For a couple years I’ve thought about whether to do a traditional IRA or a Roth IRA.  I haven’t come to a firm conclusion.  Until this week.

Whether to do traditional or Roth is important because the “wrong” decision can mean paying thousands of dollars of extra tax. 

I put “wrong” in quotations because contributing to either is a wise money decision.   Choosing between the two is like picking between A&W and Parker’s root beer.   On any given day one might be slightly more delicious, but you can’t go wrong because both make your life better.

Also note that you don’t have to choose between the two.  You can do both.  And it’s probably smarter to do both.  More on that later.  But it’s also nice to figure out whether one is better than the other.  If one is better, you’d like to focus on it more.

Your Current and Future Tax Rates Drive the Decision

This article assumes an understanding of the tax advantages of IRA’s and 401(k)’s, both traditional and Roth.  If you’re not sure how IRA’s reduce your taxes, you may wish to do some background research first.  Try this Motley Fool article on traditional versus Roth IRA’s (I haven’t read it, but Motley Fool is usually good at explaining basic concepts like this).

It’s well understood that the key factor in choosing between traditional versus Roth is your tax rate now versus your tax rate later.  If you have a higher tax rate now, you want to contribute to a traditional IRA.  If you have a lower tax rate now, you want to do a Roth.

There Are a Few Other Reasons

For most people the decision is driven by the tax rate expectations.  But there are a few other smart reasons for choosing one over the other.  Someday I’ll do a more exhaustive look at all the reasons that might push you toward one or the other, but for now I’ll mention two:

  • Traditional and Roth IRA have different restrictions on when you can withdraw contributions and earnings without incurring a penalty;
  • Making contributions to a traditional IRA may lower your income sufficiently that you can take advantage of a deduction or credit you’d otherwise be phased out of, such as the student loan interest deduction or the child tax credit.

Back to the Tax Rate Issue

If you had a crystal ball and could foresee that you will have the same tax rate in the future as you have right now, a traditional IRA and a Roth IRA are financially equivalent.  The problem stems from not knowing your future tax rate.

A few days ago Jonathan at MyMoneyBlog put up Daydreaming: How Can I Retire In 10 Years?   I liked the post for two reasons.  Not only is retiring early a topic dear to my heart, but Jonathan wrote something that sparked an idea.  Here’s what he wrote:

“[After retiring] if I have no other income from sources like pensions or annuities, this means I should lean towards contributing to Traditional IRAs and 401(k)s exclusively right now instead of Roth’s since my tax rate in retirement should be very low - much lower than I might have guessed before.”

Jonathan recognized a reason why his future tax rate may be lower than his current tax rate.  He correctly reasons that he should lean toward a traditional. 

This Got Me Thinking

Let me take Jonathan’s idea one step further. 

Like most people, most of my income currently comes from my salary.  I receive a paycheck twice a month.  I pay taxes as I go (through withholding) with a true-up at the end of the year (when I file my tax return on April 15th). 

Things will be different after I retire.  I will no longer receive a paycheck.  I won’t have a pension.  I plan to fund retirement through passive investments, primarily capital gains from the sale of stock. 

Since I can control when I sell stock, I plan the following approach after I retire: 

Step 1:    In one year I will sell stock out of a regular brokerage account.  My marginal tax rate will be no higher than 15% because it will be long term capital gains.

Step 2:    In the next year I will avoid selling any stock from my taxable account.  Instead I will sell stock in my traditional IRA and distribute just the right amount so that I remain in the 0% tax bracket.  To the extent I have deductions from things like mortgage interest or charitable donations, I can distribute more from my IRA while maintaining a sufficiently low income to avoid paying any tax.

Step 3:    In subsequent years I will repeat Step 2 as much as possible while maintaining a sufficiently low income to avoid paying tax.  When I need more liquidity or if my living expenses go up, I will make up any difference by repeating Step 1 so that I’m only taxed at long term capital gains rates. 

Step 4:    Continue alternating between Steps 1 and 2 depending on whether I need access to a lot of money during the year (through Step 1) or a little bit of money (through Step 2). 

By alternating between Steps 1 and 2 I should always have enough to cover living expenses.  Eventually I will have repeated Step 2 enough times that I will empty my IRA. 

What will I have accomplished?  I will have distributed all the money from my traditional IRA without paying a cent of tax.  If this idea doesn’t seem like a big deal, then keep reading. 

How Much Will This Approach Save Me in Taxes?

To get an idea of how much this approach could save me, I need to know how big my IRA will be when I retire.  The current contribution limit to an IRA is $4,000.  The amount goes up periodically, but I’ll take the conservative approach and assume a $4,000 annual contribution over 30 years (starting withdrawals at age 59½).  Assuming a conservative 10% annual return, I’ll have $730,000 after 30 years. 

My wife will have a similar IRA.  Combined we will have nearly $1,500,000.

If I simply sold everything in the IRA’s and made a lump sum distribution, I would be taxed on $1,500,000 of ordinary income.  It’s impossible to know what the tax brackets will look like in 30 years, but under the current rates my tax would be around $500,000.

Most people don’t liquidate their entire IRA in one year.  A more likely approach is to make annual distributions sufficient to cover living expenses. 

I don’t know what my living expenses will be in 30 years, but with inflation, health care, and a California mortgage my living expenses would easily top $100,000 per year.  If I distributed $120,000 from an IRA during a single tax year, under current rates the tax would be around $20,000 after taking into account standard deductions and personal exemptions.  After tax I would have $100,000 per year — probably not even enough to cover living expenses in the year 2038.  At that withdrawal rate the $1,500,000 in our IRA’s would last 12.5 years, during which time I’d pay about $250,000 in taxes.

Under my method, my tax is zero.  My method could save me $250,000.

Is My Method Realistic?

First of all, my method is completely legal.  There’s nothing wrong with timing distributions from my IRA in a way that minimizes tax.  Frankly, I would be dumb not to do it.

The bigger question is whether I’ll live long enough to distribute the full $1,500,000 balance.  To stay in the 0% tax bracket I will need to keep my taxable income relatively low.  Is this realistic? It is very realistic if I have large deductions from things like mortgage interest and charitable contributions.  Any deductions or credits would increase the amount I could distribute from the IRA without incurring tax. 

The tax brackets will continue to move up with inflation.  If I’m still paying a mortgage in California, I will easily be able to have $75,000 or more of gross income and not pay any tax.  With IRA balances of $1,500,000, it would take me twenty ”Step 2″ years to drain the IRA’s completely.  Starting at 59½ years old, I hope to be able to fit in twenty “Step 2″ years.

One Factor I Haven’t Included in the Analysis

Roth IRA’s have an advantage I haven’t included in my analysis.  It is well known that a Roth IRA allows you to shelter more income than a traditional IRA. 

While this makes a Roth a little more compelling, I’m not sure that it outweighs the advantage of following my strategy.

Conclusion

I believe I’ve found a way to get the best of both worlds.  I will be able to take current deductions for traditional IRA contributions, and yet I should be able to largely avoid paying tax when I receive distributions after age 59½.  It’s like having a traditional IRA that morphs into a Roth IRA after I retire.  Cool.

The potential savings are even greater if current IRA contributions allow me to avoid the phaseout of certain deductions and credits (e.g. student loan interest deduction, child tax credit).

It’s impossible to know how the tax laws might change in the next 30 years.  They could get rid of IRA’s, change how they’re taxed, or they could put in place other provisions that might prevent me from implementing my strategy.  That would be sad.  The wise course may be to practice what Walter Updegrave calls “tax diversification.”

But I’m still going to lean strongly, if not exclusively, toward traditional IRA’s.