Thriving Millionaires

By Patrick

Note: This post is Part Three of a three-part series. You can find the other parts here:

Part One: Intro to Individual Retirement Accounts (IRAs)

Part Three: In Defense of the Roth IRA

In our previous post, Intro to Individual Retirement Accounts, Eric brought up the two different types of IRAs you can invest in. Chances are, most people you talk to will recommend that you go for a Roth-IRA. The rationale behind this is you will most likely be in a higher tax bracket later in life, so you might as well pay the taxes now. They also speculate that there is significant uncertainty as to what the tax rates will be, so you might as well pay taxes now so you don’t have to deal with a larger potential tax bill in the future. Either way you slice it, I feel like this is common feedback I hear.

                What I’d like to do today is take a defensive position of the traditional IRA account. While I am not providing specific feedback as to what you should do, I want to share certain variables that may or may not influence someone to take a more serious look at a traditional IRA. At the end of the day, and financial decision you make needs to be done with a thorough analysis of your own life situation.

                So, why invest in a traditional IRA? While many people like to use the language “tax-deferred”to explain the traditional IRA, I prefer to use the term “taxed later.” A similar way to look at a Roth IRA is to say, it isn’t necessarily “tax-free,” it’s just “taxed now.” With that framework in mind, here are a couple considerations as to why a traditional IRA may be the best bet for you:

• You don’t anticipate being in a higher tax bracket in the future

If this is the case, it could make a lot of sense to go with a traditional IRA. A good step to take would be to estimate your future tax rate. There are a variety of ways you can do this, but the best would be to consult with a professional. While there is a level of uncertainty when estimating your future tax rate, if you are someone further along in your career with limited savings, it might be a good place to start with a traditional IRA because you may not have the same amount of time to save up a significant amount of retirement income. As a result, your withdrawals would be lower and you wouldn’t be in a high tax bracket.

• Not planning to have some source of retirement income other than investments

You would need to have a significant amount of money saved in order to be in the top tax bracket when withdrawing your income. Let’s assume that you have $750,000 saved in your account, and you are withdrawing following the 4% rule. This would put your income at $30,000 and place you in the 12% bracket based upon 2018 rates. So unless you are someone who will need a significant amount of money saved, a traditional IRA can be an important component of your retirement strategy without having a significant impact on the taxes you pay in the future.

• The future is uncertain

When social security was first announced, income on it wasn’t taxed. As our government has tweaked the program over the years to make it more financially viable for the future, taxes have become part of the equation. So, why do so many people always say a Roth-IRA is a safe bet? What is stopping the government from taxing withdrawals from those someday? The truth is, nothing is 100% safe. The government could change tax rates on Roth-IRAs simply by passing a law. The same could be said in regards to the tax rates surrounding income and traditional IRAs. The truth is, you need to evaluate what you think will happen and not assume that anything is foolproof.

                With all that being said, I still believe diversifying your strategy to accommodate your life needs is the best bet. There will be situations where a full-on traditional IRA strategy makes sense. The same goes for the Roth. Many of us will probably fall in-between. The important thing is you need to understand where you’re at, where you want to go, and what you’re going to do about it.

Note: This post is Part Three of a three-part series. You can find the other parts here:

Part One: Intro to Individual Retirement Accounts (IRAs)

Part Three: In Defense of the Roth IRA

Eric’s Thoughts:

Patrick outlines the key reasons that a Traditional IRA may make sense for an individual, and I agree with his points. If you don’t believe you’ll be in a higher tax bracket in retirement, if you plan on living on a lower income in retirement, and/or if you have uncertainty about how the IRS may handle things in the future, a Traditional IRA makes sense.

In defense of the Traditional IRA, I’d like to outline a few additional reasons (or, the same reasons from a different perspective, depending on how you look at it) that Traditional IRAs can play an important role in your investment portfolio.

First and foremost, at least in my mind, is the ability to deduct contributions from your taxable income base in the year you make the deductions. Using Patrick’s language, this money falls into the “taxed later” bucket, but that doesn’t mean you don’t receive benefits from lowering your taxable base currently. This can be especially true if you sit near the upper/lower limits of a tax bracket.

For example, let’s say you are filing as a single tax payer in 2019 making $42,000 per year. Because the current brackets are 12% up to $38,700 and 22% for every dollar over that limit, you will pay 22 cents of tax on every dollar over $38,700 whereas you will only pay 12 cents on every dollar below $38,700.

If, in this example, you contribute no money to a Traditional IRA, you will pay approximately $5,370 in income tax. However, if you put $4,000 in a Traditional IRA, you are able to limit the entirety of your taxable income to the 12% bracket. You would owe only $4,560 in income tax. That’s a savings of $810. That savings is money in your pocket rather than in the pocket of Uncle Sam.

Of course, this money will be taxed later in retirement, but assuming you are comfortable on your salary ($38,000 in this example, net of retirement savings via the Traditional IRA) while working, it stands to reason that you could live on the same amount in retirement. If you withdraw $38,000 in retirement from your Traditional IRA and nothing changes in the tax brackets by the time you reach retirement, you will pay at the 12% rate in retirement. That allows you to functionally save 10% on every dollar (vs the 22% rate) over the 12% bracket.

To carry this example forward through a career of 30 years, if you do not contribute to a “taxed later” retirement account, you will pay $161,000 in income tax during your working years. But, if you use a “taxed later” account such as a Traditional IRA, you will pay only $137,000 in income tax during your working years and $14,000 in retirement when the IRA contributions are taxed later. Net of everything, you would save nearly $10,000 in income tax on the exact same money by managing your income to amounts below the step up in tax brackets.

Not everyone will have their taxable income base sit so near to the bracket thresholds, but for those who do, using tax deferred accounts can be an efficient way to save in income tax paid. And, as income changes and/or life changes around you (such as getting married and living in a Married Filing Jointly world), if you don’t find yourself near a bracket cut-off now, you may in the future. It is something to keep a keen eye on over time.

One other major advantage to Traditional IRAs is the fact that there are no income limits to contribute to a Traditional IRAs. While there are restrictions on income in Roth IRAs, such income restrictions do not exist with Traditional IRAs.

There are other benefits to Traditional IRAs that I’ll call “side benefits” because they may not make or break your decision to open/fund a Traditional IRA, but if you have decided for other reasons to go with a Traditional IRA, they are “nice to haves”.

1. You can use money in a Traditional IRA to pay for qualified college expenses without paying an early distribution penalty. Yes, you will pay taxes on the distribution, but you were going to pay taxes on this money down the road either way per Patrick’s “taxed later” point.
2. You can also use up to $10,000 to help with a first home purchase without paying an early withdrawal penalty. As above, this distribution is taxed, but there is no penalty over and above the taxation that applies to the funds.

Personally, my wife and I do not have a Traditional IRA (we use Roth IRAs to balance our “taxed later” 401k contributions as a hedge against taxation changes). But, just because I don’t have one, doesn’t mean I can’t see the validity in the account type and the situations in which it would be beneficial.

Note: This post is Part Three of a three-part series. You can find the other parts here:

Part One: Intro to Individual Retirement Accounts (IRAs)

Part Three: In Defense of the Roth IRA