Financial Decoder: Season 4 Episode 4

MARK RIEPE: When I was a kid, DVRs and streaming services didn’t exist, so when you watched television, you more or less had to watch the commercials. While planning this episode, an old ad campaign came back to me. The product was Fram oil filters. The tagline for Fram commercials in the early ’70s was delivered by a world-weary car mechanic who said, “Well, the choice is yours. You can pay me now or pay me later.” In each commercial, a choice was framed for the car owner: You can pay a little bit of money know to keep your engine in good condition by, of course, buying a Fram oil filter, or pay a lot of money later to have more expensive repairs done.

This decision of paying now versus paying later shows up in all sorts of decisions that involve money, and the best choice isn’t always so clear cut. You may have noticed this the last time you did some vacation planning. Whether you’re renting a car or booking a hotel, you often face a tradeoff. If you book early and pay in full upfront, you can almost always lock in a lower rate, but there’s a cost to this. Locking in that lower rate usually comes at the expense of a no-refund policy, a high cancellation fee, or other restrictive conditions. If you decide to pay later, say, when you pick up your rental car, you might be charged more, but at least you’ll have the option to cancel before you’ve paid anything.

This pay-now-or-later tradeoff is similar to one that investors face when they decide to open an individual retirement account (or IRA), and that’s the topic of today’s episode. Should you open a Roth IRA or a traditional IRA?

The main difference between the two accounts is when you pay taxes. Just like booking a rental car, you face the decision of paying now or later. When it comes to a rental car, the difference might amount to dozens of dollars, but when it comes to a retirement account, thousands of dollars could be at stake.

I’m Mark Riepe, and this is Financial Decoder, an original podcast from Charles Schwab. It’s a show about financial decision-making and the cognitive and emotional biases that can cloud our judgment.

Before we get to our guest, we wanted to highlight a bias that could impact your IRA choice: overconfidence. You face the possibility of being overly confident or optimistic with the traditional-versus-Roth decision because it implicitly requires you to forecast what your future tax rate will be. With a Roth IRA, you pay taxes on your income now, before you deposit it in the account, and then you can withdraw funds from the account during retirement tax-free. So if you believe you’ll have more income in retirement than you do now, and that puts you in a higher tax bracket, you’d choose a Roth IRA, but the assumption that your income will go up, that could be due to overconfidence.

A traditional IRA, on the other hand, allows you to contribute pretax funds, because your contributions are generally tax-deductible. But then taxes are due when you withdraw money from the account. So if you believe you’ll be in a lower tax bracket in retirement, you’d choose a traditional IRA. But the assumption that your tax rate will be lower in the future might be overly optimistic.

This timing difference between when taxes are paid is why forecasting your likely future tax rate is so important. Unfortunately, forecasting is really difficult. Philip Tetlock documented 28,000 predictions from a variety of experts on various economic and geopolitical topics and found that, collectively, the forecasts were only slightly better than chance. One aspect of the overconfidence bias is that people believe their skills as forecasters are better than they really are, and paying the tax on retirement savings now when you contribute the money or later when you withdraw it essentially depends on two forecasts—both what you think your tax bracket will be and whether or not you believe tax rates will go up or down over time.

Young people usually start out earning less and increase their income and savings over the course of their lives. In that typical scenario, it probably makes sense to open a Roth IRA at the very beginning of your working career. Of course, everybody is different, and both account types have rules that might work best for your situation. And if you don’t have either account yet, and you’re already in a relatively high tax bracket, then a traditional IRA could be appropriate.

Roth IRAs are still relatively new. They were created by a 1997 law and quickly embraced by many Americans. By 2007, there were more than 50 million Roth IRA accounts in the U.S. This is a good reminder that tax laws and provisions do change. Predicting exactly how and when they will change, however—that’s an exercise in futility. That sort of uncertainty causes some investors to feel anxiety about the future. A Roth IRA eliminates much of that worry, because you’ve already paid the tax when you contribute to the account. Whether or not tax rates go up or down is practically irrelevant, since you’ve already paid your tax on contributions upfront.

When you’re saving for retirement, there are dozens of different factors that can affect your progress towards your goal, and tax planning is important. So let’s bring in an expert for some advice on how to approach this decision.

I’m joined now by Hayden Adams. Hayden is a CPA and Certified Financial Planner, and he’s the director of tax and financial planning for the Schwab Center for Financial Research. He was a guest back in Season 2 on the episode titled “How Can You Catch Up on Retirement Saving?” Hayden, thanks for being on the show.

HAYDEN ADAMS: Well, thanks for having me back, Mark.

MARK: We did that episode 10 months ago, and it’s still being regularly downloaded, so it looks like we really tapped into an important decision for investors.

But anyway, today, we’re looking at another important retirement saving decision, and that’s the choice of account. The financial industry, as you know, in many ways, it revolves around choosing account types. You know, we can talk all day about techniques to save money, but it’s almost as important to make sure you’re saving that money in the right type of account. There are many types of retirement accounts, but we’re going to try to keep things simple and focus on the Roth-versus-traditional IRA decision. So let’s start with the basics—what is a traditional individual retirement account?

HAYDEN: So a traditional IRA is a type of, like you said, individual retirement account that can be used in a tax-advantaged way to save for your retirement. There are many types of IRAs that … it includes, like you mentioned, the Roth, a SEP, a Simple, but the traditional IRA is most basic form of IRA account.

MARK: So how does it work?

HAYDEN: Generally, people make pretax contributions to traditional IRAs, which can help reduce your tax bill. That’s assuming you meet the requirements that the IRS sets. Once in the IRA, those assets can grow tax-free. Finally, when you withdraw the money during retirement, that money will, of course, be subject to income taxes. That’s why people generally refer to traditional IRAs as tax-deferred accounts, because they just put off taxes until a later date.

MARK: You had mentioned a pretax contribution. So by that, you mean if you make a contribution to your traditional IRA, that contribution can be deducted from your income taxes?

So who is eligible to make a contribution?

HAYDEN: Well, almost anybody can contribute to a traditional IRA, so long as you have earned income, like wages from your job, or if you’re self-employed, income from a business.

Now, when I say pretax, what I mean by that is, is that the money actually never gets taxed by the IRS. It goes directly from your paycheck right into the retirement account.

MARK: And how much can you contribute each year?

HAYDEN: For 2019 and 2020, the contribution limit is $6,000. For those who are age 50 or older, they’re allowed to make an extra catch-up contribution of $1,000.

Now, depending on the rate of inflation, the IRS will tend to raise the amount you can contribute. Every few years they’ll reassess whether or not they want to raise that limit.

MARK: Those are the contribution limits. Are there any limitations on how much of someone’s contribution can be deducted from their federal income tax?

HAYDEN: If you’re in a retirement plan at work, the Tax Code puts income limitations on the deductibility of the contributions. For people in this situation, once your total taxable income goes over that limit, your tax deduction begins to phase out, or it can completely disappear.

MARK: So if I participate in a 401(k) plan at work, that’s going to affect how much I can contribute to a traditional IRA. Can you explain in detail how that works?

HAYDEN: First, if you’re single, and not enrolled in an employer retirement plan, you will quality for the full deduction. Now, for married couples, if neither you nor your spouse is in an employer plan, then there’s also no limits on the deductibility of your IRA contributions. Where it gets a little bit more complicated is for those who are covered by a workplace retirement plan. The income limits can be a little bit hard for some people to understand because it’s affected by both your filing status and whether it’s you or your spouse who’s covered by the workplace retirement plan. For example, a really simple one would be looking at a single person. If they were covered by an employer-sponsored retirement plan, like a 401(k), they will start to lose their deductibility for IRA contributions once they reach $65,000 of income, and then they can completely lose the deduction after $75,000 of income.

To learn more about these limits, I recommend people check out IRS Publication 590-A, since there are numerous other rules that could apply here. One thing to be aware of, the income limitations for participating in a Roth IRA are different than the deductibility limits on a traditional IRA, even though both accounts have the same total contribution limits.

MARK: So that’s a good segue into the discussion about Roth IRAs. So how do Roths differ from traditional IRAs?

HAYDEN: Roth IRAs are actually basically the opposite of a traditional IRA. With a Roth, you don’t get a tax deduction upfront for your contributions, which means you’re contributing after-tax dollars to those accounts. These assets, then, can benefit from the potential for tax-free growth. And finally, when you withdraw the money in retirement, you will generally do so tax-free.

Another difference with Roth accounts is that you can only contribute to them if you meet certain income limitations. For example, if you’re a married couple, and your income is over $206,000, then you won’t be able to contribute to a Roth account anymore. And that doesn’t even matter whether you’re participating in an employer-sponsored plan or not. But there is a bit of a workaround that some people could utilize to get into a Roth.

MARK: Workarounds can be interesting. So tell me a little bit about the workaround for the Roth income limitation.

HAYDEN: The workaround for the Roth income limitation is nicknamed a “backdoor Roth conversion.” It’s not an officially sanctioned strategy by the IRS. It’s, actually, basically, the combination of two completely legal strategies combined that generally works like this: First, you will end up making a contribution to a traditional IRA with after-tax dollars, so you’re not getting a tax deduction there. These types of contributions, there’s no limit on them, and so even higher-net-worth individuals can do these types of contributions. You just don’t get a tax deduction. Next, you take those contributions, and then you roll them over into a Roth account.

Now, as with any strategy, there’s all kinds of rules that can affect the effectiveness of this transaction. For instance, if you have other IRA accounts, and you try to do after-tax contributions and then roll them into a Roth, you will be subject to what’s called the Pro Rata Rule. And so basically what’s going to happen here is that even though you made after-tax contributions to an IRA, you have to look at all your IRA accounts and then, on a pro-rata basis, say a portion of the rollover to the Roth is going to be from pretax contributions and a portion is going to be from after-tax contributions. This can result in additional taxes being due and can severely limit the effectiveness of this strategy.

If you’re interested in this strategy, I definitely recommend talking to a tax or financial-planning professional. That way they can help you make sure that you’re not missing any of the rules that you weren’t aware of.

MARK: OK, let’s get to the heart of this episode. How do I make the best type of decision regarding which account to open? Under what conditions should I prefer a traditional IRA, and under what conditions does a Roth make more sense?

HAYDEN: This is the most important question to answer before making contributions. Currently, there’s a lot of hype touting Roth accounts as the best account to have versus other tax-deferred accounts, but that’s a bit of an oversimplification of a very complex topic.

MARK: I think that’s right. In the introduction, I talked about how future taxes help to determine that decision. Can you explain a little bit more about how that works?

HAYDEN: Well, believe it or not, a traditional IRA and a Roth IRA are equally tax-efficient, assuming you’re in the same tax bracket today as you are when you pull out the money during retirement. What determines which is the best strategy is looking at your marginal tax rate today as compared to what you think your tax rate will be once you actually need that money in retirement and pull it out of the account. If you’re currently in a low tax bracket and you think later on in life when you’re in retirement that you’re going to be in a higher tax bracket, generally speaking, a Roth is going to make a lot of sense. However, if you’re currently in, say, the highest tax bracket, and you think you might go down one or two tax brackets in retirement, then in that situation, a traditional tax-deferred account may be the better option for you.

MARK: Hayden, one of the themes of the episode is that it’s hard to make forecasts, or at least it’s hard to make accurate forecasts. One technique to deal with that is to not lock yourself into any one forecast and more or less hedge your bets. One way of applying that in this case is to have both a Roth and a traditional IRA. Is that even possible?

HAYDEN: Oh, definitely. You can have both accounts at the same time, and you can even make contributions to both accounts in the same year. In fact, we recommend that many people consider splitting their contributions between both accounts if they’re not sure what their future tax rate may be as compared to their current tax rate.

The strategy is very appealing to those who currently are in, like, a middle tax bracket. If you aren’t sure what the future holds for you, splitting those contributions is basically a hedge against the risk of making a bad guess as to what your future tax rate might be. But remember that the contribution limit for IRA accounts, that $6,000—or that extra $1,000, if you’re over age 50—is the total contribution limit. You don’t get to do a contribution to one for $6,000 and a contribution to the other. You can only split that total contribution between the two accounts.

MARK: Hayden, we talk a lot about diversification on this show, and I think that what you’ve just described, that particular strategy, it sounds to me like a form of tax diversification. Is that a good way to characterize it?

HAYDEN: Yes, you can definitely think of it as a form of tax diversification. By having assets in both accounts, you can choose during retirement which account you’re going to pull the assets from in order to help manage your tax liability.

MARK: The focus of this episode is which account to contribute to, but for those who have already opened one of these accounts, and they’re getting to the point of pulling money out, how do they go about doing that? How does that work?

HAYDEN: There’s a bunch of rules for governing withdrawals from retirement accounts, and for every rule, there’s also an exception to the rule. For traditional IRAs, you can generally withdraw the money penalty-free after age 59½. Of course, you will still need to pay taxes on those distributions, because they were tax-deferred accounts and you never paid taxes in the first place. There are some situations where you can get to the money before age 59½ without paying the 10% penalty, such as the first-time homebuyer purchase exemption, which allows you to pull out $10,000. For Roth accounts, you can generally withdraw your original contributions at any time, tax- and penalty-free, and that’s because you, again, already paid the taxes, you made after-tax contributions, so they’re not going to tax you again on it. However, if you withdraw the earnings from that Roth account before age 59½, you’re going to likely pay a 10% penalty on the amounts that you take out.

MARK: So which account would you take money from first, a traditional or a Roth IRA?

HAYDEN: Overall, a traditional IRA will tend to be the better account to take your money from first, since these accounts are subject to required minimum distributions, also called RMDs. If you take the withdrawals prior to your RMD age, you could potentially help reduce the account value and overall reduce the amount of RMDs you will face once you reach that retirement age that you’re forced to take those distributions. As a general rule, it’s best to leave the Roth money alone as long as possible. That’s because you had to pay taxes on the money before you were able to do the contribution, and you’ll likely need time to recoup the haircut from the taxes, and it can take many years to do that, sometimes 10, 15, or even 20 years. So it’s better to let those accounts sit for a while and benefit from tax-free growth. Also, if you have the desire to pass those assets onto your heirs, the Roth is generally a better account to pass on than a traditional IRA, since any withdrawals your heirs make will be tax-free.

MARK: Earlier this season we did an episode on how to generate retirement income that gets into more detail about how to coordinate withdrawals across multiple accounts. Listeners should definitely check that one out.

But, Hayden, lots of great information. Thanks for being here.

HAYDEN: Well, thank you.

MARK: Forecasting is difficult, just ask any meteorologist or CEO. If every company could accurately predict sales, earnings, and the direction of the market for their products, very few businesses would fail. If every meteorologist could forecast the weather perfectly, well, very few jokes would be told at their expense. My sense is that people look at current tax rates and confidently assume that these won’t change, but tax rates and rules have fluctuated and probably will change multiple times in the coming decades. In just the last few years, we’ve seen the 2017 tax law change the marginal tax rates for many American taxpayers and the 2019 SECURE Act change the rules for withdrawing from certain retirement accounts. Even if rates and rules don’t change, the rate you’ll pay depends on your adjusted gross income at the time of your withdrawal. And remember, if you’re retired, your withdrawals could impact your income enough to change which tax bracket you fall into. Keep in mind what Hayden suggested and consider opening both types of accounts.

At the very least, consider different scenarios for how rates and your income will change in the future. A Roth IRA can be a great long-term savings tool, so try to take advantage of the rules that are in place, if you can. Just remember that tax laws are subject to change, so check out the IRS’s latest news page regularly for updates, and I’ll put a link to that page in the show notes. Also, be sure to talk with your accountant or professional tax advisor about whether a Roth IRA makes sense for you. You can also try a Roth-versus-traditional calculator and learn more about each account type at Schwab.com/Roth.

Thanks for listening. If you’ve enjoyed this episode, consider leaving us a rating or review on Apple Podcasts or your favorite listening app. For important disclosures, see the show notes and Schwab.com/FinancialDecoder.