Traditional wisdom holds that you should only contribute to a Roth IRA if your income tax rate in retirement will be higher than your current income tax rate. I would argue that everyone should have a Roth IRA as part of a diversified retirement portfolio.
What is a Roth IRA?
With a Roth IRA, you pay income taxes on money you earn today and then put that money in the Roth IRA. That money then grows without you having to pay interest, dividend, or capital gains taxes each year. When you retire, you take that money out to spend in retirement and you do not pay any taxes on the withdrawals. If your taxable income in 2021 is less than $125,000 (filing single) or less than $198,000 (filing jointly), you can contribute money you earned directly to a Roth IRA after paying 2021 taxes on that income. If your taxable income is higher than those limits, you can still contribute to a Roth IRA but you cannot do it directly. Instead, you have to do a “conversion” where you first contribute to a traditional IRA and then convert the money in that traditional IRA into a Roth IRA. This is sometimes called a backdoor Roth IRA. There is a limit to the amount that you can contribute each year: $6,000 if you are under age 50 years old or $7,000 if you are over 50.
Roth IRAs have one additional advantage for retirees – there are no required minimum distributions. For traditional IRAs and other deferred compensations investments, when you reach age 72, you are required to withdraw a certain amount of money from your deferred compensation plan accounts. The percentage of the total of all of your deferred compensation plan accounts that you are required to withdraw will be based on your life expectancy. As an example, a 72-year-old retired married couple with $500,000 in their combined deferred compensation plan accounts would be required to withdraw 4.0% of the value of these accounts ($20,000) in 2021. On the other hand, an 82-year-old married couple would be required to withdraw 4.3% ($21,500) in 2021. Roth IRAs are exempt from required minimum distributions so those funds can be left alone each year if desired. This can be an advantage if you: (1) want to leave money to your heirs, (2) are saving for a planned large expense in a future year, or (3) believe that you are going to live longer than the IRA life expectancy tables would predict.
The four retirement income buckets
OK, in reality there are a lot more than 4 sources of money that most retirees can draw from, but for most people, retirement income can be divided into four general categories:
- Fixed income. This includes annual Social Security benefits, pension income, and annuity income. This is a predictable amount that does not change from one year to the next (although it may increase slightly for annual cost-of-living adjustments). This income will be taxed at your ordinary income tax rate.
- Deferred compensation. This includes a long list of retirement savings options including 401(k)s, 403(b)s, 457s, SEPs, RCPs, and 415(m)s. A traditional IRA can also be included in this group if you are able to contribute pre-tax income directly to the IRA – this is the case if you are not covered by another retirement plan at work. You can also contribute to a traditional IRA with pre-tax income if you are covered by another retirement plan at work and your income is < $66,000 (filing single) or < $105,000 (filing jointly). Deferred compensation grows tax-free, so you do not pay any taxes on interest, dividends, or capital gains. When you withdraw money in retirement, the withdrawals will be taxed at your ordinary income tax rate.
- Post-tax investments. Although this can include everything from investment real estate properties to investment artwork, for most people, this will be stocks, bonds, and mutual funds. These are investments that you buy with your disposable income after you have paid income tax that year. Each year, you will pay taxes on interest and dividends from these investments (at your ordinary income tax rate that year) and when you sell these investments, you will pay taxes on the difference between the purchase price and the selling price (at your capital gains tax rate).
- Roth accounts. Although the most common of these is the Roth IRA, there are also Roth 401(k)s, Roth 403(b)s, and Roth 457s. All of these Roth accounts are similar in that you pay regular income tax on the money the year that you contribute to the account and then pay no taxes on the withdrawals.
Why you need a Roth IRA
There are two ways that a Roth IRA can save you money on taxes. First, if you have disposable income after paying this year’s income tax and you want to invest for retirement, you can either put it in a post-tax investment (for example, by buying shares of a mutual fund) or you can put it in a Roth IRA (either directly or by doing a Roth IRA conversion, depending on your taxable income). If you put it in a post-tax investment, then you are going to be taxed every year on the interest and dividends and then when you withdraw the money in retirement, you are going to be taxed on the capital gains – over the years, that will add up to a lot of taxes. On the other hand, if you put that same money in a Roth IRA, you will never pay any taxes on interest, dividends, or capital gains. Therefore, everyone should maximize contributions to a Roth IRA before putting money in a post-tax investment for retirement purposes.
The second way a Roth IRA can save you money on taxes is by taking advantage of periodic changes in federal income tax rates. As I described in a previous post, income tax brackets are one of the most misunderstood parts of the American tax system. What is important is your effective income tax rate and not your tax bracket. The effective income tax rate will vary widely depending on how the U.S. Congress sets taxes. It is a certainty that tax rates will change every few years, largely depending on which political party is in power. Having a Roth IRA allows you to maintain a consistent annual disposable income in retirement while weathering the ups and downs of income tax rates. To demonstrate this, let’s look at the effective tax rates in 2016 versus 2020.
In 2016, the effective federal income tax rate on an a taxable income of $250,000 was 21% or $53,500. In 2020, the same income of $250,000 was taxed at 16% or $40,000. In other words, you would have $13,500 more in disposable income after taxes in 2020 than you did in 2016. In fact, in 2020, you would have to have a disposable income of $430,000 to be taxed at 21% which was the effective tax rate on $250,000 in 2016. Similarly, if your taxable income was $160,000 in 2016, your federal income tax would be 17.5% ($28,000) but in 2020 your federal income tax would be 13% ($20,800), a $7,200 difference in disposable income.
In retirement, during years when the effective income tax rate goes up, you want to draw relatively more money from a Roth IRA and in years when the effective income tax rate goes down, you want to leave the Roth IRA alone and draw more money from your deferred income accounts. By using this strategy, you can maintain a constant disposable income while minimizing income taxes.
It is inevitable that federal income tax rates will go up in some years and down in others during a person’s retirement years. American taxpayers want low taxes but they also want federal services such as Social Security, Medicare, a strong military, investment in transportation & infrastructure, and perhaps in the future even national healthcare. Our political party system results in a see saw effect every few years with pressure to decrease taxes followed several years later by pressure to increase federal services. I would argue that for most people, it is impossible to predict whether their federal income tax rate will be higher or lower in any given year during retirement than it is during the years that they are working. The reality is that over the duration of their retirement years, it will likely be both. Having a Roth IRA allows you to take advantage of these inescapable swings in the effective income tax rate in order to maximize your disposable income.
April 18, 2021