Are Roth or Traditional Contributions Better?

My recent article about backdoor Roth IRAs included a lot of nitty-gritty details about this maneuver. Congress could wipe out the backdoor Roth IRA loophole with the strike of a pen. But for now it’s alive and well, and worth considering if you’re a high-income person shut out of a direct Roth IRA contribution who doesn’t have a lot of Traditional IRA assets that have never been taxed.

But several readers homed in on and took issue with one of my assertions, comparing the tax benefits of Roth IRAs with those of traditional IRA contributions. I wrote, "If you knew your tax rate would be the same when you took your money out in retirement as it was when you made the contribution, it wouldn't matter whether you made a Roth or traditional IRA contribution. It's a wash.

How could it possibly be a wash, some readers wondered? Doesn't the ability to take tax-free withdrawals in retirement, as is the case with Roth accounts, mean the Roth IRA investor will always end up ahead?

To help answer that question, let's take a look at a couple of example. I'll then discuss situations when investors should favor Roth contributions and when they should favor traditional. (Note that this discussion generally applies to company retirement plan contributions, such as 401(k)s, too.)

Taxed on the Way In, or on the Way Out? Let's assume 35-year-old Cathy is eligible to deduct her full IRA contribution on her tax return because her modified gross income comes in under the threshold for deductibility (in 2017, the threshold for making a fully deductible IRA contribution is $62,000 for single people). Let's further assume that she has $5,000 a year to invest, she socks away money in the IRA for 30 years, earns a 5% rate of return, and is in the 25% tax bracket at the time of her contribution. Because she's not paying taxes on the contributions (she got a deduction), the full $5,000 goes to work for her from the get-go. When she withdraws her money at age 65, she'd have $332,194 built up in her account. But here's when the tax hit happens for Cathy. Assuming she's in the 25% income tax bracket at the time of her withdrawals, her take-home withdrawal, after taxes, is $249,146. None of the money in the account has been taxed yet--she took a tax deduction on her contribution and enjoyed tax-deferred growth--so her withdrawals are subject to her ordinary income-tax rate.

Now let's take a look at a similar example, this time using Roth contributions. Thirty-five-year-old Michael, like Cathy, is in the 25% tax bracket. He too has $5,000 to invest per year, but he has opted for Roth IRA contributions rather than traditional. By the time he pays taxes on his $5,000, his annual Roth IRA contribution drops to $3,750. Assuming the same number of years invested (30), the same rate of return (5%), and the same tax bracket upon retirement (25%), Michael will also have $249,146 when he begins pulling the money out in retirement. His aftertax haul is exactly the same as Cathy's.

Tax Brackets Rarely Static If the balances end up the same whether the contributions were traditional or Roth, does that mean chatter over Roth versus traditional is much ado about nothing? Not necessarily.

That's because our marginal tax rates are rarely a flat line throughout our lifetimes; they may go go up or down based on our own earnings trajectories and savings patterns. A person with a high income but a low savings rate, for example, may well be in a lower tax bracket when she retires than when she was working. After all, if she's no longer earning income from work and hasn't saved much in her retirement kitty, there's not much to tax when she begins withdrawing the money in retirement; nor will she be subject to large RMDs. For such a person, prioritizing deductible contributions is the way to go, because she can at least earn a tax break at the time of contribution when she's still earning her high salary. If her tax bracket drops from 28% when she was working to 15% in retirement, she's better off paying the tax on the way out of her IRA, at the lower rate, than on the way in.

The opposite is also true: The heavy saver who doesn't have a high income from his job may well get a bigger bang from Roth contributions. Even if he's contributing aftertax dollars to his account, as is the case with his Roth contributions, he could be in a lower tax bracket at the time of contribution than he will be at the time of withdrawals in retirement. In short, he's better paying the tax toll on the way in than on the way out.

Of course, many investors likely have no idea how their tax bracket at the time of contribution will compare to their tax bracket in retirement. For such investors, tax diversification--amassing assets in receptacles with varying tax treatments--is a valuable concept.

Here are some additional guidelines to bear in mind when deciding between traditional and Roth contributions.

Favor Roth If You:

• Cannot contribute to a traditional deductible IRA: Contribution limits to be able to deduct your traditional IRA contribution on your tax return are lower than is the case for Roth. Thus, some investors have no choice but to prioritize Roth contributions, either directly or through the backdoor. (This article includes the income thresholds for deductible and Roth contributions.)
• Expect your tax rate to be higher in retirement than it is at the time of contribution: As discussed above, Roth contributions make sense if you think your tax rate in retirement will be higher than it is today. Thus, Roth contributions are often sensible for young investors who are in a low tax bracket (15% or below). Roth contributions may also make sense for investors who expect to spend a lot in retirement and/or already have high balances in traditional accounts that are subject to RMDs.
• Predict that tax rates at large will go up: Even if you don't expect your own income to go up meaningfully in retirement, it makes sense to favor Roth contributions if you expect tax rates at large to increase. (Of course, this is a pretty tricky thing to predict, so you'd want to have some additional factor lining up in favor of Roth contributions.)
• Anticipate that you won't need all or most of your IRA assets in retirement: Roth IRAs, in contrast with traditional, don't have required minimum distributions. Thus, the wrapper can be preferable to a traditional IRA, which does carry RMDs. Roth IRA assets are ideal assets for your heirs to inherit, in that they won't owe taxes on the withdrawals.
• Think there's a risk you'll need to take your money out prior to retirement: Roth IRA contributions can be withdrawn at any time and for any reason without taxes or penalty. Thus, the wrapper is more flexible than a traditional IRA.
• Are saving within the IRA primarily for your heirs rather than your own retirement.

Favor Traditional If You:

• Are in the 25% tax bracket or above and can take a deduction on your contribution.
• Haven't yet saved much for retirement and are age 50-plus but still working. It's likely your tax bracket in retirement will be lower than it is today, making the tax break on the deductible contribution more valuable than saving on taxes at the time of withdrawal.
• Can make a deductible contribution and want to take advantage of tax credits like the child tax credit, education tax credit, or saver’s credit. Deductible contributions to a traditional IRA reduce your adjusted gross income, improving your eligibility for the credits.