I’m not here to talk about the Irish Republican Army - instead, I’m going to talk about something even more revolutionary: TAX LIABILITY ON RETIREMENT INVESTING. It’s a very exciting topic, one that I’ve spent far too long trying to read about, despite the fact that the basics could probably be covered in a few minutes.
the status quo
To understand why any of this is important, it’s worth understanding the tax landscape for investing, without using any of the “tax-advantaged accounts” available. The default scenario is that you get taxed twice: first, when you earn income (income tax), and second, when the money you’ve invested grows (capital gains tax). This ends up being pretty expensive, as we can see in the (imperfect) model I’ve built below (click on the image to expand it fullscreen):
Years 26-55 aren’t shown, but they’re still there in the model. “Allocation” refers to how much of your paycheck you allocate to saving (before paying income taxes). The “Contribution” column is how much you actually end up investing.
The big takeaway: you paid $97,714.29 in upfront income taxes and $131,976.26 in capital gains taxes, for a total of $229,690.55 in taxes paid (yes, there’s time value of money, but we’re going to table that for now). After all is said and done, you now have under just under a million dollars.
with a roth ira
A Roth IRA is a tax-advantaged account that doesn’t require you to pay capital gains taxes. Money you contribute is still post-income-taxes, but other than a few rules around using the account, that’s the basic idea to understand.
Those rules aren’t unimportant - there are limits on how much you can contribute in any given year; there are income limits that determine if you can even use a Roth IRA in the first place; there are rules around when you can withdraw money from the account. These can shift over time, so it’s worth checking on your own what they are, either by going directly to the IRS website or to some other reasonably reliable source (perhaps your bank or Reddit’s r/personalfinance). The current rules are (if we leave out the details) that you can’t contribute more than $6,000 a year [1] (if you’re under 50), you shouldn’t touch the money until you’re 59-and-a-half, and if you’re earning more than around $120k, you’re going to need a “backdoor Roth” IRA instead (I found this link helpful).
Let’s see how the above model works with a Roth IRA:
Again, years 26-55 aren’t shown, but they’re still there in the model.
This is basically the same as last time, except since you don’t pay capital gains taxes, you end up paying $131,000-and-change less in taxes and pocketing it all. Your account is now past $1.1 million, just by setting up a different account.
with a traditional ira
A Traditional IRA is a tax-deferred account that, like the Roth IRA, doesn’t require you to pay capital gains. However, money you contribute is pre-income-tax, at the cost of having to treat withdrawals from the account (even once you’re retired) as income, when you’ll then pay income taxes on. Here’s how that shapes out:
Since we don’t pay taxes upfront on income when we contribute, we end up having to allocate less of our paychecks to the account, which saves us $97,714.29 in income taxes over the course of the model. Again, we don’t pay capital gains taxes - but when we do withdraw money, it’s treated as ordinary income, which means we’re paying much more in taxes overall (assuming the same 30% tax rate).
It looks like the traditional IRA is doing worse than the default, don’t-do-anything-special model we originally built. That’s not totally a fair comparison - since we’re allocating less of our paychecks to investing, we can take the extra cash that we would have allocated and invest that. Adding the extra in, here’s what we’re left with:
We can invest the extra $2,571.43 that we would have otherwise paid in income taxes each year and grow that in an ordinary brokerage account. Some of that money still goes to income taxes, but in the end we’re left with $292,759.65 after paying capital gains taxes on the “additional” money. Then, we add the post-tax money from the traditional IRA to net a bit under $1.1 million - not quite as much as the Roth IRA, but still better than doing nothing at all.
Now, the playing field looks much more even between a traditional IRA and a Roth IRA. When you’re allocating $6,000 or less per year, you actually end up with the same results no matter which IRA you choose. The only reason the Roth performs better in the examples I’ve listed is because the annual salary allocation is higher than the contribution limit to the Traditional IRA, which in turn forces the use of a non-tax-advantaged investment account for the remainder of the money.
Let’s recap everything here:
so, which one do you use?
That’s a question that largely depends on tax rates, and what you think will happen in the future. No one’s perfect at forecasting, however. The idea is that if you think your marginal tax rate now is higher than the marginal tax rate you’ll have in retirement, you should use the traditional IRA. If you think that your current marginal tax rate is lower than what you expect your future marginal tax rate to be, you should probably go with the Roth.
Income limits play an important role in the effectiveness of an IRA. Traditional IRA plans have income limits for being able to contribute pre-tax dollars (if you have a retirement plan at work, more details are available at this link). Contributing to a traditional IRA can also reduce the future effectiveness of the backdoor Roth IRA due to the pro-rata rule - again, see this link for an explanation of why.
model assumptions
When I built my Excel model, I assumed that you’d be perennially in a 30% marginal tax rate for your entire life - which is highly unlikely to happen. Your income will change, and so will the political situation on taxes. I’m also assuming constant growth of 7% on invested money, and a 15% tax rate on capital gains. None of this is supposed to really mimic the real world perfectly, but rather to give a general idea of the power that an IRA can have.
tax rates
I found some great videos that explain marginal tax rates from Vox and YNAB. This article from The Balance does a great job of explaining the capital gains tax.
[1] The contribution also needs to be earned income. If you earned $4,500 in a year, then you’d only be able to contribute up to $4,500.
I am not providing or intending to provide tax, legal, or accounting advice. This blog post is for informational purposes only, so please don’t rely on it for tax, legal or accounting advice. Consult your own tax, legal and accounting advisors before engaging in any transaction. I’m just a guy on the internet. Please don’t sue me.