Roth IRA vs. Traditional IRA: More than Just Tax Brackets

With the start of a new year, many investors revisit the Roth IRA vs. Traditional IRA decision when determining how to structure retirement contributions. Few retirement-planning topics generate as much discussion. The conversation often gets reduced to a single question and answer: Will your tax rate be higher now or later? If higher in the future, go with Roth. If higher now, go with Traditional. While that question surely matters, it oversimplifies what is actually a multi-layered planning decision with additional nuance.

Roth IRA vs. Traditional IRA: Structural Differences

At a basic level, the Roth IRA vs. Traditional IRA difference is simple:

• Traditional (pre-tax) contributions reduce your taxable income today. You get an immediate tax deduction, but withdrawals in retirement are taxed as ordinary income.
• Roth contributions are made with after-tax dollars. There’s no upfront deduction, but qualified withdrawals are tax-free.

If your tax rate is exactly the same today and in the future, most argue that the math does not favor one over the other, pointing to an example similar to this.

This example assumes a 32% tax rate currently and, later on, a 6.5% expected return. The contributions to a Roth account are adjusted downward to account for being “more expensive” because of the lack of a tax break that a traditional pre-tax contribution benefits from. The argument then is distilled down to, “What will my tax bracket be now versus in the future?” If relatively lower now, Roth makes sense; and if relatively higher now, traditional makes sense. Framing the Roth IRA vs. Traditional IRA decision solely around projected tax brackets, however, overlooks several second-order effects that materially influence long-term outcomes.

While the prior example is mathematically accurate, in practice, it usually looks something more like this:

In this example, the tax savings that traditional contributions benefit from are usually spent. As a result, Roth contributions are a forced savings mechanism that can result in a higher ending balance after taxes.

One might be thinking, “Well, I would invest that $7,840 – how does that affect this decision?”

Here is where a lot of the nuance lies. For the most disciplined savers and investors, the dollar amount of the tax savings from the traditional pre-tax contributions is often added to a taxable investment account. This choice makes sense for those wanting to continue to build wealth after maxing out various retirement accounts. However, inherent in a taxable account are a few things: 1) tax drag and 2) future unrealized gains.

Tax Drag, Unrealized Gains, and After-Tax Wealth Accumulation

“Tax drag” refers to the interest, dividends, and capital gains that investments pay out each year and are reported on your 1099. However, tax drag can be mitigated by a few things, like tax-efficient ETFs and tax-loss harvesting.

Taxable investment accounts also result in unrealized gains. Although taxed at preferential capital gains tax rates when sold, there is often an embedded tax liability that’s triggered by using money from these accounts. However, to offset these embedded gains, investors often contribute highly appreciated stock to satisfy charitable goals and/or let the basis get stepped up at death.

Look how ending values compare when factoring in tax drag and unrealized capital gains when savings are used to invest in a taxable account. This example keeps tax rates the same at 32% now and in the future, but Roth comes out ahead.

Now look at what happens when tax rates drop in retirement from 32% to 26%. The ending values are very close to each other, with Roth coming in slightly higher. This shows that the conventional wisdom of only contributing to Roth if you are in a lower bracket today isn’t always the right answer.

None of this suggests that the Roth IRA vs. Traditional IRA analysis always favors Roth contributions. Traditional contributions can be very effective when current marginal tax rates are high and a future low-income window is likely (gap year(s) after a business sale, the “income-valley” years after retiring but before RMDs and Social Security income start, etc.). There might be a great opportunity for planned Roth conversions at lower tax rates as opposed to contributing straight to Roth to begin with.

Tax Diversification as a Risk-Management Strategy

The key is intentionality and planning. We are currently in a historically low tax regime, but where tax rates will be in the distant future is unknown. It also helps to have “tax diversification” – different pockets of savings across all three account types you can pull from when planning for the future: taxable, tax-deferred (traditional), and tax-free (Roth). The value of that diversification becomes most apparent during retirement, when withdrawal sequencing decisions directly influence lifetime tax liability, Medicare premium thresholds, Social Security taxation, and portfolio longevity. Contribution strategy and withdrawal strategy are not separate decisions; they are sequential components of the same long-term tax framework.

Like most personal finance questions, the Roth IRA vs. Traditional IRA decision depends on your unique circumstances, preferences, and goals.

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