The decision to allocate between a pretax retirement savings vehicle (e.g., a traditional IRA) and an aftertax retirement savings vehicle (e.g., Roth IRA) depends on both current and expected future wealth. Aftertax retirement savings accounts are preferable for workers with both low and high current incomes. Those with intermediate incomes should opt to use both so as to avoid being pushed into a higher marginal tax bracket.
This was a conclusion of an analysis of retirement accounts and historical changes to the tax code. The study’s authors considered both the progressive nature of the U.S. tax code and how income tax rates have changed over time. Time periods of 10 and 30 years before retirement were used.
Those with low levels of current income benefit from the low tax rate on contributions. By using Roth accounts, investors lock in low tax rates. Doing so hedges them against having higher income in the future and therefore being exposed to higher tax rates.
High income earners face a trade-off. If future tax rates are known, pretax retirement accounts are preferable to avoid paying the higher marginal income rates on aftertax contributions. When future tax rates are uncertain and guaranteed future income is high, paying the highest current tax on contributions offers certainty. The current tax rate is paid on the Roth IRA contributions and avoids potentially higher tax rates down the road. Should investment performance be worse than expected—bad enough to put the investor into a lower tax bracket—pretax accounts offer some advantages.
Those with intermediate incomes should consider how close they are to the lower and/or higher current tax brackets. Pretax contributions should be used to stay in the lower tax bracket or avoid being bumped into the higher tax bracket. Any marginal dollars beyond this amount should be placed in aftertax accounts.
Some assumptions were made to simplify the analysis. Only three tax brackets were used. The ability to convert pretax retirement savings into a Roth IRA was also not factored in. Randomized historical tax rates were used and the actual variance in future tax rates may differ.
Source: “Tax Uncertainty and Retirement Savings Diversification,” David Brown, Scott Cederburg, and Michael O’Doherty, SSRN, July 25, 2016.
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Herbert Edminster from KY posted over 9 years ago:
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