Roth or Traditional: Keep the Decision Personal
When choosing an IRA, consider concrete personal factors such as your asset level and your stage of career rather than difficult to predict tax-law changes, says Michael Kitces.
Michael Kitces is a partner and the director of wealth management for Pinnacle Advisory Group, co-founder of the XY Planning Network, and publisher of the continuing education blog for financial planners, Nerd's Eye View. You can follow him on Twitter at @MichaelKitces.
Christine Benz: It's IRA contribution season, and many investors are confronted with whether to make a traditional or Roth IRA contribution. Joining me to discuss this topic in the wake of the new tax laws is Michael Kitces, he's a financial planning expert.
Michael, thank you so much for being here.
Michael Kitces: Absolutely. Thanks for having me.
Benz: Now, a lot of people rush in their IRA contributions for 2017 late in innings …
Kitces: 'Tis the season. We're coming up on the tax deadline.
Benz: April 17. Many people hit that fork in the road where they can make either traditional or Roth contributions. Can we start by talking about the differences between those two account types from a tax standpoint?
Kitces: Everybody now contributing to retirement accounts gets this fundamental decision: do I do the so-called traditional accounts, where I get a tax deduction when the money goes in, but some day down the road when I spend the money I have to reckon with Uncle Sam and pay my tax bill and report it as income; or do I do the Roth-style account, where I don't get a tax deduction upfront--there is no benefits when you put the money into the accounts initially, but all the money you get in the future is tax-free. It creates this challenge: Do you want to put the money into the IRA now and get a tax deduction today, or do you want to put the money into a Roth and get tax-free income later?
Benz: We should say that income issues could make some of your choices for you. If you earn over the thresholds for deductible IRA contribution, your only choice may be to do a Roth IRA.
Kitces: Right. We do still have income limits on Roth contributions. If my income is too high, I can't do a Roth contribution. I can only do a traditional contribution, and then maybe I'll convert it later and kind of get into the Roth account backdoor. Ultimately income constrains us at least a little bit in the options. Everybody gets to that choice at some point about whether to do traditional accounts or Roth accounts, if only because even if you can't do a Roth contribution upfront, since 2010, we've had no income limits on conversions. If at least you are determined to get to a Roth you can make everything a Roth at the end of the day, you just either do it now, or you put it in traditional now and you make it Roth later under the conversion rules. Anybody saving for retirement ultimately has to make this Roth versus traditional decision.
Benz: One thing that people often hear is that if you are faced with that decision the key thing you want to think about is, is my tax rate higher now when I make the contribution, or is it higher later on, in which case I should make a Roth contribution and pay taxes at the outset. How does the new tax package which went into effect in 2018 affect that calculus?
Kitces: The decision, do I want to pay my bill now or later, is actually really simple: Pay your bill when your rates are lower, and you save money in the long run. If my rates are lower now, I would rather go ahead and put into a Roth, settle up with Uncle Sam. If my tax rates are higher now, but I expect them to be lower in the future, then I put my money into a traditional retirement account, get my deduction while I am working, and then take the money out when I am retired and my income is lower, which was the classic construction for IRAs in the first place.
For most clients historically, we've gone through this with the people that we work with, it's kind of just a projection process: What does our income situation look like now if we are saving this money for retirement. What does retirement look like for you? Some people, we say your rates are actually probably going to be higher by then. You are making good money now, but you are saving really aggressively, you are accumulating a lot of wealth, by the time you retire you've got this pension that your job is going to have, and you've got Social Security, and you've got this retirement savings you are putting on top, and we add it all up and, with all the accumulation you are actually going to have higher tax rate in the future than you do right now. Let's go ahead and put money into a Roth and save for the long term. Particularly we tend to see that with younger folks who are still early in their income and career, so their tax rates are still a little bit lower, and just pay the bill now, your rates are low, you will be settled up for good.
Others are at much higher rates right now. Peak earnings years, they are in their 40s and 50s, dollars are higher and rates are higher. We say let's put money into a good old traditional IRA, and when you retire, and all your wages go away and only partially get replaced by Social Security because the rest of the money gets replaced by your portfolio, we can run that portfolio pretty tax-efficiently so by the time you get to retirement your bill is going to be lower. Let's just do a good old-fashioned traditional IRA and take the money out later.
It was all driven by the trajectory of your income and your wealth and your accumulation so we could figure out, do the dollars added up today that puts you in a certain tax bracket differ than the dollars added up in the future, and what tax brackets are you in then.
Then the Tax Cuts and Jobs Act comes along and says, so here are your tax rates--asterisk--until 2026 when the law lapses and sunsets and goes back to the way it was last year when rates were higher. Suddenly now we have a different factor that comes into play, which is if nothing changes in my income situation, I am just steady throughout and my retirement portfolio perfectly replaces my income now, my rates go up in the future simply because the lower rates now lapse after 2025, starting in 2026. And so that's spurred, we are finding, a lot of new conversations around: should I actually just be doing Roth-style accounts because rates are going up with the sunset down the road and I am retiring more than 10 years out; I am going to use the money more than 10 years out, because I got a long retirement time horizon. Do I need to be doing a Roth account for that reason alone?
That is a part of the conversation for us. I will admit, as we look at it--I do a lot of work on looking at tax policy and tax trends--we've been down this road before. We actually did the same thing with the 2001 tax cuts that President Bush put through. They had a sunset provision, they were temporary for nine years, and they ended up being permanent. Only because when we get there in real time it's not going to be looking at a lapse. When we get there in real time, sometime in December of 2025, Congress could sit down and say, if we don't do anything there is going to be a multitrillion dollar tax increase when the laws go back to the way they were. Whoever is there in 2025 who probably hopes to get re-elected in 2026, usually makes the decision at the time of, we've got to actually keep this thing around after all. That was what happened with President Bush's cuts in 2001--we extended them in 2010. We ultimately made them permanent in 2012.
We are a little bit more sanguine about the idea of, the rates have to go up because this sunset provision that's going to lapse. I live in Washington. The culture in Washington at the end of the day is, the people that are there like to get re-elected and stick around. That usually doesn't happen when giant tax increases go through. Every now and then we manage to raise taxes, but the pressure is likely to be so immense on Congress when the time comes, that we are very skeptical about whether the rates really go up on that basis alone. We think odds are good its going to get extended.
Benz: So that doesn't automatically embellish the case for doing Roth contributions.
Kitces: It doesn’t automatically embellish the case for doing Roth contributions. What it means is, even if the Tax Cuts and Jobs Act lapses, most of the tax rate differentials were about 1 to 4 percentage points, so the 15% bracket became 12%, and the 25% became 22%. We're talking about 2% or 3% increases or changes. We see a lot of people, by the time they go from their peak earnings years in their 50s until they retire, their tax rate goes down by 20%. If it only goes down by 17% because they retire and their income goes away but the tax rates go up--still a much better deal to do a traditional account; maybe ever so slightly less because the rates go up a few percentage points. The actual changes in our income and wealth over time often move us by far more in bracket changes than the Tax Cuts and Jobs Act tinkered with the brackets in the first place.
So yes, it's a factor that we look at, but, A., we think odds are pretty good when the time comes we're probably going to end out extending it; B., in practice if you actually look at how your income and wealth tends change over time, the personal factors tend to be a much bigger magnitude impact than changing the brackets by a couple of points anyway.
Benz: A related question, and you said this is one you hear a lot, a point, really, is that tax rates have to go higher because the most recently enacted tax cuts are going to add to the deficit, which in turn will force someone at some point to raise taxes. How about that argument perhaps being a case for Roth contributions and even conversions of traditional IRA assets to Roth.
Kitces: Certainly, you look at the projections for deficits, both for the core operating budget for the federal government plus the entitlement programs and the compounding issues around Social Security and Medicare--we hear this frequently. Don't tax rates inevitably have to go up at some point? We keep forestalling the day of reckoning, but at some point the reckoning has to come and we have to figure out how to do something about deficits, and if that means all the rates have to go up in the future then shouldn't we be doing everything in Roth accounts. I think there is a really significant caveat to that argument. The caveat is, there is a difference between our tax burdens have to go up in the future--in some way, shape, or form Congress has lots of different tax …
Benz: As a country.
Kitces: Right, as a country in the aggregate--and to say the ordinary income tax bracket on my IRA withdrawal will be higher in the future. We can have higher tax burdens in lots of ways down the road that have nothing to do with making the tax bracket on your IRA withdrawal in the future higher. The primary driver for deficits in the long term over the next 50 to 75 years are driven by the entitlement programs--by Social Security and Medicare. We don't pay for those from our income tax bill now. We pay for those with a separate thing called the payroll tax system, FICA taxes. We pay 15.3%, 12.4% of it is for Social Security, 2.9% of it is for Medicare.
Not to belittle the significance of the entitlement deficits and the issues, but all of the leading proposals on the table have nothing to do with taxing your IRA more. It's entirely built around changing the system we already use to pay for entitlement programs, which are FICA payroll taxes that don’t touch your IRA. Even when we look at the way tax reform played out here, it's actually a very good case in point example. There are lots of ways that we can move tax levers beyond just raising rates. The big one that we already saw a version of: We can just reduce deductions. Congress can increase your tax burden by saying, we are going to cut all your tax rates and we're going to cut all your tax deductions. It turns out if your rates come down and your deductions come down a lot, your burden may go up, you may pay more.
Benz: It sounds like a broad takeaway there is, don't hurt your brain too much trying to think about secular changes in taxes when making this Roth versus traditional decision. Bring it back to your own personal situation, your assets, your point in your career, some of the more personal factors is that overall your guidance?
Kitces: Look at the factors that if we can control or at least we know more about the trajectory of. I am not quite certain who is going to be leading Congress in 20 or 30 years. I am a little bit more certain about what literally your plan is for reaching retirement and if you reach your goals. Let's at least make sure that the strategy you are executing for Roth versus traditional matches the actual goals that you have. And again, it's not to be sort of blase or ignorant of the ramifications of deficits, but just to understand that the idea that we have to deal with a reckoning on deficit some day and tax burdens must go up is a very, very different thing than making a prediction that the tax rate on my IRA will be higher in the future. We can very much solve deficit issues and increased tax burdens without necessarily increasing the rate on your IRA. So for that reason alone we tend to push toward, let's keep it more focused on the things that we are literally planning for and that we can control a little bit more, rather than making some maybe overly precise forecast that the one particular way that Congress will decide to solve the burden is tax my personal IRA more, when that may not be what they chose to do when the time comes.
Benz: Great advice as always, Michael. Thank you so much for being here.
Kitces: Absolutely. My pleasure. Thanks for having me.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.