by Gene McGovern, MBA, Principal, McGovern Financial Advisors
In the old Popeye the Sailor cartoons, the character J. Wellington Wimpy was often heard to say, “I’ll gladly pay you Tuesday for a hamburger today.” In retrospect, Wimpy can be thought of as employing a metaphor for what’s come to be known as the “traditional” deductible IRA: he’ll gladly pay the IRS on Tuesday (in the future) for a hamburger (a tax deduction) today.
The Core Question: Tax Deduction Now, or Tax-free Income Later?
Wimpy’s offer represents one side of a basic choice many taxpayers and investors face each year. Would you rather:
(1) get a tax deduction now for your IRA contribution, invest the money tax-deferred for 30 to 40 years, and then pay taxes on it all when you take the money out (the traditional deductible IRA), or
(2) pay the tax on your contribution now, invest the remainder for 30 to 40 years, and then take all the money out tax-free (the Roth IRA)?
The Answer May Surprise You
A host of rules and requirements make the choice between a traditional deductible IRA vs. a Roth IRA complicated, but at its core, paying taxes now (at today’s known rates) or later (at unknown future rates) is the central question. And the short answer, which may surprise you, is that it makes no difference at all, if your tax rate stays the same.
Example: Assume that Popeye and Wimpy are each in the 25 percent income tax bracket, both today and when they retire. Also assume that Popeye and Wimpy each decide to contribute $5,500 (the 2017 maximum if you’re under age 50), to an IRA. Popeye chooses the Roth IRA, so he pays 25 percent of his $5,500 in tax today, or $1,375, and invests the rest ($5,500 – $1,375, or $4,125) for 40 years, earning an average compounded rate of return of 5%. Wimpy, true to form, takes his tax deduction (hamburger) today and invests the entire $5,500 for 40 years at the same 5% return.
Flash forward to 40 years later: Popeye’s initial Roth IRA nest egg of $4,125 has grown sevenfold, to $29,040, all of which is tax-free.
Wimpy’s traditional IRA of $5,500, meanwhile, has also grown about seven times, to $38,720. However, Wimpy now owes 25 percent of that in taxes, so he pays the IRS $9,680 ($38,720 X 25%), leaving him with—you guessed it—$29,040.
Popeye and Wimpy end up with exactly the same amount.
The Tax Rate Gamble
Of course, if your tax rate in retirement will be higher than your tax rate today, you’re better off choosing the Roth IRA, since you’ll pay the tax up front at a lower rate. On the flip side, if your tax rate in retirement will be lower than your tax rate today—which may well be true for many taxpayers after they retire—then a traditional, deductible IRA may make more sense.
Complicating matters further, no one can know what future tax rates will be. If you’re using a Roth IRA, you’re essentially betting they’ll be higher. With a traditional IRA, you’re gambling (or at least hoping) that they’ll be lower. As a result, a common strategy is to diversify your tax risk (similar to diversifying your investments) by having a mix of both traditional and Roth IRAs.
Beyond the Core Question: It Gets Complicated
Many other factors beyond simple tax deferral also enter into the choice of a traditional deductible IRA vs. a Roth IRA. Some of these considerations include:
• You’re not eligible to make a Roth IRA contribution at all if your adjusted gross income (AGI) exceeds $196,000 (married filing jointly) or $133,000 (single taxpayers) in 2017.
• By contrast, there are no AGI restrictions on your eligibility to make a traditional IRA contribution. Whether or not that contribution is deductible depends on (1) whether you and/or your spouse are covered by an employer’s retirement plan, and (2) your AGI.
- Note that traditional IRA contributions can be made in two flavors: deductible and nondeductible.
- If both you and your spouse are not covered by an employer’s retirement plan, your traditional IRA contributions are fully deductible, with no AGI limitations.
- If you and/or your spouse are covered by an employer’s retirement plan, the deductibility of your traditional IRA contributions is phased out at various income levels.
Converting from a traditional to a Roth IRA:
• You can convert a traditional IRA (deductible or nondeductible) to a Roth IRA, with no income restrictions. If you took a tax deduction for the traditional IRA, you’ll owe taxes on the amount you convert to a Roth.
• Taxpayers whose income makes them ineligible to make a Roth IRA contribution can instead make a traditional, nondeductible IRA contribution, then later convert the IRA to a Roth IRA, regardless of their income. This is known as a “backdoor” Roth IRA.
• Contributions to a traditional IRA may not be made after age 70 ½.
• There are no age limitations on contributions to a Roth IRA.
• Distributions from a traditional IRA before age 59 ½ are not only subject to income tax but may also be subject to a 10 percent penalty unless certain exceptions apply.
• On the other hand, withdrawals of your contributions (on which you’ve already paid tax) to a Roth IRA may be taken at any time without tax or penalty. In effect, your Roth IRA contributions can serve as a fallback emergency fund.
Required Minimum Distributions:
• For traditional IRAs, the IRS requires that you begin to withdraw certain amounts (called “required minimum distributions,” or RMDs) each year after age 70 ½. These amounts are based on your life expectancy. Failure to do so results in a severe, 50 percent penalty on the amount not withdrawn, in addition to the regular tax due.
• Roth IRAs, by contrast, have no RMDs during the owner’s life. (Inherited Roth IRAs, however, do have RMDs.)
Effect of IRA distributions on your other tax benefits:
• Many tax deductions, credits, and exemptions are phased out if your AGI exceeds certain limits. Moreover, up to 85 percent of your Social Security benefits become taxable once your income exceeds certain thresholds.
• Taxable distributions from a traditional IRA increase your AGI and may result in a reduction or loss of these tax deductions, exemptions, and credits.
• Qualified Roth IRA distributions, because they are tax-free, do not increase your AGI and may thus allow you to keep other tax benefits.
Deciding Which Is Right for You
In the end, the decision of which vehicle to use in making an IRA contribution comes down to your individual tax situation, age, income status, and beliefs about the future. Moreover, as noted above, traditional IRAs can be converted to Roth IRAs (and even back again, within limits) as your personal situation changes. The best option may very well be to employ a mix of the two.
In the meantime, there are a few situations that may clearly favor one type of IRA over another:
• If you (or your children) are early in your career and in a low tax bracket (for example, the 10% or 15% bracket), the Roth IRA is likely to be more beneficial.
• A year in which you are in a low tax bracket (whether starting out, unemployed, or for other reasons) may also be a good year to consider converting a traditional IRA to a Roth, since the tax bite will be smaller.
• If you anticipate wanting or needing flexibility in accessing your retirement savings, the Roth IRA has no 10 percent penalty for early withdrawal (before age 59 ½) of your contributions. (The 10 percent penalty may apply, however, to early withdrawals of earnings on those contributions.)
• Finally, if your income currently puts you in one of the highest marginal tax brackets (e.g., 39.6%), a deductible traditional IRA contribution may be the better bet.
Gene McGovern, MBA is a principal with McGovern Financial Advisors in Westfield. He may be reached at (908) 789-9462 or at moc.s1493514239rosiv1493514239dalai1493514239cnani1493514239fnrev1493514239ogcm@1493514239eneg1493514239.
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