We are often asked whether it is better to contribute to a traditional IRA or a Roth IRA. Since tax free withdrawals are better than taxable withdrawals, Roth contributions must be the simple answer to the question – right? Not necessarily.
Withdrawals of pre-tax retirement account contributions are subject to income taxes, while withdrawals of Roth contributions are tax free. But there is more to know. It is important to understand the advantages and disadvantages of Pre-Tax and Roth retirement accounts, and whether or not you are eligible for either. It is also important to understand IF you are eligible to make a pre-tax or a Roth contribution each tax year.
PRE-TAX CONTRIBUTIONS to an IRA
Taxpayers may make a tax-deductible contribution to a Traditional IRA if you (and your spouse if you are married) are NOT covered by an employer-sponsored retirement plan. The annual contribution limit in 2023 = $6,500 (or $7,500 if over age 50). Note you cannot contribute more to your IRAs than the income you earn each year.
Advantages of Pre-Tax Contributions
- Pre-tax contributions defer federal and state income taxes. For example, if you are in the 24% federal and 6% state marginal income tax brackets, every $1 of pre-tax contributions defers 30 cents of taxes, or 30%.
- Pre-tax contributions can reduce your taxable income and marginal income tax bracket. With a lower income you can qualify for a Roth IRA, realize capital gains at a 0% or 15% capital gains rate, and perhaps realize other tax savings.
Disadvantages of Pre-Tax Contributions
- Pre-tax withdrawals are taxed at your marginal federal and state income tax brackets. At retirement:
- If you expect to be in the 32% federal and 8% state marginal income tax brackets, every $1 of pre-tax withdrawals will be subject to 40 cents of taxes, or 40%.
- If you expect to be in the 12% federal and 8% state marginal income tax brackets, every $1 of pre-tax withdrawals will be subject to only 20 cents of taxes, or 20%.
Make Pre-Tax Contributions Instead of Roth Contributions if…
Make pre-tax contributions instead of Roth contributions if your current income tax bracket is expected to be higher than your future income tax bracket in retirement.
Contributing at a 30% pre-tax rate and withdrawing at a 20% rate creates a 10% tax arbitrage.
Not all taxpayers are eligible for contributions to a Roth IRA. Contributions are allowed only if your Modified Adjusted Gross Income (MAGI) is lower than the certain income thresholds. In 2023:
- For Single, Head of Household, or Married Filing Separately, your MAGI must be less than $153,000 in 2023. For MAGI between $138,000 to $152,999, your contribution will be reduced.
- For Married Filing Jointly, your MAGI must be less than $228,000 in 2023. For MAGI between $218,000 and $228,000, your contribution will be reduced.
Advantages of Roth Contributions:
- Roth contributions are subject to federal and state income taxes. If you are currently in the 12% federal and 8% state marginal income brackets, every $ of Roth contributions is subject to 20 cents of taxes, or 20%.
- Lower income earners, such as younger employees, can utilize their full ‘low’ marginal income tax bracket as an arbitrage to a higher income tax bracket on withdrawals in retirement.
Disadvantages of Roth Contributions:
Roth withdrawals are tax free. At retirement:
- If you expect to be in the 10% federal and 5% state marginal income tax brackets, every $1 of Roth withdrawals will avoid only 15 cents of taxes, or 15%.
- If you expect to be in the 22% federal and 8% state marginal income tax brackets, every $1 of Roth withdrawals will avoid 30 cents of taxes, or 30%.
Make Roth Contributions instead of pre-tax if…
Make Roth contributions instead of pre-tax contributions if your current income tax bracket is lower than your expected future income bracket in retirement. Contributing at a 20% after-tax rate and withdrawing while avoiding a 30% rate, creates a 10% tax arbitrage.
The Bottom Line…
- Realize tax arbitrage by deferring taxes with pre-tax contributions if your current income tax rate is higher than your future income tax rate.
- Realize tax arbitrage by paying taxes today with Roth contributions if your future income tax rate is higher than your current income tax rate.
One final note – you to NOT have to wait until tax time to make your contributions. For any given tax year, contributions can be made anytime from January 1 of the current calendar year to April 15th of the following calendar year.
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Janet Rhodes Friedman, CFP®, CDFA®, MBA
Financial Planning Solutions, LLC (FPS) is a Registered Investment Advisor. Financial Planning Solutions, LLC (FPS) provides this blog for informational and educational purposes only. Nothing in this blog should be considered investment, tax, or legal advice. FPS only renders personalized advice to each client. Information herein includes opinions and source information that is believed to be reliable. However, such information may not be independently verified by FPS. Please see important disclosures link at the bottom of this page.