When Are Roth Accounts Better than Tax-Deferred?

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I recently spoke at a Camp FI event. In one breakout session, participants debated the benefits of traditional tax-deferred accounts vs. Roth accounts.

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I listened to strong opinions favoring one type of account over another. Unfortunately, these opinions often lack nuance and miss key details.

In reality, there is no one size fits all advice that works for everyone. So it is worthwhile to explore circumstances when Roth options are superior to tax-deferred retirement accounts to round out previous articles on this blog that emphasize the value of tax-deferral.

A Few Words on Terminology

Throughout this article I’ll distiguish between traditional and Roth accounts. 

Traditional retirement accounts (IRA, 401(k), etc) allow you to defer taxes on income in the year it is earned. Investments grow tax-free. You pay taxes at ordinary income rates in the year you take money from the accounts.

You make contributions to Roth accounts (Roth IRA, Roth 401(k), etc) using after tax-dollars. From that point forward they are tax-free. Investments grow tax-free and there is no taxation of withdrawals.

There are IRA and work sponsored accounts of both traditional and Roth varieties. The basics outlined in the above paragraphs are true for all of them.

There are differences in contribution amounts, withdrawal rules, etc. between different specific account types. Those details are beyond the scope of this discussion. The goal here is to help establish foundational understanding of the differences between tax-deferred and Roth accounts.

The Math of Roth vs. Traditional?

Both Traditional and Roth accounts allow investments to grow without annual taxation of dividends, interest, and capital gains. Eliminating the drag of annual taxation is a major advantage any tax advantaged account has over a taxable account.

How do you determine whether traditional is better than Roth? It all depends on whether you would pay more taxes now or later.

If you pay taxes on these dollars at the same rate now or later, traditional and Roth accounts leave you with the exact same amount of money in the end.

As an example, consider an investment of $10,000 invested for 20 years with a 7% return taxed at 25%.

A traditional account would allow you to defer taxes and invest all $10,000. After twenty years, this would compound to $38,697. After paying 25% tax, you would ultimately have $29,023.

A Roth contribution would be only $7,500 after paying 25% tax on your original $10,000. After 20 years, your $7,500 would grow to an identical $29,023. You could take this amount from the account tax-free.

Related: Understanding the Time Value of Money

Recapping the Case For Tax-Deferred Accounts

This blog has long made the case that early retirement is very tax friendly. The key idea is if you have a high savings rate that enables early retirement, then you by definition live on significantly less than you earn.

Emphasizing tax deferral to the greatest extent possible in your highest earning years allows you to pay less taxes in lower income years.

This is true for people who:

  • Will retire or semi-retire early, earning most of their lifetime income in relatively few highly taxed years and spreading tax-deferred income over many lower-taxed years, and
  • Have figured out how to live well for relatively little, which I’ll define as less than $100,000/year for a married couple, or $50,000 for a single person.

This strategy provides a large window of time to recognize this tax-deferred income in low tax brackets. You can accomplish this through Roth IRA conversions or simply using the money to provide living expenses.

I’ve provided a framework for this theory here: Early Retirement Tax Planning 101.

Darrow has shared why he doesen’t fret about taxes in retirement. He then backed up his assertions sharing his retirement income taxes in:

I’ve shared that even in semi-retirement, our household has a very low tax burden. Finally, I addressed a reader’s concerns about taxes in retirement, and demonstrated that taxes in retirement are often much lower than people assume.

We’ve established the case for tax-deferred investing. Let’s explore the rationale for emphasizing Roth accounts.

Making a Case For Roth Accounts

The case for Roth accounts is that you likely will be taxed at higher rates in retirement than you would in the year you earned the money. If this assumption is correct, then indeed, Roth accounts would be superior to traditional accounts.

However, the arguments I most commonly see for why this will be the case are weak. At the same time, there are good reasons why taxes may be higher for some people in retirement. Many people misunderstand or completely overlook them.

Let’s explore why taxes may be higher in the future, making Roth accounts superior.

Tax Rates Are Going Up

I often read arguments that Roth accounts are superior because future tax rates will be higher.  This argument assumes that we can predict the future, a dubious assumption. I base my planning on laws as they are currently written and adjust my strategies as laws actually change.

Even if tax rates do go up, this argument mistakenly compares marginal tax brackets with your effective tax rate on the dollars in question. Money contributed to tax-deferred accounts always avoids taxation at your highest marginal rate. This money may later be recognized in lower tax brackets in retirement.

Tax rates could increase. The 12% tax bracket may revert to the 15% bracket and the 22% bracket revert to the 25% bracket. It is still better to defer income at the current 22% bracket today if you will recognize it at the 15% bracket (or less!) later when retirement income is lower.

Related: Early Retirement Tax Planning 101

This thinking has led me to emphasize tax-deferred accounts in my personal planning.  However, there are stronger arguments as to why Roth accounts would be superior.

Traditional/Late Retirees

One assumption I use in my own planning is that I will have many years of early/semi-retirment over which to spread tax-deferred income. If you don’t plan on retiring until your late 60’s or early 70’s, your tax-deferred income will be recognized in a more compressed time period.

Working, saving, and having your money compounding longer may also mean a larger tax-deferred balance when you start drawing from these accounts. This combination of factors means more taxable income in each year of retirement. 

Retiring later also means less potential years until you start receiving Social Security benefits — or none at all. Social Security income will take up space in lower tax brackets, pushing your tax-deferred income into higher tax brackets. This higher taxable income may in turn cause more of your Social Security benefit to be taxable.

Tax-deferred retirement accounts are also subject to required minimum distributions (RMD). RMDs currently start at age 72.

This combination of factors can result in a large tax-deferred account balance with less control of how much income you can recognize from it in any given year. It is important to understand your individual circumstances.

Traditional or late retirees with substantial tax-deferred savings may face higher taxes in retirement than they would have in the year when the money was originally earned. In that case, Roth accounts would be superior.

Pensions

Another potential source of retirement income is pensions. Pensions are becoming more rare as we shift from defined benefit to defined contribution retirement plans, but they are still a factor for some people.

Even more rare in our society of non-savers is someone with both a substantial pension and substantial tax-deferred retirement accounts. If you find yourself in this position, it is an enviable one.

However, it does create a potential tax bomb in retirement as the pension is another source of retirement income that will fill your lower tax brackets and push tax-deferred income into higher brackets.

Having a pension is another factor that may make Roth accounts a better choice than tax-deferred traditional retirement accounts.

Death of One Spouse

In my own planning, I’ve traditionally focused on longevity risk. This is the risk that we would run out of money before running out of life. Thus I always ran our calculations with both of us living to at least 90 years of age.

However, I have had two friends from the FIRE community whose spouses passed away only a few years into their early retirements. Talking to them has been enlightening.

Related: Adjusting Early Retirement Plans After the Death of a Spouse

Married filing jointly (MFJ) tax brackets are approximately twice as wide as those for single filers and standard deductions are twice as large. When we defer income with the assumption of later utilizing a larger standard deduction and recognizing the income in these wider MFJ brackets in retirement, but then are forced into narrower single filer’s brackets, it creates a much less tax-friendly situation.

Longevity risk is a bigger risk and a worse financial outcome than having a higher than anticipated tax bill. So this isn’t a strong argument to shift from a strategy emphasizing tax-deferred to Roth accounts. But it is something to be aware of and may be an argument to diversify among account types over time.

Family Circumstances

Another family circumstance was brought to my attention that is a strong argument for favoring Roth IRA accounts. A friend asked to pick my brain about his tax strategy after reading my book. He always utilized Roth accounts and was second guessing whether he should be using tax-deferred investments.

We reviewed his situation. He has four young children and his wife decided to take a few years off work to be with them. They currently have only one income spread over MFJ tax brackets. They are able to utilize four child tax credits. As a result, they pay no federal income tax while saving enough to max out his Roth 401(k) and two Roth IRA accounts.

In the future, he anticipates his wife wanting to go back to work, increasing their household income. They will lose the child tax credits as their kids age out. 

An even more compelling case was recently brought to my attention. A recent divorcee and mother of three is getting herself re-established financially. She saved up an emergency fund last year and is wondering whether to start saving for retirement in tax-deferred or Roth accounts.

Similar to the family above, she already pays virtually no income tax after applying child tax-credits. Even more compelling, she files taxes utilizing head-of-household status. As her kids become adults, she will lose the credits and eventually be forced to file using more narrow tax brackets filing as a single person.

In both cases, these households pay no federal income tax now. Simultaneously, they can save generous amounts in Roth accounts on which they will owe no future tax in retirement. If you can do that, I don’t see a compelling reason not to do so.

Those on the Fence

In some cases, there is a strong case for either tax-deferred or Roth accounts. What if you don’t have a clear winner?

In that case, a Roth account is likely the better choice because you will end up with more tax-advantaged dollars invested.

Returning to my earlier example comparing the math of Roth vs. Traditional accounts, I assumed you had $10,000 to invest because it is a nice round number. I ignored contribution limits. 

That’s not how the real world works. What if you are able to invest more than the allowable maximum contribution limit?

There is a $6,000 contribution limit to either a Traditional or Roth IRA in 2022. Likewise, 401(k) contribution limits are an identical $20,500 for Traditional or Roth contributions.

But remember that Roth contributions are made with after-tax dollars. So every dollar contributed to a Roth and all of the growth it produces is yours to keep and use tax-free in retirement.

Conversely, you will owe taxes on all contributions and the growth they produce in traditional tax-deferred accounts. This will be paid at ordinary income tax rates in the year the money is taken from the accounts.

So remember, if you’re on the fence as to which type of tax-advantaged account to use, the Roth will give you more tax advantaged space to utilize.

Using Calculators to Guide Your Decisions

In the past, we’ve made arguments for utilizing tax-deferred investments. In today’s post, I’ve made arguments for Roth accounts. So what should you ultimately do?

A retirement calculator can help answer this question. A the best retirement calculators allow you to see the impacts of various circumstances and decisions compounded over long periods of time. The results are not intuitive for most of us.

Of particular value when making tax related decisions is to use a calculator that does detailed federal and state tax calculations, as both the NewRetirement PlannerPlus and Pralana Gold retirement calculators do. Both also do Roth conversion analysis. (Disclosure: Each are affiliates of this blog, meaning if you purchase them through links on this site a portion of proceeds benefit the blog.)

A word of caution. Any tool is only as good as the assumptions and data fed into it. 

Take the time to understand the principals outlined in this post and those linked within it. Identify which assumptions will impact your outcomes and experiment with a variety of possible circumstances, using your best guess as to the probability of each.

Then, use these tools to compare how outcomes differ. Use this data to help determine which path makes the most sense for you.

A Case For Tax-Rate Diversification

Ultimately, the traditional vs. Roth debate, like most aspects of retirement planning, requires a lot of assumptions about an unknowable future. This calls for a dose of humility.

Do the best you can with the knowledge you have on a year to year basis. I personally try to limit my tax bill each year, within the constructs of understanding the big picture of our future tax situation.

Based on the factors outlined, there is a likelihood that emphasizing tax-deferred or Roth accounts will be better for you. But there is rarely certainty.

In the face of uncertainty of financial markets, we diversify investments between different asset classes, rather than putting all our eggs in one basket. It is wise to have some tax diversification as well.

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[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. After achieving financial independence, Chris began writing about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. Chris also does financial planning with individuals and couples at Abundo Wealth, a low-cost, advice-only financial planning firm with the mission of making quality financial advice available to populations for whom it was previously inaccessible. Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He has spoken at events including the Bogleheads and the American Institute of Certified Public Accountants annual conferences. Blog inquiries can be sent to chris@caniretireyet.com. Financial planning inquiries can be sent to chris@abundowealth.com]

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17 Comments

  1. Chris,

    You certainly have shown that the answer to the question about tax deferred vs Roth is “complicated” and highly dependent on each individual’s unique circumstances. It gets even more complicated after age 65 and enrolled in Medicare considering the income related monthly adjusted amount (IRMAA)! Although IRMAA is not technically a tax, it can be viewed as such in that that Medicare premiums can be increased depending on taxable income especially when required minimum distributions (RMDs) start at age 72.

    I have chosen to do modest annual tax deferred to Roth conversions from age 65 to 71 purposely to try avoid or at least minimize any IRMAA increases in the near future.

    1. Fritz,

      You are correct. Thank you for adding that nuance.

      I also omitted ACA subsidies for early retirees, though losing or decreasing those subsides by increasing taxable income is in effect an increase in taxes. Both were omitted for the sake of not overcomplicating this already complex issue that tends to overwhelm people.

      Both of these issues may make paying tax upfront and contributing to a Roth more appealing than deferring taxes.

      Best,
      Chris

  2. Generally after retirement tax rates will decrease – larger standard deductions, lower income, SS is favorable taxes etc. But not always the case. Rarely is it cut and dried.

    You did fail to point out that Standard accounts can be rolled over in a year that has a major rightoff – Hurricane, fire, earthquake loss. Having money in taxable accounts provides flexibility that the Roth (having already paid the taxes) does not provide.

    1. Shawn,

      I do like the idea of tax rate diversification which I touch on a bit at the end. This is something that I track in my investment accounts. I currently have about 50% tax-deferred, 35% taxable, and 15% combined b/t Roth and HSA accounts. I like the flexibility that provides and am emphasizing building up the HSA account that I didn’t have access to when working and the Roth account that wasn’t emphasized in our higher earning years.

      Best,
      Chris

  3. One thing that people might want to consider is what some of the options are going to be when you “age out”. When I was deciding on whether to defer taxes, I assumed that I would be living very frugally in retirement. I didn’t really look at what kind of choices I might have to make in my 70s and 80s.

    Now it is decades later and the most logical final planning revolves around moving into a continuing care retirement community. This is really the only “good” option for a childless couple. Unfortunately, they are extremely expensive.

    The result of this is that my retirement spending is going to be quite a bit higher than what I was spending while working. (My house was paid off and I have no car payments).

    Which all means that I will be pulling a lot out of deferred accounts and the marginal tax rate is going to be as high or higher than when I was working.

    1. Robb, to soften the blow, part of the initial deposit and on-going expenses of a continuing care community may be considered a medical expense deductible on Schedule A. The CCC should be able to report to you each year which % of the total expenses is considered medical.

    2. Robb,

      I don’t disagree with what you write, but if you again look at my assumptions when favoring tax-deferred accounts they are especially advantageous for early retirees who live relatively frugally. For people in that camp, they could have spent down and or converted to Roth by the time they reach these later life decisions. As such you can build a sizable retirement “paycheck” with money from Social Security + withdrawals from Roth and taxable accounts with a low tax burden.

      Best,
      Chris

  4. A friend of mine has been trading stocks within his Roth IRA for years. He’s good at it and has accumulated a large portfolio all free of taxes. So I have to pay 22% taxes on my regular IRA while he pays nothing. Were both on the ACA too so in addition my premiums increase and his don’t. Im envious and wish I had invested in a Roth when I was working.

    1. Mitch,

      You make a point that I didn’t really address b/c it is beyond the scope of this post, but a Roth is a great place to hold assets that have potential for significant growth, as those assets will never again be taxed. In our case, our Roth accounts are where we hold our most aggressive investments. In contrast, we use our tax-deferred accounts to hold the assets we anticipate will have the least amount of growth, i.e. our entire bond allocation, as eventually those assets will be taxed at ordinary income tax rates. This is yet another argument for having tax diversification unless there is an obvious choice between tax-deferred and Roth accounts given your individual circumstances.

      Best,
      Chris

  5. Good write up Chris! I like how you summed it up quickly that there is not much difference between a Roth and Tradition IRA using $10,000 invested over 20 years. I have told a few people that I like the Tradition IRA route because you can take a deduction now and most people don’t have enough money saved up to be worried about paying higher taxes. And if you are in a state that has income tax, all the better when you move to a state that doesn’t. As an added bonus you included Darrow’s writes up about not fretting on taxes. As well as other considerations like pensions, death of spouse, family circumstances, etc. Well done!

  6. I know many individuals who retired early and without fail they wish they had more Roth $, even if it can be argued that their marginal tax rates when they earned the income (generally 25%) indicated deferral as the better choice. Reasons include income source flexibility, Social Security and Medicare income considerations, looming out of control RMDs and the ACA.
    There is a significant difference between individuals who reached a minimum threshold of financial independence and stopped working (40 somethings) and those who worked longer, built a more substantial asset base and then retired (~early-to mid 50s). Over the course of a lifetime number of children is also a big factor. The first group can manage their income to that $100k living level and enjoy the low tax rate environment. The second is looking at forced RMDs several times that $100k level regardless of their living requirements and scrambling to somehow limit the pain pre-age 72 – Roth conversions and drawing down IRAs for living expenses in early retirement are among the few possible options. Of course, in the scheme of life it’s a “good” problem.
    My own approach in my early 60’s, supported by analysis from two recognized national experts in the field, is Roth conversions to the top of the 22% bracket (actually going into the 24% bracket involves such a minor step that it is feasible too). It is painful at tax time (and when paying estimates), but it is what the numbers dictate.

    1. Jeff G,

      Thanks for the thoughtful comment. I mostly agree with your sentiments, which is why I ultimately land on having some tax rate diversification. In my lower income semi-retirement years we’re putting more emphasis on getting money into Roth and HSA accounts. In my own portfolio I currently sit about 50% tax-deferred, 35% taxable, 15% Roth/HSA.

      Ultimately, there is a lot of uncertainty. Whether traditional or Roth is better depends on many future unknowables.

      That said, even if you are 100% tax-deferred and retire at say 60 (i.e. not super early) and with $2 million (relatively large account size), it is not a bad place to be. That would give you 10 years before having to take SS and another 2 (currently) and possible 5 (if proposed legislation passes) years until RMDs. That gives you a decade+ to take $100k/year at very low effective tax rates. If your investments grow further in that time and you ultimately end up with a tax bomb in your 70’s/80’s/90’s, I mostly resonate with your idea that it would be a “good” problem of having over saved.

      As noted in the post, the later you retire, the larger your tax-deferred account size, and the more other sources of retirement income you have (pensions, p.t. work, larger SS benefit, rental income, royalties, etc.) the less favorable traditional and the more favorable Roth accounts would be.

      Best,
      Chris

  7. I do both by contributing to a traditional 401K and max out my Roth IRAs. One thing that I never see mentioned in these discussions is how one should diversify their investments between the two. For example, if an investor has a 60/40 stock/bond portfolio shouldn’t they put more of the high growth investments in the Roth since there is no tax on the growth? Then put the bonds or lower risks stocks in the 401K since those accounts are taxed and are not expected to grow as much?

  8. Thanks for this nice breakdown. I will add it to my Fawcett’s Favorites next Monday.
    Dr. Cory S. Fawcett
    Financial Success MD

Comments are closed.