To Roth or Not to Roth
To Roth or Not to Roth, that is the question.
There are some inherent assumptions in the question itself – primarily that the questioner has already decided to kick some hard earned Washingtons into a retirement account. Rainy days are inevitable, and even squirrels are wise enough to stash acorns away for later. And while bank haters exist (and the millennial version perhaps hoards gift cards instead of stashing paper bills in coffee cans), the vast majority of us have enough faith in financial institutions to place a long term bet on a retirement account. So given that Keurigs seem to be replacing coffee cans, and gift cards have expiration dates, a long term account in a financial institution is not a bad way to go. But To Roth or Not to Roth, what should a saver do?
The term “roth”
William V. Roth, Jr. was actually a person, a senator from Delaware that suggested that perhaps some people would prefer to pay tax on their retirement account contributions instead of deferring the tax until later. Americans traditionally have an abysmally low savings rate. Deferring tax on contributions made to retirement accounts was a kicker initially intended to incentivize taxpayers to save. The deal was that a taxpayer could deduct the contribution to the retirement account and thus pay less federal tax when the contribution was made. But the tax would be assessed later when the money is distributed from the account. The contribution would grow tax free until distributed, and both the contribution and the earnings would be taxed later.
The strategy worked. Taxpayers began kicking money into Individual Retirement Accounts, and IRA became an everyday term for long term money. The smart thinking was deferring tax was a good idea, especially if you’re in a higher tax bracket now than you will be when you retire and start reaping the rewards doled out by your IRA. Throwing money annually into an IRA was a great rule of thumb for every taxpayer. And then along came radical Roth.
Roth said, pay the tax now, not later, and the kicker is that both the contribution and the earnings will be tax free later. As plot complications go, this one is a zinger. First, most people don’t know what their marginal tax rate is now, let alone what it will be later. And estimating what earnings will be when you take the money in the future is another fun calculation due to the compounding nature of interest. Then there is the whole government trust issue, what if the government reneges on their promise that the contribution and the earnings will be tax free in the future (and that’s not too far fetched – the tax law is constantly changing, and taxing at least the earnings as a preference or for alternative minimum tax purposes is an idea that some would generate a lot of revenue for uncle Sam).
Pay now or pay later
Conspiracy theories aside, and assuming the government keeps their Roth promise, is it better to pay tax now on the contributions, or pay tax later on both the earnings and the contribution? So there are few general guidelines. The longer you’re stashing the money, the higher the earnings. Under Roth rules, the earnings are not taxed. So if you have a long savings horizon (eons before you get to stay home and eat chocolates in retirement bliss), paying now and avoiding the tax on the earnings is a good plan. This is especially true if your tax bracket now is approximately the same as what you expect it to be when you retire. But what if you’re not a spring chicken, you’re already hoarding chocolates in the freezer, and your big screen TV is already set to increased font size? Your tax rate now may be much higher than it will be a few years down the road when you’re taking money out.
A good accountant could further complicate this by adding in time value of money (a greenback now is worth more than later) and considering the decision as a stream of annual contributions. And will this contribution be the first money you take out of your IRA or the last? And I’m all for keeping accountants employed, but for simplicity sake, ignore that for now. Make your decision on this year’s contribution only.
To do the basic calculation, you need to know four things:
- What is your tax rate now?
- How long before you retire?
- What will your tax rate be when you retire?
- How much will the contribution earn between now and when you retire?
Step 1: Take the contribution plus the earnings, and multiply by the retirement tax rate to determine the traditional IRA tax. Subtract the traditional tax from the contribution plus the earnings. This is your traditional IRA result.
Step 2: Then take the contribution multiply that by your current tax rate. That is your Roth tax. Tally your contribution, less the Roth tax, plus the earnings. Compare that result to your traditional IRA result.
Step 3: Go with the higher result.
Here’s an example – 35% tax rate now, retiring in ten years, 20% tax rate upon retirement, 6% earnings over ten years, (6% * ten years = 60%, or 69% if you insist upon compounding).
For a one thousand dollar contribution:
Traditional – (1,000 + 600)* .2 = $320 tax – traditional result of $1,280.
(1,000 contribution plus earnings of 600 less tax of 320).
Roth – 1,000*.35 = $350 Roth tax, Roth result of $1,250.
($1,000 contribution- $350 tax + $600 earnings)
So, for all you taxpayers that still have 20/20 vision, go Roth! Beyond a time horizon of ten years, the elimination of tax on the earnings beats the initial tax paid now on the contribution. And if you already have a pair of drug store readers, and you can take a Roth contribution later than when the year you retire – then consider it. But if you’re like most of us, and you need a little reduction in your annual tax bill to afford the contribution, then go traditional. But whatever you do, the first decision, the one to save money, is a good one. When was the last time you heard someone say they wish they had saved less? Roth or not, we all need a few acorns.
Nancy Keene is the Chief Financial Officer at Dan T. Moore Company. She plays a major role in DTMCo.’s success and Investment Philosophy. Her blog series, Nickels and Dimes with Nancy, will periodically share her insights and wisdom on a plethora of financial topics. Visit Our Team page to learn more about Nancy.