What’s the best retirement strategy for you?
What type of retirement account will provide a larger balance and therefore greater distributions? Will it be a traditional IRA, 401(k), 403(b), etc., where contributions are either deductible or made pre-tax? Or, will it be a Roth IRA, or Roth 401(k) where contributions are made after-tax?
The answer depends on the tax bracket you are in when making contributions as compared to the tax bracket you are in when you are taking distributions.
Let’s look at an example:
Let’s assume that you are in a 30% income tax bracket for every year that you contribute $6,000 to a traditional individual retirement account (IRA). If the account earns 5% every year, then, at the end of 10 years you will have accumulated $79,241. Most people think that they will be in a LOWER income tax bracket when taking distributions. If your tax bracket is LOWER when taking distributions than it was when you were making contributions, then a traditional IRA provides a larger balance at the end of ten years for you than a Roth IRA. In the above example, if you are in a 20% income tax bracket in your distribution years, you will net $63,393 with a traditional IRA compared to $55,469 with a Roth IRA.
If you are in that 30% bracket when making contributions to a Roth IRA, then the after tax contribution would be $4,200 after paying income taxes of $1,800 (30% of $6,000). If the account earns 5% every year, the Roth IRA accumulates to $55,469, which can be withdrawn tax-free regardless of your income tax bracket., assuming you are at least 59 ½.
If you are in the SAME tax bracket during contributions as you are during distributions, then the traditional and the Roth alternatives produce the SAME net after tax result, $55,469.
If you are in a HIGHER income tax bracket during your distribution years than you were in during your contribution, then the Roth IRA provides a larger balance at the end of ten years when compared to a traditional IRA. If you are in a40% tax bracket when taking distributions and a30% bracket when making contributions, then the $55,469 Roth IRA account value is greater than the $47,544 traditional IRA account value.
However, income tax brackets in the U.S. have been both higher and lower than they are today. In 1975, for example, a married couple filing jointly would have been in a 50% bracket with income of $44,000. Source: Federal Income Tax Brackets for Tax Year 1974 (Filed April 1975)(tax-brackets.org) The top income tax bracket that year was 70%. For 2020, that married couple’s $44,000 of income would have been in a 12% bracket. Source: Federal Income TaxBrackets for Tax Year 2019 (Filed April 2020) (tax-brackets.org) The top income tax bracket for 2020 was 37%.
Keep in mind that traditional IRAs require the owner to take required minimum distributions (RMDs) starting in the year you turn 72, whereas a Roth IRA does not require an owner to take RMDs.
Which is better for you? Just like you should diversify your investments, consider diversifying your retirement savings. Have both traditional and Roth accounts. Who knows what the income tax brackets will be for the rest of your life?
The information herein is for informational purposes and is not intended to be, and should not be construed as, legal or tax advice.
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