If you are trying to decide between Roth IRAs and traditional retirement savings, the key is knowing if your retirement income is going to exceed your present income or not, according to USA Today in “Why more people should probably use pre-tax retirement accounts instead of Roths.”
If you think your income in retirement will be higher than it is right now, that’s a reason to put retirement savings into a Roth IRA. However, if you’re already saving for retirement and you expect to maintain the same lifestyle, you’ll want to be sure your retirement income does not exceed your current income, because it’s all about the tax burden.
Comparing your current income as you are working to your expected retirement income isn’t exactly an apples-to-apples comparison. Instead, you’ll need to include calculations of your tax rates for IRA withdrawals and other taxable accounts. People often pay a lower overall tax rate on withdrawals from traditional retirement accounts than they pay on Roth contributions today–even with a higher retirement income.
To fully understand this, you’ll want to understand the difference between marginal tax rates and effective tax rates. The marginal tax rate is the tax rate on your next dollar of income. For example, people say “I’m in the 22% income bracket”—that’s their marginal tax rate. Then there’s the effective tax rate, which is the total tax bill as a percentage of income. This number is always lower than the marginal tax rate.
For every dollar you add to a traditional retirement account, you’re reducing your taxable income and saving on taxes at the marginal tax rate. Every dollar saved in a Roth IRA account is effectively taxed at your marginal tax rate. You could have chosen to save it in a traditional IRA, but you chose the Roth.
Here’s an example: a single person who earns $60,000 annually is in the 22% tax bracket, after taking the $12,000 standard deduction. That single person needs to have an income of $195,105 in retirement to reach a 22% effective tax rate on a traditional IRA withdrawal.
It works better for someone in the 12% income bracket. A man who earns $50,700 annually is right at the top of that 12% bracket, after taking the same standard deduction. He’d have to withdraw $52,605 from a traditional IRA in retirement for it to be worth having a Roth IRA.
This decision requires making correct calculations about how much you intend to spend in retirement.
Reference: USA Today (July 8, 2018) “Why more people should probably use pre-tax retirement accounts instead of Roths”