The choice between contributing to a traditional or Roth IRA. It’s been a long-running debate ever since the Roth IRA was created at part of the Taxpayer Relief Act of 1997. As we discussed in the last post, both types of IRAs have valuable tax advantages. Utilizing a traditional IRA allows you to avoid taxes on contributions and gains, but you are taxed on withdrawals. In contrast, with a Roth IRA you are taxed on your contributions, but your gains and withdrawals are tax-free. So which is better? (In this article I’ll be comparing traditional and Roth IRAs, but the principles also apply to traditional and Roth 401(k)’s as well.)
Traditional IRA/401(k)
Roth IRA/401(k)
Why aren’t we discussing taxable brokerage accounts in this argument? I think the decision whether to contribute to an IRA vs a taxable brokerage account should be obvious. Max out your IRA before putting money into a taxable account, since in an IRA you don’t have to pay tax on capital gains. But the choice between a traditional IRA and a Roth IRA is a little harder. Both are good options for investing your savings, and either should be used before contributing to taxable account. For my analysis on which is better for tax avoidance purposes, I assumed:
- Taxpayers are married filing jointly
- They are in the second tax bracket ($19,901 to $81,050)
- They take the standard deduction ($25,100)
- Inflation affects costs evenly
There is a Definitive Winner
I crunched the numbers and it turns out that the answer is based on your savings rate. If you have a high savings rate, a traditional IRA is better, and if you have a lower savings rate, a Roth IRA is better. The break even point mathematically comes out to be when your IRA contributions can drop your effective tax rate by half. When that happens, you should pick a traditional IRA over a Roth.
If your IRA contributions are less than a certain amount, then it’s better to contribute to a Roth. For example in 2018 the median income for a Midwest family was $64,069/year and their effective tax rate would be 6.6% (after the standard deduction). If this family was regularly contributing $10,000 to a traditional IRA, their effective tax rate would drop to 4.8%, saving them $1,200 in taxes. But when they retire, they would withdraw $54,069/year and incur $3,078 in taxes. This equates to a loss of $1,878 per year due to taxes. So as you can see, we haven’t reached the break even point yet.
If they were contributing $17,900 to a traditional IRA [This is more than the IRA limit, but you could do this with a traditional 401(k) which we already said works in practically the same way], their taxable income drops to $21,069 for an effective tax rate of 3.3%. If they contributed the same amount to a Roth, their taxable income would be $38,969 for an effective tax rate of 6.6%. This is where the break even point is, where contributing to either a traditional or Roth is equally beneficial. If this family were to contribute more than $17,900 they should contribute that money to a traditional IRA, if there were to contribute less, they should opt for a Roth IRA.
What about Inflation?
Again, this is assuming married filing jointly, and taking the standard deduction which is pretty common in the Midwest. This means that all income is taxed in the 10%-12% bracket. The tax code is pretty kind towards Midwest families in that between $19,901 and $81,050 you are only taxed at 12%. And if you include the standard deduction of $25,100 a family can make up to $106,150 before reaching the next tax bracket!
This is also ignoring inflation. Normally I’d get mad at any accountant who ignores inflation, but in this case I think the math works out. The variables that change with inflation are:
- Income
- Cost of living
- 401(k) contributions
- The standard deduction
- 401(k) contribution limits
- Withdrawals (Cost of living in retirement)
Inflation should affect all of these factors evenly (or close enough to be negligible). Below is a table of incomes and which retirement accounts to contribute your savings towards. If a family makes $40,000/year they should contribute up to $5,800 to a Roth 401(k), if they’re saving more than that they should contribute the rest to a traditional.
Income | Roth | Traditional |
$40,000 | <$5,800 | >$5,800 |
$60,000 | <$15,800 | >$15,800 |
$80,000 | <$25,800 | >$25,800 |
$100,000 | <$35,800 | >$35,800 |
Try it for Yourselves
I uploaded the spreadsheet I created. If you want to test it out with your own income and savings just download it and fill in the two green boxes. The result in the yellow box is how much you’ll save in taxes by choosing a traditional over a Roth IRA. If the result is negative then you’re better off contributing to a Roth IRA.
I have read a few articles stating that a traditional IRA is better, but they are usually assuming dual incomes, large salaries, and high savings rates. However here in the Midwest $80,000/year is considered a high salary and it’s not uncommon to have only one working spouse and the other stays home to take care of the children. So in our case a Roth is almost always a better option.
Tax Rate | Married Filing Jointly |
10% | Up to $19,900 |
12% | $19,901 to $81,050 |
22% | $81,051 to $172,750 |
24% | $172,751 to $329,850 |
32% | $329,851 to $418,850 |
35% | $418,851 to $628,300 |
37% | $628,301 or more |
Roth IRA Conversion
There’s also the option of a Roth conversion, which is using a traditional IRA then slowly converting it to a Roth after you retire. If you only convert enough to reach the standard deduction each year, you’ll never have to pay any taxes on it. Of course in 2021 that’s assuming you don’t need more than $25,100/year. Living off that little income is hard, but not impossible, especially if you’ve already paid off your house.
Again this is assuming you have an extremely high savings rate, something that’s hard to do when you only make the median Midwest income of $64,069/year. If you can do it, more power to you! But if you’re closer to the normal end of the savings spectrum, after running the numbers, I’d recommend using a Roth when you can. These principles also apply to 401(k)’s, but as I mentioned in my previous post on what order to contribute to your various retirement accounts, if your company offers a 401(k) match contribute enough to your 401(k) to get the match regardless of whether it’s a traditional or Roth 401(k).
What do you think? Do you agree with my analysis? Do you contribute to a traditional IRA, Roth IRA, or both? Let us know in the comments below!