthier when you retire, you might be in the 25% tax bracket at age 60 and beyond. Thus, it doesn’t make sense to save 10% on taxes today, when you may pay 25% on your marginal income at retirement.
On the other hand, if you believe your retirement tax rate will be lower than your current tax rate, then a 401k or Traditional IRA may make the most sense hands-down. (Imagine that you and your wife are fully employed and are supporting kids or a mortgage. In retirement, you may not have those expenses, and thus can live on less income, which might reduce your tax bracket.)
Either way, the best retirement plan for you is likely to have some money in both types of accounts (if not all of it in a 401k.) Let me explain why:
Fill up those low brackets!
1) The first reason (other than employer-matching) to funnel money into a 401k is to ‘fill up’ your lower tax brackets. This concept (and many others in this article) is excellently described here at ‘The Finance Buff’s’ site. I highly recommend your read his article as well, especially if you have any questions about the below. His graph (see below) illustrates what I mean:
Because the United States tax system is progressive, the first dollars of income you have are taxed at a lower rate than the last (or marginal) dollars. In 2008, a married couple filing jointly could take 2 exemptions and the standard deduction and not pay ANY taxes on their first $17,900 of income. Then, they’d pay 10% on their next $16,050 (“taxable income.”) After that, they move into the 15% tax bracket and pay that rate on their next $49,050.
For simplicity, let’s assume that a 401k is your only source of income and that when you retire, the tax brackets will remain the same as they are in 2008*. If you withdraw less than $83,000 (adding up all the amounts in the 10%, 15% and “0%” brackets above), you’ll pay only 15% at the marginal dollar of income. If you and your spouse make, say, $100,000 combined today, you’re in the 25% bracket. Thus, it would make sense for you to contribute to a 401k and save the 25% now, paying the 15% later (rather than a Roth which would save you the 15% later, but cost you 25% today.)
In addition to filling up your retirement low tax brackets with 401k income, there’s another reason why a 401k might be a better choice than a Roth IRA.
Like a Ford Explorer, it’s easy to rollover a 401k
2) You can rollover a 401k into a Roth IRA (after leaving your employer), paying the taxes in the year you convert the Roth. What this means is that you effectively (but not really) cash out your 401k into a Traditional IRA, then, you convert the Traditional IRA into a Roth IRA. You have to pay regular income taxes on the value of the conversion (because you were never taxed on the 401k contributions.) Why might you want to do this? Let’s look at an example:
Say you’re currently in the 25% tax bracket and expect to remain in that bracket in retirement. Because you’ve read this article, you contribute to your 401k to fill up your lower brackets for retirement. This year however, you’re fed up with the rat race. Maybe you quit your old job to take a sabbatical, go back to school, or start your own business. If your new marginal bracket is low (say 15%), you could rollover some money from your 401k/Traditional IRA to a Roth IRA, only paying 15% tax to do so. If this chunk of your 401k represented money you would’ve paid 25% on in retirement, you’ve just saved yourself 10% (=25% – 15%)!
There are other reasons that I’ll let you read about in the above-mentioned article by The Finance Buff (including avoiding phase-outs and the dreaded Alternative Minimum Tax.) For most people though, I believe the above two reasons, especially the ‘filling lower brackets’ strategy, are the most important.
Don’t get me wrong, there are still some great reasons for using a Roth IRA for retirement. Like ‘hedging’ against higher future taxes and not being forced to take the minimum distributions at age 70.5 that you have to with a Traditional IRA/401k. There are also some non-retirement Roth IRA usages that I’ll discuss in the next column.
Bottom-line: For most people, the 401k/Traditional IRA should make up the bulk of their retirement contributions. I see entirely too many personal finance sites that recommend putting your money into a Roth IRA as soon as you max out your employer matching. This is dangerous, blanket advice, which I think is dead WRONG for many people.
Even if you determine the Roth isn’t the best thing for your retirement money, check out how to ‘hack your Roth’ for use as a tax-free, short-term investment vehicle.
Note: I’m not an accountant, so please review your personal tax situation with one, or make sure you understand it when planning for your own retirement. As always, if you have specific questions about the above, please comment on this article or email me.
* This would be a good approximation if real dollar (inflation-adjusted) tax brackets stay the same. However, it may be that tax rates increase in real dollars. This could be due to, oh, I don’t know, our MASSIVE and increasing federal debt in the US.