Thriving Millionaires

By Eric

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 Two: In Defense of the Traditional IRA

Roth IRAs typically catch a lot of grief because of their inability to lower your taxable income. Without that offset, people choosing to contribute to Roth IRAs end up paying a higher tax rate while contributing and because the contribution limit to IRAs is a static sum regardless of whether the money is contributed to a Traditional IRA or a Roth IRA. However, it is possible to view reducing taxable income in the contribution year as short-sighted, depending on one’s personal finances.

Roth IRAs provide significant long-term benefits that can often be more valuable than the single-year tax savings. These benefits depend on the individual situation, but I’ll discuss them holistically and leave it up to you whether or not the benefits may apply to your situation.

Ability to Manage Taxable Income

By paying income tax on the money before putting it into an IRA, you begin to build a pool of funds that can be used in combination with 401ks to manage taxable income in retirement. If you assume that the 2019 tax brackets and rates remain the same until your retirement (an assumption I will challenge later, but will use for this example), income is taxed at 12% up to $77,400. The next bracket is taxed at 22% until $165,000 for married filing jointly. If you and your spouse plan to spend $85,000 per year in retirement, it would be wise to pull the first $77,400 from a tax-deferred account and pay the 12%, but then manage the difference with money from a Roth account.

The math for this example works like this (note – I am ignoring deductions, both standard and itemized to simplify the example):

If you pulled the entirety of the money from a tax-deferred account, to reach the $85,000 per year, you would need to withdraw $96,600 from this account with a tax liability of $11,592.

However, if you pulled from both tax-deferred accounts and made up the difference with a Roth account, you would withdraw $77,400 from your tax-deferred account and $16,888 from your Roth account. You would pay a total of $9,288 in income taxes.

This equates to over $2,300 in tax savings per year!

While this is a sizable tax savings (nearly a 20% reduction), the impact can be seen when you look at the impact of leaving this money in your retirement accounts over a 25-year retirement. Assuming all things remain equal and a 5% return on investments during this time, just the savings on tax liability would equal an additional $110,000 at the end of this time period.

Hedge Against Increasing Tax Rates

I am unable to predict the future. Unfortunate, but true.

Given that fact, I cannot tell you with any level of certainty whether or not tax rates and tax brackets will increase or decrease between now and when you plan to retire. The uncertainty surrounding this topic is what makes Roth IRAs an excellent hedge to traditional 401ks and traditional IRAs.

Because Roth accounts are funded with money that has already been taxed, the individual who contributes to a Roth IRA has locked in today’s tax rates until retirement for the money put into a Roth account. While there is no way to know where tax rates may move in the future, you can remove the uncertainty for a portion of your money by knowing you won’t pay more than current rates.

It is true that tax rates may decrease by the time you reach retirement, but if you accept that you can’t predict the future of taxation, then there is an equally likely chance that rates will increase during the same period. For this reason, using Roth IRAs as a hedge against future taxation changes is an excellent way to think about the money you contribute to Roth accounts now.

Roth IRAs During Low Income Earning Years

Another application of Roth IRAs that potentially gives them the edge over Traditional IRAs is with the underlying assumption that your lowest income earning years are early in your career and that you will receive raises and promotions during the span of your professional career.

If you enter your line of work making $50,000 per year and, through various raises and promotions, end your career making $170,000, it would make sense to contribute as much after-tax money as possible in your early years when you are likely in the lowest tax brackets. As you progress through your career and (hopefully) enter higher tax brackets, the incentive to contribute to Roth accounts diminishes. Because of this diminishing value over time, people currently in lower tax brackets should max out their Roth contributions and then shift to traditional retirement accounts over time as their income increases.

Again, using the 2019 tax brackets and rates for married filing jointly, at the start of your career ($50,000/year), your money would be taxed at 12%. That means that you are locking in that 12% rate on the money you contribute to Roth accounts during this period in your life. If you contribute to a Roth account at the end of your career ($170,000/year) your money would be taxed at 24%.

Maximizing your Roth contributions in your low-earning years will pay dividends in retirement more so than making Roth contributions in your high-earning years.

While there is no perfect answer to whether Roth IRAs or Traditional IRAs are better, there are certainly good supporting cases for when Roth provides advantages over Traditional. Because of Roth IRA’s ability to help manage taxable income in retirement and the fact that my wife and I are likely in our middle income earning years, we contribute the bulk of our IRA contributions to Roth accounts but contribute more to tax-deferred accounts through 401ks. For us and where we are in life, we believe this is the right balance. As our income changes and the government potentially changes tax rates and brackets, we will re-evaluate, but for now, we have a good balance.

Whichever account type you choose to fund, Roth, Traditional, or a mix of the two, the most important thing is to start saving for retirement. You should only begin to worry about tax implications and optimal savings strategies once you have found a way to begin saving. Over-paying on taxes in retirement is always a better problem to have than not having retirement savings at all.

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 Two: In Defense of the Traditional IRA

Patrick’s Thoughts:

It’s hard to argue with Eric’s logic above. There isn’t just one way to approach a retirement strategy or only one right answer. I think Eric did a nice job laying out some conditions where a Roth IRA may make the most sense. If those situations don’t reflect yours, you may want to look at alternative options.

I would caution against being too bullish when it comes to using a Roth as a hedge against increasing tax rates. Since we have no idea of what the future holds, I don’t necessarily think this should be a primary driver for choosing your investments. There are several situations where a Roth makes sound sense, and I don’t think this particular reason should be your motivating factor.

I think the biggest point Eric makes above is “the most important thing is to start saving for retirement.” If you’re in a situation where you are not maxing out your contributions, or simply not saving at all, your first course of action needs to focus on saving anything, even if it’s just putting money in a savings account.

At times, the end goal can seem daunting. Assume, for example, that you need anywhere from $1 million to $1.5 million to be ready for retirement. It’s a scary proposition when you think of it in those terms. I challenge you to break down the amount you need to save on a weekly or monthly basis and just start doing it. There are a variety of online calculators that can help determine how much you need to save based upon your current income, projected retirement income needs, and other variables. I’ve included an example here.

By breaking it down in to bite-sized portions, you’ll not only feel more comfortable with your strategy, but you’ll start showing yourself that you can do it. While you might be frustrated the first few months, as time goes on you will see your savings grow and it will become easier to keep on with your strategy.

One of my favorite quotes states that “80 percent of our results are going to come from 20 percent of our actions”. While Eric and I have shared several thoughts over the last few posts on different strategies you can take to squeeze even more out of your retirement plan, the bulk of the success you have will come from simply saving the money on a monthly basis. Once you get those basics figured out, then you can take the time to optimize exactly how you are spending.

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 Two: In Defense of the Traditional IRA