The Taxpayer Relief Act of 1997 introduced, for the first time, the opportunity for individuals to contribute to a tax-free Roth IRA for retirement. Up until that point, retirement accounts — in the form of both IRAs and 401(k) plans — provided a tax deduction when contributions were made to the account in exchange for the fact that subsequent distributions at retirement would be taxable (in essence, allowing not only growth to compound on a tax-deferred basis, but the original contribution to be tax-deferred as well). Roth-style accounts were unique, though, in that contributions would no longer be tax-deductible … but growth within the account would still be tax-deferred, and could ultimately be withdrawn tax-free (at least if certain requirements were met).
From nearly the moment of their inception, the promise of a lifetime of tax-free growth made Roth accounts popular, especially amongst higher-income households that faced top tax brackets. However, to limit their use by high-income households, Roth accounts were established with income limitations, both on contributions themselves (with the ‘maximum’ contribution reduced to $0 for those above specified income thresholds), and on Roth conversions (which were prohibited for households with more than $100,000 of AGI, although the Roth conversion income limitation was subsequently removed starting in 2010 by the Taxpayer Increase Prevention Act of 2005 [TIPRA]). As a result, the highest-income households that faced the highest tax rates — for which tax-free growth would ostensibly be most valuable — were the ones that were least able to actually utilize Roth accounts.
Yet the irony is that, in reality, the tax-free growth of a Roth-style account is not necessarily more valuable than the pre-tax contribution to a traditional IRA in the first place. While a tax-free Roth account is clearly more valuable than simply investing in a “normal” taxable investment account, traditional IRAs do have a significant additional benefit: the upfront tax deduction on the contribution in the first place, which substantively changes the comparison beyond a simple rule of thumb that “tax-free Roth accounts are always better.”
The tax equivalency principle of Roth versus traditional retirement accounts
Imagine for a moment that you learn you are going to receive a $5,000 bonus from your employer — funds that you wouldn’t need to cover your current household spending — and are suddenly faced with the decision of where to save this additional income.
On the one hand, you could contribute the full $5,000 to a traditional IRA and receive the associated upfront $5,000 tax deduction. On the other hand, you could contribute to a Roth IRA, but doing so will mean that you would have to hold aside some of the money for taxes (presuming that the rest of your wealth is already invested, so you don’t have extra cash lying around), such that if your Federal-plus-state marginal tax rate is 25%, only $3,750 will actually end out in the Roth account (with the other $1,250 going to taxes).
Assume that you leave the dollars in the retirement account long enough for its value to double (whether that’s compounding 7% per year for 10 years, or 4% per year for 18 years). At the end of the time period, the Roth account will grow from $3,750 to $7,500, while the traditional account will grow from $5,000 to $10,000. However, the traditional account is still a pre-tax account, and being able to spend the money will require withdrawing it and paying the associated taxes … which, if tax rates haven’t changed, will reduce its value by 25%, to a net value of $10,000 – (25% x $10,000) = $7,500 of after-tax value.
The end result is that the Roth account produces neither a dollar more nor a dollar less than the traditional retirement account because in practice, when Uncle Sam has “earmarked” 25% of a growing retirement account, the value of the account grows to the upside at the exact same rate that the tax liability grows to the downside. As a result, regardless of the time horizon or the growth rate, the after-tax value of a traditional retirement account is always exactly the same as the value of the Roth account (as long as the tax rates remain the same).
Roth versus traditional when tax rates change
The “tax equivalency” of Roth versus traditional retirement accounts exists because, in the long run, the additional value of tax-free growth in a Roth is the same as the additional value of the upfront tax deduction for the traditional retirement account with the caveat that in the end, the value of the upfront tax deduction on a traditional retirement account is not just a function of the marginal tax rate when the deduction occurs. The value of a traditional IRA will also be impacted by what the final tax rate turns out to be when the dollars are actually withdrawn in the future.
After all, the $3,750 Roth IRA that doubles in value with growth to $7,500 will ‘always’ be worth $7,500, because the tax impact was ‘locked-in’ upfront (at the assumed 25% tax rate), while the final value of the $5,000 pre-tax traditional IRA contribution is not actually determined until the end. If the future tax rate turns out to be 35% (and not 25%), the traditional IRA will grow to $10,000 but only be worth $6,500 after taxes. If the future tax rate declines and is only 15% in the end, the traditional IRA that grew to $10,000 will be worth $8,500 on an after-tax basis.
As the chart above shows, for any given upfront tax rate (that is “locked in” with the after-tax Roth contribution), if future tax rates are higher than that initial tax rate, then the traditional IRA’s value will fall behind the Roth account. If future tax rates are lower, though, then the traditional IRA’s value ends up being ahead of the Roth account. Which means it’s the change in tax rates — between the upfront contribution and the final distribution — that ultimately determines whether a traditional IRA ends up being better or worse than a Roth-style account.
How tax diversification minimizes tax alpha opportunities
When it comes to investing, there is significant uncertainty about what the future price of any particular stock (or the overall stock market) will be, such that one of the most common investment strategies to manage this uncertainty is to diversify into a wide range of investments. And for many individuals and households, there is also significant uncertainty about what their “tax future” will look like, given both the potential for job and income changes, sudden wealth events (for better or worse), and the potential that Congress itself will change the rules of the game such that some people look not only to diversify the investments in their portfolio (to manage investment uncertainty) but also to diversify their investments across their traditional and Roth retirement accounts (to manage tax uncertainty).
In other words, recognizing that a traditional retirement account will fare better if the individual’s tax rates are lower in the future, but the Roth will turn out to have been preferable if the individual’s tax rates end up higher, having some dollars in each type of account — Roth and traditional — is a way to diversify against this uncertainty. Which might mean contributing evenly to traditional and Roth retirement accounts every year (whether via an IRA or 401(k) plan). Or it could mean taking what were historically accumulations in traditional retirement accounts (especially since many 401(k) plans still only offer a traditional and not Roth-style option) and doing a partial Roth conversion to turn half of the traditional account into a Roth.
The end result, though, is simply that by having some dollars in a traditional account (which benefits if tax rates go down) alongside some money in a Roth account (which benefits if tax rates go up), the household can “ensure” at least some benefit, regardless of which direction tax rates actually go. As with traditional diversification, by holding some exposure to each, there is an opportunity to benefit as long as either does well in the future. The household has “tax diversified” its retirement accounts in the face of tax uncertainty.
Why tax diversification doesn’t actually diversify
While there is a clear, intuitive appeal to the concept of “tax diversification,” the caveat is that, in practice, the outcomes are not really consistent with the traditional benefits of diversification. Because with traditional diversification — in the investment context — the outcomes of each investment are (at least ideally) independent of each other (i.e., not correlated to one another). Whereas when it comes to tax diversification, the outcomes are directly related to each other; every 1% tax rate increase that benefits the portion that was allocated to the Roth impairs the funds that remained in a traditional account, and vice versa when tax rates decrease (where the traditional account benefits but the Roth does not).
Although in reality, because the tax rate on a Roth account is effectively “locked in” at the time of contribution or conversion, the outcomes of tax rate changes — for better or worse — are driven entirely by whether the traditional retirement account fares better or worse. As the Roth account is always worth the same after-tax value in the future, regardless of what actually happens to future tax rates. Whether that Roth outcome is better than what the traditional IRA would have been is determined by future tax rates (which reveal what the traditional IRA might have been worth on an after-tax basis).
As a result, the decision to put dollars into Roth versus traditional accounts effectively just takes money off the table altogether from a tax-planning perspective. With a traditional account, future outcomes could be better or worse (depending on what future tax rates turn out to be), while increasing the percentage of dollars in the Roth account simply narrows the range of outcomes altogether (to the point that with a full Roth conversion, there is no upside or downside from future tax rate changes).
Or viewed another way, splitting dollars between traditional and Roth accounts is not akin to investment diversification (e.g., between large- and small-cap stocks); instead, it’s more analogous to taking money out of the markets altogether (eliminating both the downside and upside opportunity) and just holding zero-risk, zero-opportunity cash instead.
How tax timing beats tax diversification
Investment diversification is popular because markets are incredibly efficient, and, at best, most investors will struggle greatly in their efforts to time the markets to determine when to buy or sell individual stocks (or the overall stock market). However, when it comes to our tax situation, there is no aggregate market trading in and out of our individual tax futures to arbitrage away opportunities to generate alpha. Instead, we are uniquely privy to our own tax situations and our own plans and expectations for the future, which creates unique opportunities to engage in tax timing that tactically navigates our changing tax situation over time.
After all, our tax picture can and does change — sometimes quite significantly — over time. In some cases, this is a function of our growing careers (e.g., tax rates tend to rise during our working years as our careers build) or growing net worth (e.g., the more wealth that is accumulated, the more passive investment income that tends to be generated, filling lower tax brackets and crowding marginal income into higher tax brackets).
In other situations, it’s any number of “one-time” events that occur with surprising regularity, from being laid off in a recession or taking time out from the workforce to go back to school, taking leave for a health event, launching of a new business that drags our income down, or, conversely, a big bonus at work, a home run investment, a business that takes off or a major liquidity event that boosts our income higher.
Accordingly, rather than simply having an arbitrary strategy of tax diversification (e.g., always contributing 50% to a traditional account and 50% to a Roth account), a Roth-optimized tax timing strategy would aim to more opportunistically determine when to contribute to traditional accounts and when to contribute to (or convert into) Roth-style accounts.
For instance, consider an approach where instead of arbitrarily diversifying 50-50 between Roth and traditional IRAs, the aforementioned household over its lifetime contributed to Roth-style accounts any time its tax bracket was 10% or 12% (or Roth-converted one-tenth of their existing IRA once retired, and no new contributions can be made), went 50-50 between the two account types only when their tax rates were 22% or 24% and contributed to a traditional account (to get the upfront tax deduction) anytime their tax rates are 32% or more.
As the results reveal, engaging in Roth accounts more opportunistically (rather than consistently tax diversifying) produces a nearly 10% lift in cumulative lifetime after-tax wealth, amounting to more than $400,000 in additional wealth for optimizing just $10,000/year annual contributions ($5,000 per person) for the couple during their working years.
Finding the equilibrium point in Roth optimization
The good news is that, while trying to time the markets is challenging at best, timing one’s own tax circumstances is far more practical. After all, we know with reasonable certainty our current tax bracket as it exists in the current year, which provides a helpful initial baseline. And through the financial planning process itself, we typically will already be formulating a plan for at least what we’re trying to achieve in the future, which is generally associated with some level of expected future wealth and future income. And from this, our future tax brackets can also be projected.
Of course, the reality is that in some cases — particularly for those that are in the middle tax brackets already — the path forward may not be as clear. A married couple earning a strong joint income of $200,000 per year and building wealth is already in the 24% tax bracket, and while they may believe they can stay in a 24% bracket even in retirement (by keeping their income to “just” $329,000 or less) and not creep into higher tax brackets, they may be skeptical about ever getting to lower tax brackets (e.g., it may be difficult for them to get below $81,000 of income given their portfolio wealth and its passive income, Social Security benefits, required minimum distributions, etc.).
Yet, because the potential wealth that can be gained from Roth optimization relative to tax diversification is only created by changes in tax brackets, the truth is that for a household whose tax bracket isn’t likely to change in the future — higher or lower — it doesn’t actually matter which type of account they choose because both will have the same wealth outcome anyway.
But in some cases, tax brackets do move to an extreme in one direction or another. The otherwise higher-income household has an unusually low-income year (perhaps due to a layoff, an illness or some other event), or alternatively has an especially high-income year (due to a big bonus, liquidity event or some other moment of financial serendipity).
And those extreme years — with especially high or low tax brackets — are the ones that actually create the most wealth from a Roth optimization strategy, which means in the end, the years that are obviously high- or low-income years are the only ones that matter anyway (for which the decision to contribute to a traditional retirement account or convert/contribute to a Roth account will likely be readily apparent).
Finding the tax equilibrium point for current versus future tax brackets
While tax brackets are graduated based on income, what constitutes a high-income year for some households may actually be a low-income year for another. For instance, a household that typically earns $100,000 per year would find a $300,000 income year to be huge, but a household that earns $1 million every year would treat it as a very low-income year. Consequently, it’s important to recognize that high-income years (for traditional IRA contributions) and low-income years (for Roth contributions or conversions) must be evaluated relative to the household itself.
Fortunately, though, the progression of tax brackets lends itself to natural transition points around which Roth decisions can be optimized. In particular, with the seven income tax brackets – 10%, 12%, 22%, 24%, 32%, 35%, and 37% – progressing from one tax bracket to the next is “only” a 2% or 3% increase, with two exceptions: from the 12% to the 22% bracket (a 10% increase), and from the 24% to 32% bracket (an 8% increase). Accordingly, Roth optimizations will largely focus on keeping households that can stay within those 12% and 24% thresholds, to try as best they can to stay within those thresholds. And, of course, for anyone whose income is significantly higher, at some point, any tax bracket that is not the 37% tax bracket will be a good deal.
Accordingly, the middle-income households who are able to remain under $81,050 of taxable income as a married couple in 2021 (eligible for the 12% income tax bracket and 0% long-term capital gains and qualified dividends) will generally want to contribute to Roth accounts as long as they remain under 12% but use traditional retirement accounts when their income exceeds these levels (to get the deduction at higher rates, in the hopes of withdrawing or converting in the future back at 12% or lower rates).
More affluent households (e.g., those with one or several hundred thousand dollars of income and/or up to a few million dollars in wealth) who can stay under $329,850 in income as a married couple in 2021 (and thus remain in the 24% tax bracket) may want to more aggressively Roth convert if they are able to leverage the 12% or lower brackets, and will want to focus on traditional (deductible) contributions at higher (32%-plus) brackets.
And ultra high net worth households, for whom any tax bracket that is not the top 37% bracket (at $628,301 in income or higher for a married couple in 2021) would be a good deal, will likely want to Roth-convert right up to the threshold of crossing from the 35% back into the 37% bracket (and continue to use pre-tax traditional accounts to reduce their income in years when they are in the top tax brackets).
Tax diversification versus Roth optimization to navigate future changes in tax law
While many households can maximize Roth optimization strategies by simply focusing on the select number of years where their tax brackets are clearly higher or lower than usual (which, by definition, are the years that matter the most because they are associated with the biggest difference between current and future tax rates that create Roth value), in some cases the driving concern is not that an individual’s tax rates will be higher in the future (such that a Roth contribution or conversion would be appealing now), but that tax rates in the aggregate (i.e., as set by Congress) may be higher in the future. After all, if Congress enacts broad changes to the tax law that increases future tax brackets across the board, then tax rates may be higher for everyone down the road. That would make Roth accounts the preferred approach for everyone.
Yet, in the end, while marginal tax rates have changed significantly over the years as tax policy has changed, the actual average (i.e., effective) tax rate that households pay has been relatively stable for decades. In fact, while the top marginal tax bracket has varied as high as 90% to a low of 28% since World War II, the average tax rate of the top 1% has remained in a far tighter range from 30% to 45% over that time period. And the average tax rate of households overall has hovered even more narrowly between 23% and 33% (with much of that increase the result of expanding payroll taxes, not changes in income taxes).
In other words, because Congress tends to change deductions and other rules at the same time it changes the tax brackets (adding deductions that mitigate the impact of increased tax rates and curtailing deductions alongside decreases in tax rates), in practice, the tax system is more stable than most realize, and the variability of a household’s individual tax circumstances is much wider — and therefore presents a greater planning opportunity — than trying to figure out the net effect of future tax law changes. Especially when recognizing that even if overall tax burdens go up in the future, it may not be in the form of an income tax bracket increase (e.g., Congress might implement a wealth tax or a consumption tax or some other approach that would not benefit the decision to use a Roth account).
Whereas a household that typically is in the 22% tax bracket is experiencing an off year in either the 12% or 32% tax bracket has a known 10%-plus swing that can be capitalized upon immediately (or alternatively, the household that plans to retire in a different state, which could entail a 10%-plus change in marginal tax rates simply by moving).
Ultimately, while the uncertainty tied to the tax system — both with respect to a household’s own tax rates as income rises and falls over time, and the potential for Congress to change the laws themselves — introduces a non-trivial amount of tax uncertainty, engaging in tax diversification by splitting dollars between Roth and traditional retirement accounts doesn’t necessarily improve the situation. Instead, choosing to pursue Roth accounts simply narrows the range of future outcomes, eliminating the downside risk of tax brackets moving the wrong way and also eliminating all of the upside potential of making good tax-planning decisions. Which means in practice, tax diversification doesn’t diversify the opportunity; it takes the opportunity off the table altogether.
The alternative instead is to focus on opportunistically utilizing Roth accounts — whether in the form of a contribution or a conversion — specifically to leverage the Roth benefits in low-income years while capitalizing on the good old-fashioned benefits of traditional retirement accounts to defer taxes in high-income years (when, by definition, tax deferral is most valuable because the tax rate is higher). As while in most years, households may not have a clear view on which direction their tax rates are going to go, but if their tax rates don’t change much, it doesn’t actually matter which account is chosen anyway. Instead, the Roth-versus-traditional decision matters the most when there is a significant difference between current and future tax brackets, which means that most of the tax-planning opportunity really can be captured by just focusing on the few years when income has clearly moved to an extreme for that household (to the upside or the downside).
Fortunately, though, significant changes in income often are clear at the time, whether due to imminent plans for a change (e.g., retiring to a state with a materially different tax rate), a major challenge that reduces income for the year (e.g., laid off, an illness or a business loss), or an upside surprise that makes it an especially good year to capitalize on traditional deductions (e.g., a big bonus or a business liquidity event). Which provides the opening to consciously contribute fully to a traditional retirement account (in high-income years) or to a Roth account (via contribution or conversion) in low-income years. Because splitting dollars between Roth and traditional accounts may be fine in years where income is in the middle and there is no clear direction, but a broad policy of tax diversification will, on average, lag a more proactive approach of Roth optimization, even if it only gives taxpayers something to do once every few years.
