The Forgotten Deductible Traditional IRA

This article is inspired by a post made by Kevin M on the Bogleheads forum. You may have heard of this rule of thumb about retirement savings priorities:

  1. Contribute to 401k (or 403b) to get the full employer match
  2. Maximize Roth IRA
  3. Maximize 401k (or 403b)
  4. Invest in taxable account

Kevin asked why a Roth IRA as opposed to a deductible Traditional IRA is used in Step 2. It’s a very good question. In the financial media and blogs, everybody talks about the Roth IRA. The deductible Traditional IRA is hardly mentioned.

There are reasons Roth IRAs have better publicity. Some are good reasons; some aren’t. Today’s article is about the forgotten deductible Traditional IRA and how it shouldn’t be neglected.

Available to Most

One reason a Roth IRA is recommended more often than a deductible Traditional IRA is probably because some people can’t contribute to a deductible Traditional IRA but they can contribute to a Roth IRA. For people covered by a retirement plan at work, the AGI cutoff for contributing to a deductible Traditional IRA in 2014 is $70k single, $116k married filing jointly whereas the cutoff for contributing to a Roth IRA is $129k single, $191k married filing jointly.

Therefore for people with an AGI between $70k and $129k (single) or between $116k and $191k (married filing jointly), if they are covered by a retirement plan at work, the Roth IRA is an option but the deductible Traditional IRA isn’t.

But that’s only a narrow band. The vast majority of people have an AGI below $70k single, $116k married. The deductible Traditional IRA is also an available option to these vast majority of people but they probably don’t hear about it as often as they do about the Roth IRA.

Also remember the AGI is after all pre-tax deductions from the paycheck such as 401k contributions and health insurance. The actual cutoff for gross income is probably another $10,000 higher.

It could be because people who consume financial media tend to have a higher income. Therefore the financial media write for the higher income people. If your AGI is below $70k single/$116k married but you are reading articles written for people with income above that, you are not getting the full picture if the articles don’t state that assumption.

Moreover, according to data from EBRI, only 60% of all workers have a retirement plan at work to begin with. For the other 40% of the population who don’t have a retirement plan at work, there’s either no income limit at all for contributing to a deductible Traditional IRA or the income limit is the same as that for contributing to a Roth IRA.

I would say most people are eligible for a deductible Traditional IRA but they don’t know it.

Traditional Wins

When both options are available, should you automatically choose a Roth IRA over a deductible Traditional IRA, as the coverage in the financial media would suggest? Of course not.

I wrote The Case Against Roth 401k in 2008. It’s still as relevant today. Everything I mentioned in that article against a Roth 401k applies to Roth IRA as well, if you have the option to use a deductible Traditional IRA. To summarize, a deductible Traditional IRA helps:

  • Fill in lower tax brackets in retirement
  • Avoid high state income tax
  • Leave the option open for Roth conversion in the future
  • Avoid triggering phaseouts and AMT

You still have to evaluate today’s tax bracket versus the possible tax brackets when you retire. If today’s tax bracket is 25% plus state income tax rate, it’s far from a forgone conclusion that tax rates will be higher when you retire than they are when you are working.

Don’t Worry About RMD

Roth proponents often cite lack of Required Minimum Distributions (RMD) as an advantage of Roth accounts. It’s true but I’m afraid that’s another artifact of today’s retirees having pensions.

When you have a pension and you live comfortably on the pension and Social Security, RMD from your 401k and IRAs starting at age 70-1/2 adds to taxable income, which is taxed at the marginal income tax rate and probably triggers some other taxes and phaseouts.

However, most of today’s workers don’t have a pension. They will need to withdraw from their 401k and IRAs anyway for retirement income. RMD won’t be a big problem if you don’t have a pension or you don’t have a large account balance. For the vast majority, the problem will be not having enough balance in the 401k and IRAs. It won’t be being forced to withdraw more than they need.

Irrational Reasoning

So why are Roth IRAs and Roth 401k’s so popular that the deductible Traditional IRAs are almost forgotten? I can think of two reasons.

First, many people have a zero marginal income tax rate. It’s been reported nearly 50% of taxpayers don’t actually pay federal income tax after all deductions and credits. If the marginal tax rate is zero, Roth IRA is the right choice.

The second reason is certainty. Paying a known rate today versus an unknown rate in the future is appealing, but I don’t think it’s rational, at least not for everybody. If the rate is low enough (< 10%?), paying it to remove uncertainty can be worth it. If it’s 25% plus state income tax rate, it’s not clear at all. Going for certainty can cost you in retirement income.

Don’t forget the deductible Traditional IRA.

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  1. mikep says

    There is one case you did not include. Married filing joint with only one spouse covered by a retirement plan, the non working spouse can contribute to a deductible IRA up to $167k phased out to $177k, which is what we do. The working spouse is not eligible for a deduction but the non working spouse is.

  2. Harry Sit says

    mikep – Thank you for your comments. I sort of include it in the “income limit for deductible = income limit for Roth” case but it’s always good to call it out specifically.

    “For the other 40% of the population who don’t have a retirement plan at work, there’s either no income limit at all for contributing to a deductible IRA or the income limit is the same as that for contributing to a Roth IRA.”

    The spouse eligible for a deductible IRA doesn’t have to be non-working. The spouse can be working for an employer that doesn’t offer a retirement plan. If their combined income falls in between the limit for a deductible Traditional IRA and a Roth IRA, one spouse with a retirement plan at work can’t do a deductible Traditional IRA but the other spouse who doesn’t have a workplace plan or doesn’t work can still do a deductible Traditional IRA.

  3. Wai Yip Tung says

    What I have against Roth IRA is that I like to have a steady stream of taxable income even after retirement. That’s because I have factored in the tax deduction for mortgage interest and property tax when I brought a home. (Yes I may still be paying mortgage after I retire, why not.) Not having an income to deduct is amount to a tax increase for me.

  4. Kevin W says

    To clarify – just because someone doesn’t pay any federal income tax doesn’t necessarily mean that their marginal tax rate is zero. Refundable tax credits can mean that someone in this situation might still prefer a deductible IRA. I’m sure you realize this as you covered refundable tax credits earlier this year.

    I chose a deductible IRA this year because I calculated that refundable tax credits made my marginal tax rate 31%

  5. Jason Sacks says

    Can one of you fine readers help me? I’m not sure I follow the math here, and I’m not clear how this affects my family.

    We’re married filing jointly, and our joint household income is approximately $180k. My wife’s work offers a traditional IRA but mine does not offer any retirement. I’m unclear whether I can contribute to a deductible IRA. Can one of you fine readers help me understand the answer to that question?

    Second question: what if I change employers midway through the year next year, from an employer that does not offer IRA to one that does? What are my contribution limits in 2011 if I qualify to make IRA contributions currently?

  6. Harry Sit says

    @Kevin W – Good catch. Thank you. If an additional deduction makes the total tax more negative, the marginal tax rate isn’t zero.

    @Jason – If your combined income for 2010 comes out to $180k, because it’s more than the $177k upper limit, you won’t qualify for a deductible IRA or a Roth IRA. You can only do a non-deductible IRA. If you don’t have other traditional IRAs (say a rollover from a previous 401k), you can immediately convert the non-deductible IRA to a Roth IRA with minimal tax impact.

  7. Pete says

    Another factor is probably “tax diversification” — generally people have significant tax-deferred assets from 401k plans and the like, but one’s eligibility to make Roth IRA contributions (even if alternatively eligible for the IRA deduction) may be the only opportunity to obtain that treatment on a relatively small amount of savings. Roth 401k is still fairly new.

    As problematic as rules of thumb can be, the built-in hedging of bets that you get from recommending “fund your 401k up to the match, then Roth IRA” gives it a certain cachet — especially in venues where investing aphorisms have to be bandied about in the absence of particulars (as in mass media reports, and to some extent online forums).

  8. slug | says

    @Pete Exactly. That’s why I Roth. Tax diversification helps me sleep well at night. I don’t trust the markets much, but I trust politicians and tax policy even less.

  9. Steve says

    What if you and your spouse both have 401(k) plans, but your income after the max contributions to both plans is below $109k?

  10. Steve says

    I assume the answer is the same, but furthermore, what about other tax deferred options, including but not limited to: 403(b), 457 deferred compensation, flexible spending plans, HSAs…

  11. Harry says

    Steve – Those pretax contributions coming directly out of the paycheck don’t show up as income on the W-2 and therefore are not part of the AGI. As long as your AGI is below the threshold, you are eligible for contributing to a deductible traditional IRA.

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