Choosing Between Roth and Traditional IRAs
Among the most important decisions investors make is their choice of location for assets within the various alternatives available for retirement (tax-advantaged) accounts. Allocating between a traditional IRA (a pretax, tax-deferred account) and a Roth IRA (a post-tax, tax-free account) can have a pronounced impact on retirement outcomes, given the $14 trillion in tax-advantaged retirement account assets at the end of 2015.
David Brown, Scott Cederburg and Michael O’Doherty contribute to the literature on retirement asset location with their June 2016 paper, “Tax Uncertainty and Retirement Savings Diversification.”
The modeling approach they adopt accounted for investor age, current income and taxable income from outside sources in retirement, as well as the highly progressive income tax regime now in place. The authors point out that “the marginal rate for a single taxpayer with inflation-adjusted income of $100,000, for example, has changed 39 times since the introduction of income taxes in 1913 and has ranged from 1% to 43%.” This creates considerable uncertainty.
Because risk-averse investors (and most investors are risk averse; it’s generally only a matter of degree) dislike uncertainty, this should create a preference for Roth accounts, as they “lock in” the current rate, eliminating the uncertainty associated with future changes.
On the other hand, a traditional account, which offers retirement savers the benefit of deducting current contributions, allows investors to “manage their current taxable income around tax-bracket cutoffs, which is valuable under a progressive structure.”
Another benefit of traditional accounts, the authors write, is that “the progressive tax rates faced in retirement provide a natural hedge against investment performance. Investors with poor investment results and little wealth in retirement will pay a relatively low marginal tax rate, whereas larger tax burdens are borne by investors who become wealthy as a result of good investment performance.” This creates tension between the traditional and Roth options.
Who Should Use The Roth Structure?
The authors state: “Roth accounts are primarily useful for low-income investors who can lock in a low marginal rate by paying taxes in the current period.” They add that because “future tax rates are more uncertain over longer retirement horizons” and their analysis of historical tax changes suggests “that the rates associated with higher incomes are more variable,” eliminating “exposure to tax risk is particularly attractive for younger investors with relatively high incomes and correspondingly high savings.”
The authors continue: “Despite high current marginal tax rates, and contrary to conventional financial advice, these investors benefit the most from the tax-strategy diversification offered by Roth accounts.”
Brown, Cederburg and O’Doherty concluded: “Whereas conventional wisdom largely supports choosing between traditional and Roth accounts by comparing current tax rates to expected future tax rates, the hedging benefits of traditional accounts and the usefulness of Roth accounts in managing tax-schedule uncertainty are important considerations in the optimal savings decision.” They note that, for wealthy investors, their analysis shows “tax-strategy diversification is particularly attractive, despite their high current marginal tax rates.”
The authors also examined their findings’ economic implications: “Our results are of practical importance to employers and regulators who determine the retirement savings options available to employees. In particular, broadening access to Roth versions of workplace accounts would provide investors with important tools for managing their exposures to tax risk. Given that these accounts are available under current regulations, encouraging the widespread adoption of, and education about, employer-sponsored Roth plans could substantially improve investors’ welfare.”
What the authors found provides investors with the proper framework to make informed decisions regarding the asset location of their retirement savings and the diversification of tax risk.
This commentary originally appeared July 27 on ETF.com
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The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2016, The BAM ALLIANCE