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:
- 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
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 2017 is $72k single, $119k married filing jointly whereas the cutoff for contributing to a Roth IRA is $133k single, $196k married filing jointly.
Therefore for people with an AGI between $72k and $133k (single) or between $119k and $196k (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 $72k single, $119k 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 $72k single/$119k 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.
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.
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 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.