Trying to figure out whether you should fund a Roth IRA or a Traditional IRA can be a tricky choice. You put funds in after-tax with a Roth. Your money grows tax-free, and it's tax-free upon withdrawal. You get a tax deduction when you put the funds into a "traditional" retirement plan. It grows tax-deferred, and the money is taxed upon withdrawal.
It makes sense to take a look at your current marginal tax rate relative to your projected marginal tax rate in retirement when you're making the choice. Your marginal tax rate is very useful in determining what type of account you should contribute to.
Why Marginal Tax Rates Are So Useful
Let’s say you own a home with a mortgage and you itemize your tax deductions each year. Assume you usually have about $18,000 a year in itemized deductions. Using 2022 tax rates for a married couple filing jointly, this means:
- You will pay no federal tax on the first $25,900 of taxable income.
- The next $20,550 of taxable income is taxed at 10%.
- Earnings above $20,550 and up to $83,550 are taxed at 12%.
Now let's assume that you and your spouse earn a combined $72,000 a year:
- You don’t pay tax on the first $25,900 because of your 2022 standard deduction, so you have $46,100 in taxable income.
- $20,550 of your taxable income is taxed at 10%, and the next $20,550 is taxed at 12%.
It would save you $600 in federal income tax at the 12% rate if you put $5,000 into a traditional IRA or 401(k). But what will your tax rate be when you withdraw that money at some point in the future? You could be in the 22% or 24% tax rate in retirement, so you would pay $1,100 or $1,200 in taxes on that $5,000 when you withdraw it at that time.
Deductible retirement plan contributions may not be the right way to go if you think your tax rate may be higher in the future.
It makes no sense to save 15% in taxes when you put the money in, but pay 25% in taxes when you take it out.
Tax Planning Helps: An Example
A bit of tax planning each year can help you determine what type of contribution is best.
Let's say you're a real estate agent, and you're 54 years old. Your income varies from year to year. You fund a Traditional IRA each year (a deductible contribution) so you can save as much as possible in taxes…or so you think.
Your income becomes less than it had been when you started your regular IRA funding as the economy slows. You decide to do some tax planning and you run a tax projection. You have plenty of deductible business expenses, and you're able to itemize your deductions. You estimate that you're going to pay no federal income tax for the year, only self-employment tax. A deductible or traditional IRA contribution would therefore offer you little tax benefit.
A much better option during your low-income years would be to fund a Roth IRA or Roth 401(k), which also offers no tax deduction. But all investment income earned is tax-free, both now and in the future. And Roths have a unique advantage in retirement: income you withdraw from a Roth IRA is not included in the formula that determines how much of your Social Security benefits will be taxable.
Having Roth IRA funds to withdraw from in retirement will help you minimize the amount of taxes you'll pay. You'll have to run a tax projection each year so you can estimate your marginal tax bracket and determine which type of account is most advantageous for you to use. This strategy will add up to thousands of extra after-tax dollars available to you once you retire.
Let’s say you have five low-income years where it makes more sense to contribute to a Roth because you wouldn't be able to use the deduction if you made a Traditional IRA contribution. You accumulate $25,000 in your Roth, plus it earns $5,000 of interest over 10 years. You're still in the 12% federal tax bracket at retirement, so you save an estimated 12% of $30,000, or $3,600, when you withdraw the entire balance of the Roth IRA.
You would have received a cumulative benefit of $3,000. Traditional IRA contributions at the 12% federal tax rate works out to $600 over five years. The difference would be tax savings of $600.
Withdrawals over several decades in retirement could result in thousands of dollars in tax savings.