In my August column, I wrote that Roth is wrong—for some people. Basically, my analysis was that, for many, and perhaps for most, participants, their retirement incomes will be so low that they will pay little if any taxes on that income. However, if they were making Roth deferrals while working, they were paying income taxes on the deferred amounts. Thus, in making pre-tax deferrals, they violated one of the basic principles of taxpaying: Always pay your taxes when you are in the lowest bracket.
To determine whether to Roth, a person needs to look at his highest tax bracket (sometimes called the marginal tax rate), both while working and in retirement. Keep in mind that this refers to your personal marginal tax bracket—now and anticipated in retirement—and not to tax rates generally. Since most of us will have less income in retirement, it is possible—perhaps even likely—that we will be in lower tax brackets then, even if the top marginal tax rates are higher.
My previous column generated some questions about whether I had considered the special tax on Social Security retirement benefits. The answer is, I did. That calculation includes a special threshold amount, which must be exceeded before any portion of the Social Security benefits is taxable. In the case of my hypothetical married couple, both age 65, the threshold is $32,000. The calculation is explained in IRS Publication 915. Page 8 shows the calculation for a hypothetical husband and wife in retirement.
My column used an example of a married couple age 65 with $20,000 a year of retirement income from an IRA and with another $15,000 a year in Social Security benefits. The $20,000 per year of retirement income was based on a $400,000 IRA, which was being withdrawn at the rate of 5% per year (and which, according to a number of experts, has less than a 90% probability of lasting for 30 years). However, there is 25% to 30% probability that one will live beyond 30 years, so it is not an unrealistically low withdrawal rate.
Using the methodology illustrated in the IRS publication, the calculations are:
1. Enter the total amount of your Social Security income 15,000 2. Enter one-half of line 1. 7,5000 3. Add the amounts on Form 1040, line 7, 8a, 8b, 9a, 10 through 14, 15b, 16b, 17 through 19, and line 21 20,000 4. Add lines 2 and 3 27,500 5. Enter $32,000 if married filing jointly 32,000 6. Subtract from 5. If zero or less, enter -0 32,000
Thus, it was more tax-effective to make before-tax deferrals rather than after-tax Roth contributions. However, as with many issues, the answer is not that simple; the calculations need to be done on an individual basis. Since there is no easy answer, I can give you some rules of thumb:
1. The taxation in retirement should be based on a reasonable withdrawal rate. At age 65, 4% is recommended and 5% is probably okay, but anything more than 5% creates a significant possibility that the participant and/or the participant’s spouse will deplete their benefits in retirement.
2. A participant, and particularly a married participant, should probably have a $400,000 or $500,000 taxable account at retirement. This will give the participant the opportunity to withdraw amounts in the zero and lowest tax brackets, which means that deductions are taken out of the highest tax brackets while working and placed into the lowest tax brackets in retirement.
3. If a plan sponsor makes taxable contributions (for example, profit-sharing contributions and/or matching contributions), then it may make sense to make Roth deferrals, since the taxable employer contributions will result in taxable benefits that will be taxable in retirement. The higher the employer contributions, the more likely that Roth deferrals will be beneficial.
Roth is not a panacea but, in the right situation, it is a valuable tool. In the wrong circumstances, it is an expensive mistake.