While this rule is generally true, you may still benefit from contributing to a Roth IRA, even if your tax rate declines in the future, especially if you’re making the maximum contribution.
What’s the difference between Roth and traditional IRAs?
Sheltering your savings
A maximum contribution to a Roth IRA shelters more savings than a maximum contribution to a traditional tax-advantaged account.
To see how, consider a hypothetical investor, Bob, who’s a single filer. He wants to make the maximum $5,500 contribution to his IRA for the 2018 tax year.
Bob’s contribution to a Roth IRA is worth more than a $5,500 traditional IRA contribution. Why? Because the Roth contribution uses after-tax dollars, whereas a traditional contribution uses pre-tax dollars.
So, if Bob has a 35% marginal tax rate, a $5,500 traditional IRA contribution has the same saving power as a $3,575 Roth IRA contribution.*
To see which IRA may make sense for Bob, let’s compare a $5,500 Roth IRA contribution to a $5,500 traditional IRA contribution plus another $1,925 deposited in a taxable account. (The $1,925 represents the difference between $5,500 and $3,575. Bob would have to save that money in a taxable account since he’s already reached the maximum allowable IRA contribution.)
The graph below shows the growth of both contributions after 20 years and assumes Bob’s marginal tax rate stays at 35%. Because of the tax drag in the taxable account, a maximum contribution to a traditional IRA is worth less after taxes, even when factoring in the extra savings in a taxable account.**
Maximum Roth contribution generates higher after-tax wealth
This hypothetical illustration does not represent the return on any particular investment and the rate is not guaranteed. The final account balance does not reflect any taxes or penalties that may be due upon distribution. Withdrawals from a traditional IRA before age 59½ are subject to a 10% federal penalty tax unless an exception applies.
See our research paper for more details on the BETR analysis
How low does the tax rate have to go?
We recently published a research paper that helps answer this question.
Our paper describes a break-even tax rate (BETR) analysis, which shows the future tax rate when the 2 scenarios generate the same future after-tax wealth.
Based on our BETR analysis, Bob would still likely benefit from making the maximum Roth IRA contribution, even if his marginal tax rate declines all the way to 23.5% in the future.**
Consider the rule of thumb, but verify
If Bob followed traditional investing advice, he might have made a traditional IRA contribution since he expected his marginal tax rate to decrease. But this is one case where following a rule of thumb wouldn’t make sense.
And, of course, tax benefits are only one factor you need to consider when deciding which IRA to make a maximum contribution to, so we recommend speaking to a tax or financial advisor about your current situation.
*We assume the traditional IRA contribution is fully tax-deductible. Alternatively, you can think in terms of a 401(k),which provides a tax deduction for a traditional contribution.
**Our calculations assume a 6% annual return, a 35% ordinary income tax rate, and a 20-year investment horizon. For the taxable account, the entire annual investment return is taxed annually. If the taxable account is invested in a tax-efficient manner (a 2% dividend yield is taxed annually at an 18.8% dividend tax rate; capital gains are deferred until the end of the investment horizon and are then taxed at an 18.8% long-term capital gains tax rate), the after-tax withdrawal value would be $16,634 and the break-even tax rate would be 29.6%.
All investing is subject to risk, including the possible loss of the money you invest.
Withdrawals from a Roth IRA are tax-free if you’re over the age of 59½ and have held the account for at least 5 years. Withdrawals taken prior to age 59½ or 5 years may be subject to ordinary income tax or a 10% federal tax penalty or both.