This article was 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:
- Contribute to 401k (or 403b) to get the full employer match
- Maximize Roth IRA
- Maximize 401k (or 403b)
- 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 People
One reason a Roth IRA is recommended more often than a deductible Traditional IRA is probably that 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 2022 is $78k single, $129k married filing jointly whereas the cutoff for contributing to a Roth IRA is $144k single, $214k married filing jointly.
Therefore for people with an AGI between $78k and $144k (single) or between $129k and $214k (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 $78k single, $129k 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 $78k single/$129k 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.
Higher Income Limit Without a Workplace Retirement Plan
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.
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. It’s still true 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 future Roth conversions
- Avoid triggering phaseouts
You still have to evaluate today’s tax bracket versus the possible tax brackets when you retire. If today’s tax bracket is 22% plus state income tax rate, it’s far from a forgone conclusion that tax rates will be higher when you retire than when you are working.
Don’t Worry About the RMD
Roth proponents often cite the 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 72 adds to your 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. Their problem won’t be being forced to withdraw more than they need.
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 think they have a zero marginal income tax rate because they have low income. It’s been reported nearly 50% of taxpayers don’t actually pay federal income tax after all deductions and credits. However, their marginal tax rate isn’t necessarily zero. If they take a deduction they will receive more refundable tax credit.
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 everyone. If the rate is low enough (10%?), paying it to remove uncertainty can be worth it. If it’s 22% plus the 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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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.
Forgot to include a reference. See Table 1-3 in IRS pub. 590 (http://www.irs.gov/publications/p590/ch01.html)
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.
Thanks for clarification and an overall good article.
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.
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%
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?
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.
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).
slug | sunkcostsareirrelevant.com 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.
What if you and your spouse both have 401(k) plans, but your income after the max contributions to both plans is below $109k?
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…
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.
Trevor Shepherd says
There is another reason people may prefer a Roth IRA over a traditional IRA, even if the math might favor a traditional IRA, and even if they fully accept your points that a traditional 401K is better than a Roth 401K. Savings outside of workplace plans include taxable accounts, traditional IRA, Roth IRA. The major reason that people do not put more of their income into tax-advantaged retirement-oriented plans (workplace and external to work) is because they either need that money now for living expenses or they want to be able to get it if they ultimately do need it. Some of us actually think about how we might have sudden unexpected expenses that we did not know to plan for, and that can be anything from medical issues, to an older car that is not worth fixing and driving anymore, to needing a new roof, new furnace, dog needs surgery, whatever. So, some of us do not live our lives in a way that forces us to go into debt when an unexpected expense comes up; we keep saved money available to be withdrawn and spent when the unexpected happens. With taxable accounts, one can do that as needed, of course. With money put into a traditional IRA, you can not for all practical purposes get any of it if you need it. The financial planning industry completely ignores the thought processes and analysis that most normal people use to determine how much money they want to have access to just in case they need it. The industry has brainwashed itself into thinking that retirement savings is such an obviously brilliant and overriding objective that no other concern or thought should intrude into the shoveling of money into the inaccessible vaults of retirement investments. But normal people have never been brainwashed that way. They think about how they might actually need to access some that savings and might need it quickly. With Roth IRA, the earnings can not be withdrawn penalty-free before the age-limit for withdrawal but the principal, the amounts placed into the account by the person who owns it can be withdrawn anytime for any reason with no tax or penalty being due. So, a Roth IRA is a useful form of an “emergency savings” account that allows tax-advantaged growth while maintaining full access to any money committed to the account (i.e., deposited) by the saver. The financial planning industry does not live in the real world. People do.
Harry Sit says
Doubling up as an emergency fund is appealing in the beginning. That part is done after a few years of contributions. Additional contributions should be purely for retirement. Whether to continue with Roth IRA or switch to Traditional IRA should be based on the tax benefits. Yes, many will continue with Roth IRA due to inertia (and therefore the Traditional IRA is forgotten) but that’s a costly decision.
Trevor Shepherd says
There are other issues, too, that you left out of your discussion about the advantages of regular 401K over a Roth 401K, and you left out of this discussion of the Traditional IRA vs the Roth IRA vs the taxable investment account. The earnings from a Roth 401K and the earnings from Roth IRA are not taxed when distributed (withdrawn) by the retiree. They are not taxed at all. But the earnings from a traditional 401K and from a regular IRA, meaning the reinvested dividends and the cap gains when shares are sold to create a distribution (withdrawal) are taxed at regular income tax rates, not at the preferential dividend rates and cap gains rates that apply to taxable investment accounts. It seems fair to require that previously-deferred income that was used to make contributions to a traditional 401K or IRA should be taxed at regular income tax rates when it is actually distributed to the retiree, but it does not seem to be good financial sense to automatically opt for accounts where the EARNINGS are also taxed at traditional income tax rates (e.g., as it is with the traditional 401K and IRA). The Roth 401K and the Roth IRA, and even the taxable investment account avoid that higher tax rate on earnings.
Harry Sit says
This part is addressed in The Commutative Law of Multiplication. When the earnings are taxed at the same rate as the rate at the time of contribution, the end result is the same between Traditional and Roth. Whether you give up 20% of the seed (Roth) or 20% of the harvest (Traditional), you’re left with the same amount of the crop.
John Endicott says
” Yes, many will continue with Roth IRA due to inertia (and therefore the Traditional IRA is forgotten) but that’s a costly decision.”
That assumes that they don’t already have a sizable amount in Tax deferred accounts. The problem with tax deferred accounts is that the tax eventually comes due. Just with where my account balances are now, RMDs at 72 are going to be a killer in regards to taxes (not just because of the tax bracket I’ll be in, but the knock on affects of the taxing most of my SS benefits and the huge increasing of the Medicare premiums that result from having too much taxable retirement income) assuming I haven’t managed to transition a good portion of those accounts into a Roth before then. And transitioning enough of that money to a Roth between the time I end my working years till the time RMDs start is already going to be a huge task, even with them pushing the first RMD date back from 70.5 to 72. #firstworldproblems.
Choosing a traditional IRA over a Roth now, just increases the size of the problem and adds to the amount that I’ll have to convert to a Roth, and pay taxes on, between now and then in order to lower my retirement taxes enough to avoid or at least lessen the negative tax consequences in the RMD years.
In short, if you already are looking at having a huge tax deferred balance, choosing the traditional IRA over the Roth could be the costlier decision (or at least the decision that makes planning for your taxes in retirement more complicated).
Tom H says
John, I agree 100%. While the usual analysis pits the Roth IRA versus the Traditional IRA, a strong case can be made that a taxable investment account is actually preferable to the Traditional IRA. Why? Because you give up a lot of tax preferences when you dump money into a Traditional IRA. Most importantly, you agree that everything that you or your heirs withdraw will be ordinary income – you do not get to use the generous zero tax bracket for qualified dividends and capital gains. Almost as important is the fact that you lose the “step up” in basis for your heirs at death, so you give up the zero tax on gains in bought and held stocks. And now, large inherited tax-deferred accounts must be distributed (and taxed) over a period of just 10 years, meaning that a working heir may well be looking at a 30%-35% tax rate on distributions they don’t need. It’s not simple.