Quick: How do you set your annual retirement savings goal?
Very wealthy households usually seek professional assistance. Once you get to the point where planning for estate tax is an issue – when you and your spouse expect to leave more than $11 million in gross estate – it’s indispensable, since you must juggle multiple types of tax.
But if you’re like most people, you base your savings on a combination of IRS contribution limits (for IRAs), 401(k) employer matches (if you’re employed) and rules of thumb, such as 10% of pretax income.
A recent study found that most American retirement savers do exactly that. They let the system decide for them how much to save based on the tax rules and their employers’ whims.
That’s understandable. But the interesting fact is that they do so regardless of the type of savings vehicle they use… with remarkable results… results that provide a fascinating free lesson in retirement planning.
To Roth or Not to Roth: That Is the Question
IRAs and 401(k) plans come in two flavors: traditional and Roth. Contributions to the former are tax-exempt – i.e., you don’t pay tax on the income you set aside for them. Your accumulated contributions plus investment growth are taxed when you withdraw them in retirement.
Since the IRS gave you a tax break when you saved into a traditional vehicle, it insists on its pound of flesh when you retire in the form of annual required minimum distributions (RMDs). Those can create massive headaches and tax complications for retirees.
Contributions to a Roth vehicle, on the other hand, are subject to tax… but the proceeds are tax-free when you retire – and there are no RMDs.
At the level of logic and math, the decision to go the traditional or Roth route should depend on a combination of your cash flow needs during your working life and your expectation of future tax rates.
All else being equal, if you need more money now and/or expect taxes to remain the same or fall in the future, you’d go the traditional route. If you can spare the extra tax now and/or expect tax rates to rise in the future, you’d choose Roth. That’s because if you expect future taxes to be higher, it makes sense to pay them now when they’re low.
In 2017, a married couple filing jointly can contribute a maximum of $11,000 to their IRAs, whether Roth or traditional. Contributing to a traditional IRA lowers their current tax bill; they’ll pay later. Contributing to a Roth leaves it unchanged, but future withdrawals are tax-free.
In theory, that sets up a complex net present value calculation of current versus future income, tax rate expectations and other factors.
But most Americans don’t think about that. They contribute the same amount whether it’s to a traditional or Roth vehicle. As Harvard Business School researchers found, that’s because they simply save according to the IRS maximum, whether it’s a traditional or Roth IRA.
If they have a Roth IRA, this accidental choice creates a huge unintended retirement windfall.
Let’s say the couple saved $5,000 a year in an IRA for 40 years, earning a 5% annual return. Their balance at retirement will be more than $600,000.
If the IRA is a Roth, the full balance is available for their retirement spending. If it’s traditional, taxes are due on the balance.
Let’s say their tax rate is 20% in retirement. That’s what they’ll pay on withdrawals from their traditional IRA – which they must take whether they need them or not, due to the RMD rules.
If they opt for a Roth, on the other hand, their taxes will already have been paid, and they’ll enjoy $120,000 extra spending power in retirement – about $700 a month more.
I’ve said it before, and I’ll say it again: U.S. income tax rates will be higher in the future. That makes a Roth IRA a more sensible choice.
Our current income tax rates are the lowest in over a century. Our national debt is enormous and growing. Those in charge of the federal government show no signs of reining it in – quite the opposite. The population is ageing, but retirement benefits are politically sacrosanct. Our national infrastructure requires urgent and expensive repairs. And so on.
When taxes do go up, having a Roth IRA and/or 401(k) means you’ll be able to ignore them. Some people will be in that situation accidentally.
You, on the other hand, can choose it consciously. My advice is to do so… it’s a no-brainer.