The folly of choosing a Roth IRA or Traditional IRA based on tax brackets


If you’re saving for retirement (and you are saving for retirement, or at least working towards it, right?) you have probably been confronted with a choice when it comes to self-directed retirement accounts: Do you use a Roth IRA or a Traditional IRA?

I’m not going to rehash that debate here. I’m clearly on Team Roth and generally think that everyone would be better using a Roth (assuming you’re able to).

But there’s one piece of the decision-making process that I wanted to focus on here, since it seems relevant to the events of today:

Deciding on a Roth IRA versus a Traditional IRA based on tax brackets.

How tax brackets affect the choice

Here is what Schwab has to say about it:

Roth vs. Traditional
Using a different site from Vanguard today so people don’t think I work for them or something.

So the choice is at least partially based on whether you think you’ll be in a higher or lower tax bracket when you retire. Higher tax bracket? Go for Roth. Lower tax bracket? Go for Traditional.

If you don’t see the problem yet, look at the recent tax law.

First, the rationale

Let’s grant that the tax bracket angle makes a certain raw sense. With a Roth IRA you pay taxes “now”, and with a Traditional IRA, you pay taxes “later”. If you’re in a higher tax bracket now, it makes sense to pay taxes “later” (Traditional), but if you’re in a lower tax bracket now, it makes sense to pay taxes “now” (Roth).

But there are two rubs.

Rub #1: It is difficult if not impossible for us to predict with any accuracy whether we’ll be in a higher or lower tax bracket in retirement.

Do you know what you’re going to be making in ten years? If I would go back in time to ten years ago and show my self my salary trajectory, I wouldn’t have believed it. Ten years from now it’ll probably be the same thing, no matter what happens.

And make no mistake, your income is one of the biggest indicators of what kind of generated income you have in retirement. If you make $200,000 a year for your working life, you’re not exactly guaranteed to have more in the bank than if you made $50,000, but there’s a good chance (and I certainly hope so).

And more in the bank means more income you can take out, which means, of course, a different tax bracket.

Rub #2: We have no idea what our tax brackets are even going to be.

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So some of you might have heard about a little tax bill that went through Congress. Regardless of the details, one thing is certain: we all have new tax brackets now.

GOP tax brackets single
Source: Fortune Click the image to see the full list of charts

So if you’re single and you make $50,000, your old marginal tax rate was 25%, but your new marginal tax rate is 22%.

(Never mind for now that your actual tax rates were 16% and 14%, respectively, in the above.)

What might your tax brackets be in the future?

My predictive powers are usually pretty terrible, but this one is especially hard.

It seems to me that taxes need to go up, as we are currently starving our government of the funds necessary to do its duty, and we as a society rely on the benefits that it provides. (We tend to stop hating the “gummit” when we need something from it. And the government is better suited to provide for all of us than private interests.)

On the other hand, we have people in power who are intent on crippling government, at least the parts that are responsible for taking care of its citizenry.

History is not a good guide. The following chart shows the top marginal tax rate over time, along with a whole lot of other goodies.

Marginal tax rates history
Source: Wikipedia Click the image to see the full size.

So anyone over the age of 40 today was alive when there was a top marginal rate of at least 70%. Was that a better system? It’s impossible to say, though I do see at least a correlation between income inequality, homelessness, and mass poverty with lower taxes paid. Just saying.

The point, if it’s not clear enough, is that no one can predict what their tax rate is going to be in the future.

So if you’re deciding on Roth IRA versus Traditional IRA, you’ll need to decide based on other criteria.

Whichever you pick, though, just pick one of them. The choice isn’t so important that you would want to hold off starting. (You can always start one of each!) Yourself from ten years in the future is about to visit, and you don’t want them to be disappointed in you.

But enough about me. How do you feel about the Roth versus Traditional debate?

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