For my wife and I, the choice between a Roth and traditional account boils down to picking the account mixture that allows us to pay the least in taxes. In simple terms, we do this by comparing the marginal tax rate we pay today and compare it to the marginal rate we expect in retirement. Both Roth and traditional accounts are great options and there are other reasons besides marginal tax rates to pick one over the other. I recommend reading the Bogleheads wiki pages if you need a primer on Roth and traditional retirement accounts or the difference between marginal and effective tax rates. The Roth article gives the following general rules that are helpful for our decision to reduce our marginal taxes:
- If your current marginal tax rate is 15% or less, prefer a Roth.
- If you expect to have higher marginal rates than your current marginal rate for most of your career, prefer a Roth.
- If you will have a traditional account or a pension large enough to meet your expected retirement expenses (and you expect to take that pension shortly after retiring), prefer a Roth.
- Otherwise, prefer a traditional account.
For my wife and I, we can cross out rule one, since we are in the 25% federal tax bracket and the 6% state bracket (highest for our state) with a total marginal rate of 31%. For rule two, I started with an online calculator to estimate how much we expect to withdraw from our retirement accounts each year. Based on a few different calculators, it is unlikely we will have a taxable income (in the form of withdrawals from traditional accounts) in retirement of $151,201 that would bump us into the 28% federal bracket (marginal rate of 34%). We don't have a pension, so rule three is out. Assuming tax rates don't change (they will), we fall into rule four and we should invest in traditional accounts. When my wife started her current job, I used these general rules and started contributing mainly to our traditional accounts. If we had continued only following these general rules over the next 30+ years of our working careers, it could have been a costly mistake. Why a mistake? Because taxes are never really that easy.
How I Tackle This Problem? Model of Course
Before I get into the specifics, let me point out that I am making very broad assumptions about the very distant future (50+ years). I am assuming everything from future market returns and the year I will die, to how Congress is going to adjust taxes to fix the Social Security deficit. Rather than trying to account for every possible outcome, my plan is to assume nothing changes. I use today's tax brackets and rules along with historical returns and inflation and assume these will apply when we retire. My plan is when I write our annual report every year to review our account mixture and update this analysis to see what needs to be adjusted to meet the rules of the day. My hope is that these annual incremental adjustments will be enough of a hedge against large errors in my assumptions. Also for simplicity, I put all dollar figures in 2016 dollars.
The above general rules do not account for how our Social Security income will be taxed. Our state does not tax Social Security income at all and the IRS treats Social Security income fairly favorably (at least at first). The IRS does not start taxing it until your gross taxable income reaches $32,000 (for married couples). To figure out your gross taxable income, the IRS only counts 50% of your Social Security income plus your traditional account withdrawals and any other income you would normally report (i.e. wages, rental income, interest, capital gains). But once you reach $32,000 in gross taxable income, things start getting much less favorable. Every dollar of income over that threshold gets doubled because you have to add a dollar of Social Security income to every dollar of real income. What this means in practice is that your marginal tax rate doubles, until 85% of your Social Security income is taxed. This doubling of marginal tax rates is referred to as the "Tax Torpedo" and, in some situations, can result in federal marginal tax rates as high at 50%.
Since our current marginal rate is 31%, we want our retirement income to stay under the 15% federal tax bracket (~33.4% marginal rate). This means the maximum taxable income we want in retirement is $18,450. That does not sound like a lot to live on for two people, but that is taxable income, not the gross taxable income described above. Our taxable income is "below the line" and is after we excluded our $8,100 exemption and our $15,100 in standard deductions. We also only count a percentage of our Social Security income and none of our Roth withdrawals in that total. So, depending on our actual Social Security benefits, we could have anywhere between $41,650 to $110,000 in gross income (not including Roth withdrawals) before we would pay a marginal rate of 33.4%, with the lower end of that range assuming we do not receive any Social Security and the upper assuming the maximum benefits possible under today's rules.
Ideally, we want to have just enough in our traditional accounts to stay below $18,450 in taxable income and the rest of our funds would be in a Roth account. This would save us at least 7.6% on taxes for the funds in our traditional accounts and 2.4% on all our funds in Roth accounts. But another complicating factor is that traditional accounts have mandatory retirement withdrawals once you reach age 70. The required withdrawals for IRA's start out at 4% of the previous year's balance and slowly increase over time. By the time you are 104, they are as high as 25% of your account balance from the previous year. So we need to make sure the balance in our traditional accounts is not so high that our mandatory withdrawals pull us into the Tax Torpedo.
Input - Social Security
Normally when I estimate Social Security income for retirement planning, I always assume I will only get 75% of what the Social Security Administration (SSA) estimates. This is because the SSA knows it has a 10% shortfall going through 2087 and 23% shortfall going through the infinite time horizon (see Table IV.B6.). A little counter-intuitive but for tax planning purposes, our worst case assumption is that we get our full benefits because this increases the tax burden relative to receiving only partial benefits.
I also assume that we will delay our benefits until we reach age 70. This will give us 5 years after we retire at age 65 to withdraw as much as $98,100 a year from our traditional accounts and stay below our current marginal rates before our withdrawals are impacted by the Social Security Tax Torpedo. Also, the longer we delay our benefits, the larger our overall benefits will be. As long as we live into our early 80's, we should come out ahead. This strategy is a little bit of a gamble. The SSA estimates that as long as I live until I am 62 (the first year I could take Social Security income) my life expectancy is 85.8 and my wife is expected to live until she is 88.9. But this also does not account for my current health, lifestyle, and family history.
My Social Security income was easy to estimate. I just logged into my account on the SSA website (SSA.gov) and looked my annual Social Security report from last year. As a side note, I recommend that you review your Social Security report every year when you do your taxes to make sure you correct any errors.
My wife's estimates were a little harder to get. While she was pursuing her doctorate, her income was exempt from FICA (Social Security and medicare). As a result, she has not earned enough "credits" yet to qualify for Social Security benefits so her account does not currently give an estimate. However, I used the SSA online calculator to get some rough numbers, which honestly are just as accurate as my report estimated.
Output - Retirement
I used a somewhat complex model to determine the maximum amount of money we want in a traditional account when we plan to retire (age 65) and start taking Social Security income (age 70). If you are interested, you can pick apart my model, I have it in a Google Spreadsheet. However, I caution you about using my model. A lot of the inputs and variables are designed for our particular situation and are unlikely to hold true for yours.
Based on the model, the most we should have in our traditional accounts at age 65 is $985,000 and by age 70 we should have withdrawn enough to only have $647,000 remaining. Anything above this amount and we will likely end up paying a higher marginal tax rate in retirement. Nearly a million dollars in a retirement account may seem an unattainable amount, but if we are able to get the historical return of 10% (I normally assume a more conservative 7% in my individual retirement planning) then that works out to only needing to invest $8,000 a year in a traditional account (or $4,000 since we have an employer match).
We are very lucky in that we have lots of options on which accounts we could put our new retirement funds. We can contribute up to $29,000 a year into Roth accounts and up to $65,000 total in all our accounts. Although we currently have a majority of our current retirement funds in traditional accounts, we are below our target maximum amount. Rather than maxing it out early in our careers and then only having Roth accounts as the best bet, we now plan to dollar cost average our contributions over the next 30+ years. This averaging approach should allow us to make it easier to adjust if and when large changes to the tax code happen. In the short term, we plan to contribute up to the match with both our employers (Roth option for my wife, traditional for me), max out both our Roth IRA's, and then add any additional retirement savings into my wife's Roth with her employer.
Although it is impossible to know for sure, based on very rough numbers, I estimate that if we had kept only adding to our traditional accounts we could have ended up paying $100,000 in extra taxes. That much in extra taxes could easily be the difference between retiring early or having to work past age 65.
Even so, I am a little disappointed that the numbers show that we should no longer contribute so much into traditional accounts. I had gotten used to paying a lower tax bill and next year's taxes are going to be a little tough to swallow. However, overall I am really glad I went through this retirement tax planning when we are still young and had not put all our eggs in our traditional accounts.