Traditional IRA or Roth IRA - How To Determine Which is Best

Your marginal tax rate holds the answer

Roth or Traditional IRA?
••• Pamspix

Trying to figure out whether you should fund a Roth IRA or a Traditional IRA? 

With the Roth, you put funds in after-tax, they grow tax-free, and they are tax-free upon withdrawal. With "traditional" retirement plan contributions you get a tax deduction when you put the funds in, they grow tax-deferred, and they are taxed upon withdrawal.

So which is better?

There is only one way to know for sure. Take a look at your current marginal tax rate relative to your projected marginal tax rate in retirement. Let’s take a look at why your marginal tax rate is so useful in determining what type of account to contribute to.

Why Marginal Tax Rates Are So Useful

Let’s say you own a home with a mortgage and you itemize deductions each year. Assume you usually have about $18,000 a year of itemized deductions. Using 2020 tax rates for a married couple filing jointly this means:

  • You will pay no federal tax on the first $24,800 of taxable income.
  • The next $19,750 of taxable income is taxed at 10%.
  • Earnings above $19,750 and up to $80,249 are taxed at 12%.

Now let's assume you and your spouse make a combined $72,000 a year.

  • You don’t pay tax on the first $24,800 because of your standard deduction, so you have $47,200 of taxable income.
  • $19,750 of your taxable income is taxed at 10% and the next $27,450 is taxed at 12%.

If you put $5,000 into a traditional IRA or 401(k), it saves you $600 of federal income tax this year at the 12% rate. But what will your tax rate be when you withdraw that money at some point in the future? For example, you could be in the 22% or 24% tax rate in retirement, which means you would pay $1,100 or $1,200 in taxes, respectively, on that $5,000 when you withdraw it.

If you think your tax rate may be higher in the future then deductible retirement plan contributions may not be the right way to go. 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. That is not a smart move!

Tax Planning Helps

A bit of tax planning each year can help you determine what type of contribution is best. Let's look at an example.

Laura is a real estate agent, age 54. Her income varies from year to year. She funds a Traditional IRA each year (a deductible contribution) so she can save as much as possible in taxes… or so she thinks.

As the economy slowed, Laura’s income was less than it had been when she started her regular IRA funding. Laura decided to do some tax planning and ran a tax projection. She had plenty of deductible business expenses, and she was able to itemize her deductions. She estimated she was going to pay no federal income tax for the year, only self-employment tax. A deductible or traditional IRA contribution would offer her little tax benefit.

A much better option for her during her low-income years is to fund a Roth IRA or Roth 401(k), which also offers no tax deduction, but once money is in the Roth all investment income earned is tax-free, both now and in the future. 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 Laura minimize the amount of taxes she will pay.

Each year Laura needs to run a tax projection so she can estimate her marginal tax bracket and determine which type of account is most advantageous for her to use. This strategy will add up to thousands of extra after-tax dollars available to Laura once she retires.

For example, let’s say Laura has five low-income years where it makes more sense to contribute to a Roth, as she would not be able to use the deduction if she made a Traditional IRA contribution. She accumulates $25,000 in her Roth plus it earns $5,000 of interest over the 10 years. At retirement she is still in the 12% federal tax bracket... so she saves an estimated 12% of $30,000 or $3,600 when withdrawing the entire balance of the Roth IRA. She would have received a cumulative benefit of $3,000 (See above: Traditional IRA contributions at 12% federal tax bracket = $600 x 5 years). The difference would be tax savings of $600. Withdrawals over several decades in retirement could result in thousands of dollars in tax savings.

You must have earned income to make a Traditional or Roth IRA contribution.