What would I favor if I were in the Save and Invest phase of life: Roth or traditional IRA?
Posted on April 26, 2024
If I were in the Save and Invest phase of life, I’d contribute ONLY to Roth IRAs. This post shows that distributions from a traditional IRAs are taxed about 25% and maybe more. Effectively none is taxed at 10% or 12% as most people think. You do not want to contribute to pre-tax, traditional IRAs today and avoid 22% or 24% tax now but then pay at 25% or more later. This makes no sense. You want to pay 22% or 24% today to get the money you’d invest in a Roth IRA and avoid 25% or more tax in the future.
If I were just starting, I’d stick with Roth throughout all my working years. If I have started with traditional IRAs, I’d change and contribute only to Roth in the future. I’d ask to have my employer’s contribution to my retirement plan directed to Roth.
Over time, before I started taking Social Security, I would work to convert as much from traditional to Roth as I thought reasonable. I’d probably not get close to 100% Roth at the time of retirement, but I’d be better off with far more Roth than traditional.
== Less taxes in your lifetime ==
At today’s marginal tax rates and tax code, you will pay less in total tax over your lifetime if you have mostly or solely Roth. You’ll pay tax at 22% or 24% and avoid paying 25% or more in the future. That means you and your heirs will keep more.
The price – the 22% or 24% tax you pay – to get the after-tax amount you contribute to Roth is rock-bottom. Current marginal tax rates, set in tax law in 2027, are the lowest in 50 years and likely will never be lower.
You will not pay less than 25% for distributions from your traditional IRAs. Many think a significant amount of distributions will be taxes at 10% or 12%, the rates of the two lowest marginal tax brackets. This is not correct.
You win the game by paying 22% or 24% now to get the money into Roth and avoid paying 25% in the future. Prior to 2017, the opposite was true: Patti and I contributed to traditional IRAs and in our prime-earning years likely avoided paying taxes at rates at 35%. We win when we pay at today’s marginal rates.
== Roth is much less stressful ==
You’ll almost certainly want to retire before the maximum benefit from Social Security: age 70. It’s easier to take Social Security early when the balance of your spending needs – your Safe Spending Amount (SSA, Chapter 2, Nest Egg Care) – comes from Roth: very little of your Social Security benefit will be taxed, as I recap below.
If you are successful in building a larger than average amount in your retirement accounts, you will totally avoid the time and effort that folks with similar amounts in traditional IRAs spend on issues like like IRMAA, NIIT, and very high tax rates that a surviving spouse might pay due to RMDs.
== Why do you pay 25% rate on traditional? ==
Last week I described how the 10% and 12% marginal tax brackets for ordinary income were really 18.5% or 22.2%. Each added amount of taxable income increases the taxable amount of Social Security.
I mentioned that distributions from traditional IRAs can trigger 15% capital gains tax that you would not pay if your distributions were from Roth IRAs. I did not measure this effect.
This post shows the effect of the two. You see the effect most clearly by comparing two examples.
== Case 1. Roth only from IRAs ==
Case 1. Joe, a single filer over age 65, has gross Social Security benefits of $40,000 in 2024. He has $6,500 in taxable dividends: $5,000 are qualified for capital gains taxes; $1,500 is dividends from money market funds. He has $5,000 of other income from a defined benefit pension plan. Joe taps his nest egg for $75,000 for his spending: he distributes $45,000 from his Roth; he sells $30,000 of stocks in his taxable account that have a cost basis of $15,000. Here’s a summary of his 1040 (from this spreadsheet):
27% of Joe’s Social Security is taxed. None of his $20,000 that is qualified for capital gains tax is taxed because his taxable income is below the trigger point for 15% gains tax. He’s in the 10% marginal tax bracket for ordinary income and pays total tax of $123.
His net cash for spending after taxes is ~$117,700 for the year.
== Case 2. Traditional only from IRAs ==
Case 2. Joe’s $45,000 is solely from traditional IRAs. Here’s the summary of his 1040 (from this spreadsheet).
85% of Joe’s Social Security is taxed. He is in the 22% marginal tax bracket for ordinary income. Taxable income is well past the trigger point for 15% capital gains tax. He pays tax of $13,310. He was just below the first tripwire for IRMAA that could have resulted in $1,000 more in Medicare Part B&D premiums.
His net cash for spending after taxes is ~$104,500, ~$13,000 less than in Case 1: the added taxes he paid.
The $45,000 he distributed from his traditional IRA results in about ~$13,000 added income tax. The effective tax rate on his distributions from his traditional IRA is 29%.
== Other examples ==
I summarize other examples here. My conclusion is that distributions from traditional IRAs are taxed at 25% or more.
Conclusion: If I were starting the Save and Invest phase of life, I’d only invest in Roth IRAs for retirement. The price – the 22% or 24% tax you pay – to get the after-tax amount you contribute to Roth is rock-bottom. Marginal tax rates are the lowest in 50 years and likely will never be lower.
The effective tax rate on distributions from traditional IRAs are about 25% or more. That’s NOT CLOSE to the 10% or 12% marginal rates that most people think they will pay in retirement. Traditional IRAs make no sense: you don’t want to avoid paying 22% to 24% now to then pay 25% or more later. You want to pay 22% or 24% now to avoid paying 25% or more later.
If I already had traditional IRAs, I’d stop contributing to them and only contribute to Roth IRAs. I’d see if I could get my employer’s matching contributions to be directed to a Roth IRA. Over time – before I started on Social Security – I’d work to convert my traditional IRAs to Roth. Ideally in retirement, I would have almost no traditional IRAs.