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Why A Roth IRA or 401k Might Not Be a Good Idea if Tax Rates Increase

Earlier this year, there was plenty of stalemate drama between Democrats and Republicans over extending the Bush tax cuts. By not extending these cuts, federal income tax rates would have increased for high-income taxpayers. The stalemate was resolved when Congress decided to extend the Bush tax cuts for two more years; at that point, they'll expire, unless taxes are changed at that time.

So if tax rates will increase in our future -- a strong possibility -- should you still contribute to a Roth IRA or, if it's available through your employer, a Roth 401k? That all depends on what your marginal income tax rates are now and when you plan to retire.

To help clarify the issue, let's briefly review the main difference between a traditional IRA or 401k, and a Roth IRA or 401k. With a traditional IRA or 401k, your contributions aren't taxed when you make them; instead, they're taxed when you withdraw them at retirement. With a Roth IRA or 401k, it's the other way around: Your contributions are taxed now -- when you make them -- but not when you withdraw them at retirement.

So the main consideration for whether or not to contribute to a Roth IRA or 401k is a bet on your marginal tax rates now compared to when you retire. If you think your marginal tax rate will decrease in retirement, the traditional IRA or Roth produces more spendable income in retirement after taxes are considered. If you think your marginal tax rate will increase by the time you retire, though, a Roth IRA or 401k would be a better choice because it produces more spendable income in retirement.

But what if your marginal income tax rate will stay the same as it is now after you retire? In this case, the after-tax amount of money you'll have in retirement is mathematically identical (after taxes are considered). Of course, this assumes you'd invest either type of account the same and would experience identical rates of return.

So now let's look at the federal income tax rates. The table below compares the final 2011 tax rates for a married couple filing jointly to what they might have been had the Bush tax cuts expired.

Note that the projected tax rates for after the Bush cuts had expired are somewhat speculative; the amounts shown above come from the budget proposal earlier this year, and were developed by the Tax Policy Center
The first thing you'll notice is that if the Bush tax cuts had not been extended, higher tax rates would have applied only if your taxable income exceeded $212,300. The vast majority of Americans have lower taxable income than this amount now, and that's not expected to change in retirement. The vast majority will also have lower taxable income in retirement compared to while they're working. Put these two facts together, and the traditional IRA or 401k would generate more spendable income, after taxes are considered.

If you're currently in one of the top two tax brackets, however, and you expect to stay in that tax bracket after you retire, and if the Bush tax rates expire, then your tax rates will be higher in retirement. Then it makes sense to use a Roth IRA or 401k.

But if you're in one of the top two tax brackets now, it's possible that your taxable income could drop in retirement. If it drops down to the 28% bracket, then your marginal tax rate in retirement will reduce even if tax rates increase. In that case, it makes sense to use a traditional IRA or 401k.

Here's the same comparison of tax rates for single filers. The considerations discussed above are the same, except that single filers have lower tax brackets compared to married filing jointly.
The above analysis only compares current federal income tax rates to the rates that would exist if the Bush tax cuts had expired. By the time you retire, you could see completely different tax rates and brackets. For example, the U.S. Deficit Commission proposed to reduce income tax rates but also eliminated many tax breaks and deductions. If this happens, there's a good chance your tax rates will decrease in retirement, again arguing for a traditional IRA or 401k.

From my perspective, your bet on your current marginal tax rates vs. your future tax rates is the primary consideration for deciding between traditional and Roth IRAs and 401ks. Here are a few other considerations to take into account:

  • If you don't know where tax rates will be when you retire, contributing to a Roth IRA or 401k could be considered a form of tax diversification.
  • A Roth IRA is not subject to required minimum distributions (RMD) at age 70-1/2, while a traditional IRA is. Note that under current law, a Roth 401k is subject to the RMD, but you can get around this by rolling your Roth 401k into a Roth IRA, which is not subject to the RMD.
And that's just for federal taxes. You've also got to consider state income taxes, using similar logic and comparisons as described above for federal income tax rates.

It's a lot to consider, but it's well worth your time -- you'll need to make every dollar count in retirement. And don't let this complexity serve as an excuse not to save. Regardless of whether you use a Roth or traditional IRA or 401k, you're still better off saving for retirement compared to spending all your money today!

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