Are Roth IRAs and 401ks Better Because Tax Rates Will Increase? Don't Count On It

Last Updated Oct 14, 2010 9:05 PM EDT

In my last post, I analyzed the pros and cons of investing current and future 401k contributions in a Roth 401k vs. a traditional 401k. In that post, I showed that the level of current and future marginal income tax rates will influence your decision as follows:
  • If you're in the same tax bracket now and in retirement, there's no difference in the after-tax amount you have to spend in your retirement between the traditional and Roth 401k.
  • If you'll be in a higher tax bracket in retirement compared to now, you'll have more money to spend in retirement if you contribute to a Roth 401k.
  • If you'll be in a lower tax bracket in retirement compared to now, you'll have more money to spend in retirement if you contribute to a traditional 401k.
Many financial planners and writers are advocating investing in Roth 401ks and IRAs because they expect marginal income tax rates to increase as federal and state governments attempt to close their significant budget deficits. It's highly possible, however, that you'll still be in a lower tax bracket when you retire, even if income taxes are raised. In that case, a traditional IRA or 401k will still result in you paying lower income taxes and having more money to spend in retirement. This post shows you the reasons for this conclusion.

For a majority of boomers, Social Security will be the largest source of retirement income. And while the rules regarding taxation of Social Security benefits are complex and beyond the scope of this post, let's just say that for most boomers, as much as half their Social Security benefits won't be included in their taxable income. For people with the highest retirement income, at least 15 percent of their Social Security benefits will be excluded from taxable income.

Now consider that most people don't have substantial pensions or 401k savings, and so their retirement income from these sources might be quite modest. Put these two facts together, and it's likely you'll be in a low tax bracket when you retire, even if income tax rates are increased from today's levels.

Let's take a look at the federal income tax rates to see why this might happen for many people. Here are the 2010 marginal tax rates for married taxpayers filing jointly:
  • 10 percent on the income between $0 and $16,750
  • 15 percent on the income between $16,750 and $68,000
  • 25 percent on the income between $68,000 and $137,300
  • 28 percent on the income between $137,300 and $209,250
  • 33 percent on the income between $209,250 and $373,650
  • 35 percent on the income over $373,650, plus $101,085.50
The tax rates shown above apply only to taxable income, which is almost always less than your gross income, due to deductions, exemptions, and other adjustments.

Many readers are likely currently in the 25 percent or 28 percent income tax bracket. During retirement, however, it's highly likely you'll fall into the 15 percent tax bracket for the reasons mentioned above. Even if the 15 percent tax rate is raised by a few percentage points, it will still be below the current 25 percent or 28 percent rates. And if you're currently in the 28 percent tax rate and retirement causes you to drop only from the current 28 percent bracket to the 25 percent tax bracket, the government would need to increase the current 25 percent tax rate by more than 3 percentage points for you to lose out.

The logic is the same for single taxpayers. Here are their 2010 marginal income tax rates:
  • 10 percent on income between $0 and $8,375
  • 15 percent on the income between $8,375 and $34,000
  • 25 percent on the income between $34,000 and $82,400
  • 28 percent on the income between $82,400 and $171,850
  • 33 percent on the income between $171,850 and $373,650
  • 35 percent on the income over $373,650
So the rationale for a traditional IRA or 401k -- that you'll be in a lower tax bracket when you retire -- may still hold for many people.

Here are three possible exceptions to this conclusion:
  • If you have substantial current income and are being taxed at the 33 percent or 35 percent rates, and you expect that level of income to continue into retirement, then your income tax rate might be higher in retirement if income tax rates are increased.
  • If you continue working during your retirement years to make ends meet and supplement your wages with withdrawals from your 401k accounts, you might remain in your current tax bracket.
  • Young people at the beginning of their careers and in the lowest tax rates might reasonably expect to jump up to higher income tax rates when they reach their full earning potential.
In any of the above situations, it might make more sense to use Roth IRAs or 401k for current and future contributions.

Note that the analyses in this post only consider federal income taxes; you'll want to consider state income tax rates as well before coming to a conclusion that works best for you.

And one more thought: Let's not forget that our politicians might not raise income tax rates, particularly given today's political environment.

As mentioned in my previous post, if you're still unsure whether a Roth IRA or 401k is for you, consider a form of tax diversification that splits your money between traditional IRAs and 401ks and Roth IRAs and 401ks. And whatever you do, don't use these complications as an excuse not to save for retirement. Regardless of the type of IRA or 401k you use, you're still better off saving compared to spending your money today.

More on CBS MoneyWatch
Roth 401k vs. Traditional 401k: Which Is Best for You?
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    View all articles by Steve Vernon on CBS MoneyWatch»
    Steve Vernon helped large employers design and manage their retirement programs for more than 35 years as a consulting actuary. Now he's a research scholar for the Stanford Center on Longevity, where he helps collect, direct and disseminate research that will improve the financial security of seniors. He's also president of Rest-of-Life Communications, delivers retirement planning workshops and authored Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck and Recession-Proof Your Retirement Years.

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