To pay income taxes now or later, that is the IRA question

Prioritizing a traditional or Roth IRA account depends on many factors, most of which are related to an individual’s current and expected future tax circumstances.

Traditional IRAs and the default account in 401(k) plans allow contributions from earnings and the deferral of income taxes on those earnings until they’re withdrawn in retirement. Traditional IRAs allow the full amount of one’s earned income to be invested without the drag of annual taxation.

With a Roth IRA or Roth 401(k) account, earnings are taxed before they are invested in the account. Like the traditional accounts, the money grows without the drag of annual taxes. But Roth withdrawals in retirement are income-tax free.

The net result: In-retirement purchasing power is the same with each type of account as long as the income tax rates in the years of contributions are the same as the rates in the years of withdrawal.

HIGHER OR LOWER

The question to consider is whether your client’s income tax rates will be higher or lower in retirement. If your client’s income tax rates are higher now than what they anticipate in the future, they are probably better off in a traditional account. Conversely, if their current rates are lower than what they expect in retirement, the Roth account is probably better.

Predicting future income tax rates is difficult, but other factors can be predicted with more certainty.

Let’s say you are advising your client’s children, who are starting their careers after graduating. Their incomes will probably be in the lower marginal tax brackets (10% and 15% federal). In later years, with higher incomes, they’ll enter into higher brackets (25%, 28% or 33% federal). Early on, Roth accounts are likely the right decision.

Now let’s look at your clients who are established in their careers. They’re earning good salaries and getting bonuses, too. Their income may be entering the highest marginal tax brackets (35% or 39.6% federal) and perhaps they’re subject to the alternative minimum tax, too. They are now earning income that could be equal or greater than what they expect to draw in retirement. If this is their situation, they may be better off contributing to a traditional account.

Where you live matters, too, for your tax rates. For example, New Yorkers face relatively high income tax rates. A client living in New York City can easily be looking at a combined city and state marginal income tax rate of 10% or more. Add federal rates and it can be significant. Then there are states like Florida, Nevada and Texas that don’t have income taxes, while states like Arizona have relatively low income taxes. If your clients work in a high income-tax state and expect to retire to a low income-tax state, then the traditional account may be best.

Temporary situations can be opportunities. In low-income years due to job changes or unpaid leaves, consider funding a Roth account or even a Roth conversion.

That all seems rather straightforward. But what about the client who expects his elected officials will raise his tax rates in the future and commits to a Roth? Or who worries Congress will change course and tax Roth accounts in the future, leading him to a traditional IRA?

Income taxes are just one of many methods governments can use to tax citizens. Though it is difficult politically to increase income tax rates, other tax schemes can be employed and increased with less public reaction. Sales tax, property tax, registration taxes, tolls and fines are vulnerable. Don’t be surprised to see the taxable wage base for Social Security, disability and Medicare increase. The point is, your client could choose to fund a Roth account solely based on an expectation of higher income taxes in the future and find that yes, his taxes increased — but through one of the other vehicles — and his Roth account won’t shield his money from them.

Regarding changing the rules to tax Roth accounts in the future, anything is possible, but it would likely be political suicide for officials to do so.

Whatever combination of traditional and Roth accounts your clients choose, they can’t go too wrong, because in either case they are contributing to their future in an account designed to help them achieve long-term growth of retirement savings.

John M. Davis is director of retirement marketing and insights, BNY Mellon Investment Management.