The core decision between a Roth and Traditional IRA hinges on comparing your current marginal tax rate with your expected future effective tax rate. We've explored the Tax Rate Difference before, but how does the "break-even" math shift as your portfolio crosses the $1M, $5M, or $15M mark? And what about RMDs, deductions, and the other factors that can affect the break-even point?
Our latest simulations reveal that the "break-even" marginal tax rate—the rate you can pay today to make one account type objectively better than the other—is not a single number. It is a moving target that rises as your projected Traditional balance grows. Note that we are finding the break-even rate for the accumulation phase (working years where you are saving), not the depletion phase (retirement years where you are withdrawing).
The Moving Target of Tax Efficiency
In traditional financial planning, the rule of thumb is simple: expect a higher tax bracket in retirement? Use a Roth. Expect a lower bracket? Use a Traditional IRA. On the surface, avoiding a 22% tax today by taking the upfront Traditional deduction, and instead paying a 15% tax on withdrawals in retirement, seems like a clear win.
However, our model reveals that this "common sense" math is often wrong because it ignores many factors.
Factors that benefit Roth IRAs:
- ACA Subsidies: Higher Traditional withdrawals (MAGI) can destroy thousands of dollars in health insurance subsidies, effectively acting as a massive "shadow tax."
- Social Security Taxation: The "Tax Torpedo" where each dollar of Traditional income can make $0.85 of Social Security taxable.
- IRMAA Surcharges: High MAGI can trigger Medicare Part B and Part D premium surcharges (Income-Related Monthly Adjustment Amounts), which act as steep, cliff-like tax penalties.
- Required Minimum Distributions (RMDs): The government forces large withdrawals at higher wealth levels, potentially pushing you into much higher brackets than the "simple" math accounts for.
- No Lifetime RMDs (Roth Only): Unlike Traditional IRAs, Roth IRAs do not require minimum distributions during the owner's lifetime, allowing tax-free compounding indefinitely.
- Estate Planning: Heirs inherit Roth IRAs tax-free. Traditional IRA heirs must pay income taxes on inherited distributions, often during their own peak earning years due to the 10-year depletion rule.
Factors that benefit Traditional IRAs:
- Accumulation Phase Deductions: The Traditional IRA deduction is a direct reduction of your taxable income, which can lower your tax liability in the accumulation phase.
- Depletion Phase Deductions: Once in retirement, there are many deductions available that can lower your tax liability in the depletion phase. These include: standard deductions, senior add-on, and senior bonus. These deductions lessen the tax burden on Traditional IRA withdrawals.
- Strategic Gap-Year Conversions: If you retire before taking Social Security or a pension, you may have "gap years" with very low taxable income. Traditional IRAs allow you to perform Roth conversions during these years, strategically filling up the lowest tax buckets.
Given all of these complexities, it is clear that the "Roth vs. Traditional" choice is not a simple matter of comparing your current tax bracket with your expected future bracket. It is a complex decision that requires careful consideration of many factors.
Let's create some algorithms to help us understand the break-even point.
Break-Even Analysis
If you just want the answer, and don't want to understand how we got there, feel free to skip ahead.
In our prior post (Considering retiring early, but worried about healthcare (ACA) costs?), we introduced our Traditional IRA Withdrawal and Roth Conversion Calculator.
To generate the data for this post, we wrapped more code around the calculator to run it for a range of Traditional IRA balances. At each Traditional IRA balance we found the maximum withdrawal rate that could be supported (I.E., we found the maximum yearly target spend such that we die with a close to zero, but still positive, account balance). We then found the minimum Roth IRA balance that supported that same withdrawal rate. We then calculated the marginal tax rate at which the Traditional IRA balance would be equal to the Roth IRA balance (I.E., the point at which after-tax purchasing power is equal given the savings sent to either the Traditional IRA or Roth IRA).
That is what is in the plot below - the accumulation phase marginal tax rate at which the Traditional IRA and Roth IRA required the same savings sacrifice, created the same purchasing power in retirement, and resulted in a terminal balance near zero.
Visualizing the Dominance Zones
The chart below shows the Break-even Accumulation Phase Marginal Tax Rate. This is the maximum marginal tax rate you can pay during your working years to have the Roth account still "break even" with a Traditional account in terms of terminal purchasing power.