How does a retired person approach the issue of Roth vs. Traditional IRA?
Dave sent an e-mail asking this very question:
Why should I assume I will be in a higher tax bracket in retirement? I am planning (with luck!) to have minimal expenses in retirement (hoping to pay off mortgage, etc by then) so why would I need to be withdrawing my current annual income and thereby, be in the same tax bracket I’m in today? Wouldn’t it be lower? And, in this case I’m better off taking the tax break today, rather than tomorrow?
I’m not sure if Dave is asking about funding a Roth vs. Traditional IRA or converting a Traditional IRA to a Roth, but either way, this is really an important topic. As you probably know, when you consider the Roth vs. Traditional IRA, you have to make some assumptions about your future retirement income and tax bracket. The Roth gives you no tax deduction now, but you pay no tax on withdrawals. So if you will be in a higher tax bracket when you make those retirement withdrawals, the Roth may be advantageous.
But if your income is going to drop like a rock when you retire, putting you in a lower tax bracket, you’re better off with the Traditional IRA. That’s because you’ll take a deduction for the IRA contribution now (at your current higher tax rates) and declare the income and pay the tax when you are in a lower bracket in the future. Now, let’s get back to Dave’s question.
The reality is, you should not assume you’ll be in a higher tax bracket in retirement – but you should do some calculations and consider the relevant facts. You can’t know what tax bracket you’ll be in, but you can calculate the odds of being in a higher bracket.
Let’s closely examine Dave’s e-mail to see if he answers his own question.
First, he says he will have his mortgage paid off when he retires and he’ll have minimal expenses. That actually argues for the Roth. Why? Well, he won’t have the mortgage interest expense to write off, and that will increase his taxable income.
And if his non-deductible expenses drop, that won’t impact the decision really – assuming he is already planning on taking the minimum required distributions from his retirement accounts. If a reduction in his expenses means he can afford to take less out of his retirement accounts, then yes, this will help reduce his taxable income.
Next, Dave, it’s important to understand what an RMD (Required Minimum Distribution) is. The reality is you only have to withdraw a small percentage of your retirement accounts when you reach age 70 ½. You don’t have to touch a penny of it until you hit that age. But once you do reach that age, you have no choice. You have to start pulling out some money or the IRS is going to slap you silly.
Now, the amount you must take out is very small (at first). The amount is based on how long the IRS thinks you’re going to live. Rather than go into a long explanation of it here, suffice it to say that in the first year, it’s about 4 1/2 % of the value of your account as of the previous December 31st.
So even if Dave doesn’t need any of this money, he will be forced to take some out. His job is to determine:
- How much he’ll need.
- How much he’ll be required to take.
He’ll take the larger number and use that to calculate how much extra income he’ll take and pay taxes on.
Next, my experience tells me that many people actually have more disposable income during retirement than they had while they were working. You will have to do the calculations to see what the total income will be from your pensions, Social Security and investment income. But spend a few minutes to tally it up. It might be more than you think.
The last piece of this puzzle is tax rates. Of course nobody knows what’s going to happen to tax rates, but they will change. In fact, they change all the time. In the 60’s, the highest bracket was 90%. Through the 80’s they dropped. But the highest bracket was still in the 70’s. They dropped to 50% in the mid-80’s and have bounced around from 38% to 28% ever since.
Are income tax brackets going to rise? Probably. But will they rise and stay up there? Who knows? It would be counter to historical experience to declare that taxes are going to stay at any particular level. They move all the time and they’ll continue to change even during your retirement. This is an unknown.
Bottom line? You may or may not be in a higher retirement tax bracket. There are a number of factors that will influence this. Some of those factors are impossible to foresee, so don’t waste your time with them. But you can easily determine how much money you’ll need to withdraw from your retirement accounts (from a budget and legal standpoint), and you should use that data to make your decision, Dave.
What other advice would you give Dave?