Tax Diversification: To Roth or not to Roth?

Just about everybody has heard of a Roth IRA.

What is a Roth?

Roth IRAs are most common, but a 401(k) or 403(b) can also be “Roth”, which means that you have already paid taxes on the money in the account. Unlike when you put money in an IRA or 401(k) or 403(b) – often called “Traditional” to differentiate from a Roth – you do not get to deduct the savings from your income on your tax return.

Why would I ever do that?

You give up the tax deduction, but in return, you never pay taxes on that money or the money that you earn on that money again. Remember, when money from a Traditional account is pulled out to be spent, you pay income taxes that year.

Hopefully this guy is ready for the tax bill.

Which is better?

If you pay the same tax rate all the time, there is absolutely no difference. Don’t believe me? Let’s assume you pay 50% taxes. If we save $100 in a Traditional IRA and over our lifetime it grows by 100% to $200, then we spend it, we’ll owe 50% income tax on $200, leaving us with $100. If we instead want to put that $100 in a Roth, we’ll be increasing our income that year by $100 and paying tax on that of $50, so we only end up saving $50. That $50 also doubles, and we end up with $100 which we can spend and owe no taxes on. Same spot. Always works regardless of tax rates and returns.

So it doesn’t matter?

Not exactly. In real life, people are in different tax brackets throughout their lifetimes. When people are just starting out in their careers they typically earn less, and when they are retired, they also tend to earn less. In general, it makes sense to save money in Roth accounts when you are young and when you are old. When you’re old typically you do this via a ‘Roth conversion’, but that’s another post for another time.

Traditional in a high-tax state:

I live in California, where taxes are sky high, so even though I’m relatively early in my career, if I end up living in a lower tax state in retirement or for an appreciable amount of time, I’ll have preferred to have made more Traditional contributions.

Purple staters, Roth aint as good for you.

Roths for a low-tax time:

There’s also a possibility that income taxes trend upwards for the rest of my life, and even if I’m in a relatively lower tax bracket now, if I knew for sure that the lowest federal income tax bracket would be, e.g., 50% in the year 2050 and beyond, I’d probably want to start saving everything in Roth accounts to effectively pre-pay my taxes.

So what do I actually do?

Balancing all of the above factors for myself, and also the fact that it’s generally harder to get money into Roth accounts than Traditional accounts, my actual savings pattern in the following:

  • Max the Roth IRA each year ($5,500)
  • Do the rest of my retirement savings in Traditional accounts

In practice, this means that I’m saving more in Traditional accounts than Roth (although this wasn’t true the first couple of years I worked when my earnings were the lowest), it also means that if I earn more and move to a relatively higher tax bracket, I’ll be saving a higher proportion into Traditional accounts, which is what I want.

The future is unknowable, so there’s no correct ratio for anybody, but having a mix of Roth and Traditional retirement accounts means that no matter what the future holds for tax rates, you’ll have the account that you need to do the job.

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