I’ve spent a lot of time thinking about the Traditional and Roth accounts (both IRA and 401k types). In trying to find the right investment mix, the decisions you make today can have large impact decades from now in retirement. I am going to discuss some of the pros and cons of each account type.
How they work
On a Traditional retirement account, you pay zero taxes and defer the liability into the future.
With a Roth retirement account, you pay the taxes today but have no future tax liability.
In theory, Roth and Traditional accounts should have a similar outcome. The key is always your marginal tax rate.
For a thought experiment assume you are in a 22% Federal Income Tax bracket and a 5% state income tax bracket.
If you invest in a $1,000 in a Roth account today then you’ll have $730 after taxes. Assuming the stock market yields 7% a year for 20 years, then you’ll end up with $2824.86 that you can spend in retirement tax-free.
Now, comparing the Traditional account. You put $1,000 in and pay no taxes. The $1,000 compounds to $3869.68 after 20 years. At this point, when you take the retirement money out you’ll owe Federal and State income tax. Subtract 27% income tax and we end up with $2824.86.
So, in theory, Roth and Traditional accounts are exactly the same. You end up with the same outcome. Of course, this is oversimplified, so we’ll dig in a bit further.
Why a Traditional Retirement Account is amazing
The key in the example was your marginal income tax rate. Your marginal tax rate will change in the future.
When an individual retires, assuming they do not have have a job their income is $0. This means every dollar taken out of a Traditional account would pay minimal income tax. Today a married filing jointly couple can take out $78,950 of a Traditional account while only paying 12% in sales tax. Compared to Roth account: families would pay taxes at very high marginal tax rates while they are working. In this scenario, the Traditional account clearly wins out. In our example, a family would walk away with 3211.8344 (12% income tax + 5% state tax). In that example, the Traditional account is about 13% better than a Roth account.
City and State Income tax
Another major thing to consider in our example is the 5% state income tax. This is actually an avoidable tax. Today, you might be living in a state with an income tax. When you use a Roth account, the state is taking a chunk of your retirement.
As you age into retirement, you could plan to move to a place like Florida which has a 0% income tax. This is another reason why the Traditional beats out a Roth account. You could in theory only be paying 12% federal income tax on the Traditional account. Now the Traditional yields $3405.31 in retirement or 20% more than a Roth. Many cities also have income taxes, so this would further justify using a Traditional account.
Benefits of Roth Accounts
One major problem here is we don’t know what the future holds. The United States is running large trillion-dollar deficits: $1,000,000,000,000 a year. This debt will compound interest over time and will likely become a larger problem requiring higher tax rates in the future. If tax rates are significantly higher in the future, then the Roth account could be a better situation.
Healthcare in the United States seems to be on a path of socialization. The costs are out of control and the inflation rate is high. I don’t support government ran healthcare, but I think it is inevitable. Healthcare will be full socialized in the United States. This will likely require much higher tax rates in the future.
Roth Account: Trust in the Future Government
One major problem with Roth accounts is future political risk. If you put $1,000 into a Roth IRA you are effectively saying: I 100% trust politicians whom I don’t know in the future (at least to some degree).
It is entirely possible a Roth account could lead to double taxation. While the Federal Government has agreed to tax it once today and never tax it in the future, that agreement could change.
Most families have minimal retirement savings, how are they going to view families that were prudent? In the future, Roth account users could be viewed as “tax cheats” that need to “pay their fair share” in order to “redistribute the wealth”.
There could be new laws passed in the future that could cause it to be taxed a second time. It is not possible to know which politicians will run the government in the future, so I think any trust here is misplaced. This is a huge risk that I never see talked about.
Future income is also a major consideration. If you plan on not working in retirement, then a Traditional account is quite nice. If you plan on having various income streams, the Roth becomes a good deal.
Households that plan on working part-time in retirement would certainly have a higher marginal tax rate. Pensions and Social Security will also boost your income, pushing you towards higher tax brackets. Depending on how your assets are structured such as interest income or rental housing, it could also increase your income. Individuals with high retirement incomes would likely benefit significantly from a Roth account.
I personally think the ideal strategy is to use a hybrid approach and put money into different buckets that are prioritized. First, you should also maximize any employer 401K match. This is free money and should be your first priority.
After the 401K match, are you using a Health Savings Account? If not, then you are missing out as it provides superior tax benefits. Before you even consider putting money into an IRA you should ensure your HSA is maxed out.
After the HSA has been maxed out, you can start looking towards an IRA. My personal advice is to use a Hybrid approach. This would mean using both Traditional IRA and Roth IRA accounts. The benefit of this strategy is that you can fill in your lower tax rates with a Traditional retirement account. Once you hit the higher tax brackets, then you can start using your Roth retirement account which has no tax liability.
This has the added benefit of diversifying risk as well. If you have all your eggs in one basket then future tax changes could have a devastating impact on your retirement portfolio.
This strategy could be achieved by contributing to a Roth account in some years and Traditional accounts in other years. Ideally one would contribute to a Roth IRA in their younger years when they likely have lower incomes and thus lower marginal tax rates. In later years when incomes are higher, they can use the traditional retirement accounts and avoid paying higher taxes.
One an individual has reached a point where they are maxing out their 401k, IRA, and HSA balances they will on a path towards retirement success. Perhaps 50% Roth 401k\IRA and 50% 401k\IRA would be ideal, but it depends on the individual. I have been doing this for four years in a row and it feels great.
Traditional and Roth retirement accounts both have their benefits and negatives. There are many unknown future variables such as tax rates and policies that are unknown. In the end, using both will give you a lot of flexibility and diversity.