A previous version of this column relied on incorrect calculations. The math and column have been corrected.
I’ve had so many reader responses since broaching the subject of traditional and Roth IRAs. It’s clearly a big retirement topic for many people—as well it should be, given that the ability to save $6,000 a year in a tax shelter can be a real help to middle-class people who need to prepare for their senior years.
And it’s a hot topic, because the new tax bill from the House Ways and Means Committee proposes ending IRA tax savings for anyone with adjusted income above $140,000 a year. Among the proposals: Ending our ability to convert our traditional IRAs to Roths after year-end.
During the presidential election campaign, Joe Biden promised not to raise taxes on anyone making less than $400,000 a year. Whether these provisions in the bill survive is an open question.
Lots of readers have weighed in on whether a Roth IRA is better than a traditional one. In a Roth IRA, you don’t get any tax break up front. You contribute money after paying income tax—but then, at least under current law, the money and all future gains are tax-free. In a traditional IRA, you get the tax-break today. You can deduct the contribution from your current income, so that making the contribution cuts your current federal tax bill. But when you withdraw the money in retirement, it’s taxed as income.
Various readers have argued that you will pay less tax in total if you choose a Roth, and you’ll end up with more money. But others argued that that’s a logical fallacy, and I think they’re right. If your tax rate is the same when you earn the money and when you retire, there’s no saving.
Let’s say your tax rate in both cases is 24%. If you invest $6,000 in a traditional IRA and it grows at 5% a year for 20 years, you will end up with $15,900. When you withdraw the money, and pay 24% tax, you’ll end up with $12,100. On the other hand, if you use a Roth, you have to pay 24% tax on that $6,000 upfront, leaving you $4,560 for your IRA. If it grows at 5% for 20 years, at the end you can withdraw, tax-free… $12,100.
(Incidentally the math is the same if you count a full $6,000 contribution to a Roth, so long as you also count the money you save upfront on your taxes on a traditional IRA.)
But here’s the thing. I’ve come to believe those calculations are moot. Most of us—including me—are almost certainly going to be way better off in a traditional IRA.
The reason? We’re paying significant income taxes today on our salaries, so the upfront tax break matters. And we’re going to be paying far lower tax rates in retirement, unless we are doing really well.
Among the reasons: We typically earn less in retirement than we do when we’re working, we often live in lower tax states, we get a higher standard exemption, and we get a tax break on Social Security income. I asked two tax experts — Mark Prendergast at Inspired Financial in California, and Ryan Losi at Piascik in Virginia — to run the numbers on a married couple, filing jointly, with $56,000 a year in Social Security income and $50,000 in other income from IRAs. The couple’s federal tax bill is going to be around $6,500, they agreed.
Furthermore—and when I think about my own senior years, this is a critical for me—financial planner John Gehri at Harvest Financial Adivsors points out that medical expenses are tax-deductible (once they top 7.5% of your adjusted gross income). That means nursing at home, and nursing homes. If you end up using your IRA money for medical costs, the money will pretty much have avoided federal taxes altogether, going in or coming out.
Ryan Losi says Roths are really mostly valuable for those with high net worth and high income. He adds that Roth IRAs are also an especially valuable tool for tax planning for those dealing with a big estate, because the heirs can draw the money tax-free.
I’ve learned this topic provokes passionate responses on both sides. To each their own. But for me? I don’t want to a Roth conversion even if they really are going to ban them after Dec. 31. And if I end up in retirement so well off that I wish I had seized the moment, well, I’ll count myself very lucky.