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Traditional IRA or Roth IRA Contribution! Which is Better?

While working and saving funds for their retirement years, people have two choices for making contributions to an Individual Retirement Account (IRA). As most everyone knows, contributions can be made to Traditional IRAs (TIRAs) with pre-tax dollars. In other words, when you file your taxes, contributions to TIRAs are deducted from your annual income. Conversely, annual contributions to a Roth IRA (RIRAs) are not tax deductible. However, TIRAs distributions during one’s retirement years are taxable, whereas RIRA distributions are not taxable income upon withdrawal. The question is, from a taxation standpoint, which retirement account is better to contribute to during your working years that leads to the most “after tax” funds available when you take distributions during retirement?

Since most people are in a higher tax bracket during their working years as opposed to their retirement years, it would seem to make sense to make your contributions to a TIRA. In many cases this is the correct course of action. However, even if one is in a higher tax bracket during their working years, there are some tax differences about these accounts that affect many people that might make one prefer to contribute to a RIRA instead. In this post I will address these differences.

Let us start with comparing the tax results of the two accounts using a straight forward example making one very basic assumption. The assumption is your marginal tax bracket during your working years and your retirement years is the same. In this case, which account is better to contribute to? When you compare the two types of accounts using the same 22% tax bracket at contribution and at withdrawal, after twenty years of 7% annual growth, the results are shown in Table 1.

Table 1

As can be seen in the table, if $10,000 is contributed tax free into a TIRA and allowed to grow at 7% for 20 years and then the withdrawals are taxed at 22%, the available amount to spend in retirement is $30,184. Alternately, the RIRA person paid 22% tax on the contributions leaving only $7,800 to invest at 7%. After 20 years, this amount grew to $30,184. Since the RIRA pays no taxes on the distributions in retirement, the entire $30,184 funds are available to spend; the same as the TIRA. If the tax rate is lower upon distribution, the TIRA would, of course, have the higher net benefit.

So, the decision seems clear. If you expect to be in a lower tax bracket when taking distributions during retirement, then you should contribute to a TIRA (avoiding the higher tax bracket while working). Conversely, if someone thinks they will be in a higher marginal tax bracket in retirement, then it would make more sense to contribute to a RIRA and pay the lower tax rate when contributing. However, the other tax differences about these accounts I mentioned earlier make the decision about which account to contribute to while working less clear. I will discuss a very common retirement scenario below that illustrates this.

The first difference is the fact that TIRAs have what is called Required Minimum Distributions (RMDs) that currently start at age 73 and increases to age 75 for people born in 1960 and later. This means, starting at age 73, a certain percentage of your total TIRA funds (currently the percentage at age 73 is 3.77% and increases every year thereafter) must be withdrawn and taxed…. whether you need the funds or not. Most retirees likely need the funds for living expenses, but for some retirees this RMD withdrawal is not needed. Conversely, the funds in RIRAs do not have any RMD requirement at any age.

Another tax nuance is that, if one makes the same non-deductible contribution amount into the RIRA same as the TIRA (in other words, the same $10k is contributed in both options in Table 1 above), and elects to pay the $2,200 of taxes out of their regular taxable savings, the RIRA gains a small net tax benefit. This is due to the assumption that the $2,200 tax funds would have been invested at the same 7% annual return and then the profits are taxed at the lower 15% long-term capital gains rate when sold 20 years later. The net tax benefit for people in the 22%, 24%, and 32% tax brackets is about 2.4%, 2.7%, 3.5% respectively. However, if the tax payer is in the 0% Long-Term capital Gains tax bracket in retirement, the net tax benefit goes away.

The biggest tax difference between these two types of IRAs is how they each impact the taxability of social security benefits. This is a major difference. A distribution from a TIRA can increase your federal income taxes by several thousand dollars per year as opposed to a RIRA distribution. This additional tax is informally referred to as the Social Security Tax-Torpedo (SSTT) and is caused by any type of additional income, not just TIRA distributions. How does the SSTT work? In simple terms, once your “non-social security income” reaches a certain level, your social security benefits start to be taxed. The amount subject to taxes increases as your non-social security income increases. The amount of your social security benefit subject to taxation stops once your total benefit is 85% taxable. Table 2 below summaries the tax and income thresholds.

Table 2

For non-married people, their social security benefits start to become taxable when their “Combined Income” (CI, defined as 50% of social security income added to all other income) is greater than $25K. For married couples, social security benefits start to be taxed when their CI reaches $32k. So, this is another problem caused by any TIRA withdrawals, whether RMDs or otherwise. This tax-torpedo situation applies to many middle-income retired couples that have a total annual income of between about $60,000 and $150,000. Let me provide a very common real-world example for many married couples of how the social security taxability is affected by TIRA withdrawals in retirement in this income range.

Let us make some assumptions about our example couple. Their combined annual social security income is $66k. They also have an employer pension of $16K per year and $10k in qualified dividend income from their taxable brokerage account. This couple only needs about $100k annually to live in retirement. So, with $92k coming from their social security, pension, and their dividend income, they have been drawing another $8k from their combined TIRAs to give them the $100k of funds to live.

This couple was in the 22% marginal tax bracket when they made many years of TIRA contributions as well as tax-deferred 401(k) contributions. Decades later and now retired; this couple rolled their 401(k) assets into their TIRAs. Today, in addition to their other assets, their combined TIRAs are now worth about $800k.

But next year the couple both turn age 73 and must begin withdrawing their RMDs from the $800k in their TIRAs. Table 3 below tallies their income and shows their federal income taxes paid and the tax rate paid on the increased income due to their TIRA RMD withdrawals.

Table 3

When this couple turned 73, when RMDs must begin, they must withdraw 3.77% of their total TIRA balance (~$800k). So, the minimum distribution, in this case, is about $30k; an additional $22k above what this couple needed for living expenses.

As the Table 3 shows, the additional $22k withdrawal caused this couple’s taxes to increase by $4,734 to a total of $6,369. This additional $4,734 in taxes means the $22K of additional income was taxed at 21.5%. If the marginal tax rate is only 12% when the RMDs start, why is the tax rate on the additional $22k of income at a higher rate of 21.5%? This is a result of two things. First the SSTT embedded in Federal tax law caused the additional income due to RMDs to increase the amount of the social security income that is taxable (from $25,550 to $44,250). For every additional dollar of taxable income added above $44k of CI, an additional $0.85 of social security income also becomes taxable. This is what causes the amount of taxable social security income to increase by $18.7k or 85% of the $22k. This $18.7k is the SSTT.

The second thing that happened in this example is the additional TIRA distribution that caused the SSTT to occur, also caused the couples marginal tax rate to jump from 10% to 12%. This jump in the marginal tax rate is why the effective tax rate on the $22k of additional TIRA income is not 18.5% but 21.5%. This is another potential consequence caused by the RMDs from TIRAs, an unexpected jump into the next tax bracket.

What would this couple’s taxes look like if, earlier in their lives, they had made some RIRA contributions and perhaps some RIRA conversions, and then pulled out the same additional $22k of income from their RIRA instead of from the TIRA? We will assume, for this comparison, the couple managed, over several years, to get $600k into their RIRAs and had only $200k remaining in their TIRAs before the start of RMDs. Table 4 below summarizes the two scenarios based on our example couple’s income of $122k this year.

Table 4

In the RIRA scenario in Table 4 above, the $8k distribution is taken from the $200k TIRA. This satisfies the RMDs for this account. The $22k balance is withdrawn from the couple’s combined RIRAs.

The taxes paid in Table 4 are the same as Table 3. The two differences in the tables is in Table 4 the couple has $22k more funds to spend from their RIRAs, but with no additional taxes. This example also illustrates another important tax characteristic of RIRA distributions. Not only are RIRA distributions tax free in retirement, they are also not included in the CI formula for determining how much of one’s social security income is taxable. In other words, RIRA distributions do not contribute to the SSTT. Many people fail to take this into account when deciding whether to contribute to TIRA or RIRA while working.

But how many retirees are really affected by the SSTT? I do not know the exact numbers. The impact of the SSTT is a function of the amount of social security benefits received in a particular tax year. In Table 5 below I provide a few social security income amounts and the associated starting and ending total income amounts that would subject a Married couple to the 85% SSTT.

Table 5

I think it is safe to say that these income ranges include millions of retired couples in the US.

Let us summarize what this example tells us about the “differences” that one should consider when deciding which type retirement account to fund while working:

1. If someone expects to be in a lower tax bracket in retirement as opposed to their tax bracket when working, contributions to a TIRA makes more financial sense. But, if you expect to collect social security benefits and will be in the approximate income ranges listed above in retirement, you will be impacted by the SSTT. If you are in the lowest 10% marginal tax bracket, any TIRA withdrawals will be taxed at the effective rate of 18.5% (10% + 8.5% = 18.5%).
2. If your TIRA RMDs withdrawals push you up from the 10% to the 12% tax bracket, the effective tax rate on the RMD withdrawal will be somewhere between 18.5% and 22.2% (12% x 1.85 = 22.2%). The SSTT is even worse if the RMD amount pushes you from the 12% to the 22% bracket as your effective tax rate on your RMD amount will be somewhere between 22.2% and 40.7% (22% x 1.85 = 40.7%) depending on how much of the RMD amount is pushed into the 22% tax bracket. So, if the RMD pushes you into a higher tax bracket, it is possible you may no longer be in a lower tax bracket than your working tax rate when you made the contributions.
3. RMDs can cause one to withdraw and pay taxes on money they do not need. However, RIRA funds can stay in the account until you die. In fact, another benefit of RIRAs is any remaining RIRA funds that pass on to your heirs can also be withdrawn by your heirs tax-free. However, TIRA funds are fully taxable at regular income tax rates when withdrawn by heirs.
4. One final benefit of RIRA withdrawals over TIRA withdrawals is insurance against higher tax rates in the future. With the amount of debt the country has accumulated, it seems implausible that tax rates will not be increased sometime in the future. RIRA withdrawals are protected against any increase in tax rates. It is certainly possible in the future that RIRA plans could also be changed or terminated. But, if this happens, it is most likely they would be changed for future retirees, not for people who have already built a retirement plan based on established RIRA rules.

So, which is better TIRAs or RIRAs? Like everything else in retirement planning… it depends. It is an important decision that is unique to everyone’s personal financial situation. Of course, this decision is best made after discussing it with your financial advisor.

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