All Things (and Tax Rates) Being Equal, Is a Roth Better?

Question: I always hear that if you expect your tax rate to go down in retirement, you should contribute to a Traditional IRA, and if you expect it to go up, you should choose a Roth. So, what do I do if I expect it to stay the same?

Answer: The question of whether investors are better off putting their money in a Traditional deductible IRA or 401(k) or in a Roth version of these accounts gets a lot of attention from financial planners (and Morningstar.com writers). For a given individual, the answer ultimately boils down to what is most advantageous in the long run: taking a tax deduction on contributions made today or being able to withdraw contributions and earnings tax-free down the road.

As you point out, conventional wisdom says that if you expect your marginal tax rate--that is, the rate you pay on the last dollar of income you make each year--to rise in retirement, then a Roth account is likely the better choice because it saves you from having to pay taxes on the money when you are in a higher tax bracket. If you think your marginal tax rate will go down in retirement, then taking the tax deduction today, when you are in a higher bracket relatively speaking, seems to make more sense. (For the sake of discussion, we'll assume the individual in question is eligible to contribute to a Roth IRA; for 2015, this option phases out at $116,000 for individual filers and at $183,000 for those filing jointly, although those making more than that can consider the backdoor Roth strategy or contribute to a Roth 401(k) if their employer offers one.)

Conflicting Viewpoints Of course, no one knows for sure what their income tax rate will be throughout their retirement, which makes these rules of thumb rough guidelines at best. (And we're mainly talking about federal tax rates here--state and local tax rates add extra uncertainty.) But what are you to do if, after estimating your retirement income, you think you may end up in the same tax bracket then as you are in now?

Some financial experts suggest that here, too, a Roth is the better choice. In fact, recent research by T. Rowe Price found that saving $1,000 in a Roth IRA results in more spendable income in retirement than saving the same amount in a Traditional IRA in nearly all cases--the exception being for investors who contribute at age 55 and older and whose tax rates decline in retirement. The study assumes that individuals were in the 25% tax bracket when they made their contribution and that they invested their tax savings from the Traditional IRA contribution.

But David Blanchett, head of retirement research for Morningstar Investment Management, disagrees with the general findings of the T. Rowe Price research and says it's overly simplistic to suggest that all retirement savers who expect their income tax bracket to remain the same should choose a Roth. He points out that a tax break on contributions can have a ripple effect on other tax benefits.

"If we think about savers, they normally qualify for a number of credits/deductions that disappear in retirement like child care, dependent exemptions, etc. In retirement, people generally have smaller incomes and they receive income that is more tax-advantaged, like Social Security income, so their marginal tax rate is much lower," he said.

Blanchett also points out that there is an important distinction between the upfront tax break one gets for contributing to a deductible IRA or 401(k) and the back-end tax break upon withdrawal of Roth assets. He argues that the front-end deduction may be more valuable because it occurs at the taxpayer's marginal, or top, income tax rate whereas distributions may be subject to multiple tax rates. For example, let's say an investor who falls into the 25% tax bracket contributes $5,500 to a Traditional IRA. All of that deduction is subject to the 25% rate. Years later, when the investor takes a distribution from the IRA, a portion of that distribution may be subject to lower rates on the way to reaching that same 25% marginal rate.

Let's say that the investor is single and had $50,000 in taxable income in 2014, and that $25,000 of it came from the Traditional IRA distribution. Because of the way the tax brackets work, the first $9,075 of the taxpayer's income would be taxed at the 10% rate, everything after that and up to $36,900 would be taxed at the 15% rate, and income above that level (and up to $50,000) would be taxed at 25%. Therefore, at least a portion of the distribution would be taxed at a rate lower than 25%, even though that's the investor's marginal (top) rate. (One potential complicating factor here is whether or not the investor has started taking Social Security. If so, income from the Traditional IRA or 401(k) could make part of his Social Security benefit taxable, thus making a Roth IRA or 401(k) more attractive.)

Roth Advantages May Tip the Balance That's not to say that a Traditional IRA or 401(k) is always the best choice for retirement savers who expect to remain in the same (or a similar) tax bracket. Indeed, Blanchett says that having some assets in a Roth can provide savers with aftertax income that allows them to avoid falling into a higher tax bracket in retirement.

All that being said, Roth IRAs and 401(k) accounts offer some distinct advantages that should be considered when making your decision.

• If you choose to go the Traditional deductible IRA or 401(k) route, you'll likely need to invest your tax savings on each contribution to come out ahead in the long run. Are you disciplined enough to do this and not spend it? If not, the Roth option may be the better choice.
• Will you max out your IRA or 401(k) contributions each year? Here, too, a Roth may be the better option because it essentially allows you to shelter more of your assets than a Traditional account does. For example, if you plan to contribute the maximum $18,000 to your employer's 401(k) plan this year (or $24,000 if you are 50 or older) but are unsure whether a Traditional or Roth account makes sense, consider that with a Roth you are adding $18,000 in aftertax money, whereas with a Traditional account you are adding $18,000 in pretax money, which will ultimately have a lower value. Of course, you will have to pay taxes upfront on the Roth 401(k) contribution, but not having to pay taxes upon distribution makes its long-term impact greater.
• Roth IRAs, in particular, have some added features that may tip the balance in their favor. For one, account holders do not have to take required minimum distributions beginning at age 70 1/2 the way those invested in a Traditional IRA or 401(k) or Roth 401(k) do. This allows more of your money to grow tax-free longer and also helps your heirs when it comes to estate planning. Also, Roth IRA contributions (though not earnings) can be taken out of the account at any time and for any reason without triggering taxes or an early withdrawal penalty.
• By holding assets in a Roth account, you know exactly how much the account is worth at a given moment, whereas with assets in a Traditional account, there is the unknown of future tax rates.

When all is said and done, investors who expect to remain in the same tax bracket in retirement, or who simply have no clue how their future tax rate will compare with their present rate, may be best off practicing tax diversification, allotting some assets to a Traditional retirement savings account and others to a Roth account. That way, they are assured of not making their worst choice (though not their best, either) while giving themselves the flexibility to use tax-free withdrawals to hold down their future tax rates.

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