How can I tell if Roth retirement assets are more valuable than traditional retirement assets?
The answer depends on your financial circumstances, and it changes over time. This case study article focuses on the beliefs of some investors that Roth retirement assets are inherently more valuable to own than traditional retirement assets. This belief centers on the fact that once initial Roth contribution or Roth conversion taxes are paid, then Roth assets would not be subject to further income taxation whereas traditional retirement assets would be subject to required minimum distributions (RMDs) and their associated income taxation in retirement. Are Roth assets really worth more, because of this “unpaid tax debt?” It depends.
It is recommended that you read this article on a laptop or desktop computer with a sizeable screen, because of its detailed case study comparison tables, regarding traditional versus Roth retirement contribution and Roth conversion taxes.
The importance of tracking lifetime after-tax effects associated with traditional versus Roth retirement assets
To avoid a false apples-to-oranges comparison, a proper and rational analysis must also take into account the lifetime tax effects associated with traditional retirement assets versus Roth retirement assets. Such an analysis requires the construction of “side accounts” that capture the effects of lifetime taxes related to either traditional or Roth retirement assets. This article demonstrates, in detail, how this should be done.
Traditional retirement assets are usually obtained through tax deductible contributions into either IRA accounts and into employer sponsored defined contribution plan accounts, such as 401(k), 403(b), 457, various employer IRAs, or Federal Thrift Savings Plan accounts. Traditional retirement contributions reduce taxable income and lower taxes while working. This is commonly known as a “tax shield.” These tax shield investment savings must be tracked over a lifetime and should include associated compound asset value appreciation, as well as, taxes on capital asset appreciation.
The tax effects of RMDs in retirement must also be accounted for. The tax effects side account must track the incremental annual income taxes caused by RMDs in retirement. RMDs simply force traditional account withdrawals, which create an income taxation event. After associated RMD income taxes are paid, the net RMD asset proceeds do not disappear. They would be deposited into taxable investment accounts and should be tracked over the years including their potential compounded asset appreciation.
Note: It is irrelevant whether net after-tax RMD assets are used to pay living expenses. If they are, then these incremental assets would just show up somewhere else in the family investment portfolio and appreciate over time. RMD assets remaining after taxes do not provide “free” money and a license to splurge. Financially rational people live their lives on budgets. In particular, those with the discipline to save for retirement understand this.
On the other side of the analysis are Roth retirement assets. Roth assets can be obtained either through non tax-deductible contributions while working or through subsequent conversions of traditional retirement assets into Roth assets. Roth conversion taxes are paid at the then-effective marginal federal, state, and local income tax rates, net of any tax basis, which is usually zero in traditional retirement accounts.
The Roth “side account” to track these tax effects will differ for that of traditional retirement assets. If one choses to make non tax-deductible Roth contributions, when one also has the alternative to make tax-deductible traditional contributions, then a potentially valuable tax shield is lost. These lost tax shield investment savings must be tracked over time, including the compounded lost asset appreciation.
Since there are no RMDs for Roth account assets in retirement, Roth assets can continue to compound and appreciate within the Roth account. There is no need to track post-taxation RMD assets in taxable accounts, like there is with traditional retirement accounts subject to RMDs.
Finally, since there are no Roth RMDs, there are no RMD income taxes related to Roth retirement assets. Therefore, once a person reaches the age when traditional asset RMDs would have begun and for each year thereafter, the Roth accounting side account must credit these reduced income tax savings back to the Roth side of the comparative after-tax ledger.
Simple, eh?
This complexity is all the result of conflict and compromise in Congress over decades. So much for the concept of easily understood retirement savings tax incentives. Subsequently, the financial services industry has promoted numerous analytical simplifications concerning traditional versus Roth retirement assets. However, whenever a DIY investor seriously examines the problem, they will find that these simplifications may be erroneous or deceptive. There is no magic wand to wave and transform complexity into simplicity. By understanding rationally, the difference between “realized” and “unrealized” asset taxation, investors can better manage emotional concerns about “unpaid tax debt” on traditional versus Roth retirement assets.
Note: There are some circumstances wherein a highly compensated retirement saver cannot make more tax-deductible traditional retirement contributions into an employer-sponsored plan account. Yet, he or she still might have a legal right to make additional contributions either as A) direct Roth contributions or as B) traditional, non-deductible retirement contributions that could be converted into Roth account assets without taxation. In such circumstances, Roth assets are obviously preferred. because it makes no difference regarding current taxation in these circumstances.
These situations are not the subject of this article. While that individual would pay initial income taxes for these potential Roth assets, there would be no investment tax recovery model to consider. Since a tax-deductible traditional retirement contribution alternative is not available, there would be no forgone tax shield savings. Take advantage of these Roth opportunities, if your high income and frugality would enable these additional retirement savings.
So that you know what to expect, these are the sections of this article:
- A) Investor concerns about future taxation of traditional retirement assets compared to tax-free Roth assets
- B) Case study: modeling the relative value of tax-deductible traditional assets versus Roth assets over a lifetime
- C) Decisions about traditional retirement contributions versus Roth retirement contributions or conversions
- D) DIY financial decision software to model the lifetime tradeoffs between traditional and Roth retirement assets
- E) Financial break even ages: When would after-tax savings on Roth conversion taxes paid in retirement exceed the after-tax value of the lost traditional contributions tax shield?
- F) The economics of 100% tax-deductible traditional contributions over a working lifetime with Required Minimum Distributions (RMDs) in retirement
- G) The economics of 100% Roth contributions over a working lifetime with no RMDs in retirement
- H) The economics of 100% traditional contributions over a working lifetime with Roth conversion taxes in early retirement paid below the 10% federal income tax bracket ceiling
- I) The economics of 100% traditional contributions over a working lifetime with Roth conversion taxes in early retirement paid below the 12% federal income tax bracket ceiling
- J) Are traditional or Roth retirement assets better for a large financial emergency during retirement?
This article is paired with another article on more cost-effective Roth conversion strategies that are more likely to pay off in the long run. You can find that other article here:
https://www.theskilledinvestor.com/VeriPlan/5657/roth-conversion-ladder-strategies/
These articles are based on two primary sources of research and experience. The first is a detailed analysis by Edward F. McQuarrie, Professor Emeritus in the Leavey School of Business at Santa Clara University. Professor McQuarrie’s analysis was published in 2021 and titled; “When and for Whom Are Roth Conversions Most Beneficial? A New Set of Guidelines, Cautions and Caveats.” You can download this research paper from the Social Science Research Network with this link:
https://ssrn.com/abstract=3860359The second primary source is this article’s author, Larry Russell. For 20+ years, I have published personal financial planning articles and have been the architect and chief developer of VeriPlan, a Microsoft Excel-based, DIY lifetime personal financial planning software application. Since 2006, VeriPlan has supported Roth retirement contributions analysis. Subsequently, the DIY ability to plan for tax-optimal, year-by-year conversions of traditional retirement assets into Roth retirement assets was added to VeriPlan.
A) Investor concerns about future taxation of traditional retirement assets compared to tax-free Roth assets
Some retirement investors have a strong preference for owning subsequently untaxable Roth retirement assets. Professor McQuarrie stated that “the analyses in this paper shed cold light on the idea that owners of traditional 401(k)s somehow suffer under a burden of “tax debt,” which it is imperative to address via Roth conversions, lest the government continue to own a major share of these savings. … the government does not own any piece of a traditional retirement savings account, rather, the government has a claim on those funds, a claim that will not be exercised against the whole as long as annual RMDs are taken as agreed beginning at some future date, a date which can be pushed out at the governments option and already has been pushed out once.” (McQuarrie, Ibid, pages 17-18)
Note: During the decade leading up to 2024, the starting age for RMDs has been sequentially pushed out from age 70 & 1/2 to 72 to 73 and now to 75 (for those will turn 75 on or after January 1, 2033).
If Roth retirement assets could be obtained without any initial taxation, then obviously Roth retirement assets would be preferred over traditional retirement assets. However, totally tax free Roth assets can only be obtained in a few very narrow ways. First, due to the standard income tax deduction, a very low wage earner (usually quite young) could make tax-free Roth IRA contributions up to the annual IRA contribution limit. However, this would only work, if their living expenses, rent, etc. were paid from another source, such as parents. A second, limited situation is when Roth conversion taxes have a zero percent tax rate up to the standard deduction ceiling in early retirement, when one has little or no other taxable income. In that situation, other assets in non-retirement accounts would be needed to fund living expenses, because parental funding is unlikely to be available.
To address the belief that “no tax debt” Roth assets are strongly preferred despite the loss of initial cash tax savings with the traditional asset alternative, consider the following. My other article, referenced above, demonstrated that the most financially optimal method of securing greater Roth assets is to do a series of lower tax rate conversions in the earlier part of retirement. Even when such an optimal strategy is followed, the breakeven age on the conversion taxes paid at the outset might be beyond normal life expectancy — depending upon your financial circumstances..
If you are married, you have no heirs, and you both die at average ages of mortality in your mid-80s, then the “unpaid tax debt” of traditional retirement assets would be irrelevant. You would not have lived long enough to break even on the extra taxes paid up front to obtain Roth assets instead. You would also have no heirs to pay taxes for up to ten years on inherited traditional retirement account assets. You would not be around to care about traditional versus Roth asset tradeoffs anyway.
However, if either of you were so lucky as to live into your mid-90s, then, before your demise, you might take pride in having done some Roth conversion tax optimizations thirty years prior. Nevertheless, Professor McQuarrie’s paper demonstrates that even in this situation the total return on investment for your “intertemporal tax arbitrage” strategy could still be modest.
Alternatively, if you had children and you both lived to 95, then the overall extended family return on investment could increase substantially. Under current law your children could keep inherited accounts for an additional ten years, before all assets must be withdrawn. If you children were then in their peak earning years, there would be a strong preference for them to inherit non-taxable Roth assets versus traditional retirement assets that would add to their income taxes.
B) Case study: modeling the relative value of tax-deductible traditional assets versus Roth assets over a lifetime
These projection assumptions were used for this article’s comparative case study models:
- A frugal 30 year-old married couple plans to retire at age 67. Both members of this couple were born on January 1, so that their ages align with the calendar year.
- They will have a $150,000 gross annual wage and salary family income until retirement. Their family living expenses will be $100,000 annually through age 100.
- Each year, while working, the $50,000 difference between gross income and living expenses will be used to pay federal and state income taxes, and the remainder will be saved for retirement. At age 30 they have saved $100,000 in cash, but they have not yet made any retirement saving contributions.
- This couple will be subject to US income taxation plus state income taxation. California was the state chosen for this modeling exercise, because it has a progressive income tax system where rates increase with income in a manner similar to the federal income tax system. In addition, California taxes Social Security benefits in retirement, and California also taxes RMDs and other traditional asset withdrawals in retirement, in line with the federal income taxation model.
- 2024 “Married Filing Jointly” tax rate schedules for US federal income taxes and California state income taxes were used. The $29,200 standard deduction for a married couple filing jointly was incorporated in the calculations.
Lifetime financial modeling requires that “real” constant purchasing power dollars be used over time so that a dollar at one age is equivalent in the spending power of a dollar at any another age. This is achieved by removing the compounded consumer price index (CPI) from all parameters that are affected by general inflation.
These projection modeling parameters are based upon the 95 year US financial history from 1928 through 2023. All factors listed are geometrically compounded annual averages:
- 3.045% compounded annual inflation rate (Consumer Price Index)
- 1.522% US compounded annual real dollar appreciation rate for US treasury bond assets (would be 4.567% with inflation)
- 6.750% US compounded annual appreciation rate for stock assets (would be 9.795% with inflation)
This couple plans to invest their savings in fully diversified and very low cost index investment funds to maintain a 40% treasury bonds and 60% stocks strategic asset allocation rebalanced annually. Therefore, their weighted average expected annual real dollar portfolio appreciation rate is 4.659% without inflation.
Neither investment management costs nor annual taxes on asset appreciation within taxable side accounts are taken into consideration in these modeling exercises. To the degree that these investors implement a fully diversified, passive, and very low cost index fund investment strategy, these factors would have relatively minor effects on these projections.
Computing after-tax values for traditional and Roth retirement assets and their side accounts
The asset value totals for all models below in this article are “after-tax.” Therefore, direct comparisons across time are proper, because taxes have been fully assessed for all models. This means that when you add the value of the assets within either a traditional or a Roth retirement account to their respective after-tax side account assets, you have the total projected after-tax asset value at any particular projection age. Therefore, it is also proper to divide the total after-tax assets of one model by those of another model to determine the age that valuations break even and relative values cross over.
Because of the lost tax shield, Roth assets are always worth less “after-tax” than traditional retirements assets at age 75 for this couple. Reduced income tax payments due to reduced RMDs after age 75 are the only way that Roth assets eventually can breakeven and subsequently become more valuable after taxes than traditional retirement assets.
The age 75 to 100 projection models below are explicit about most tax calculations. The reader can read the text that accompanies the various tables to understand how taxes are calculated.
There is one type of asset taxation that is not explicitly addressed in the case study sections and the tables below. Therefore, it will be summarized here. To derive after-tax values for the taxable side accounts associated with traditional and Roth assets, it is necessary to calculate taxes on asset appreciation within these taxable side accounts. For the case study tables below, asset appreciation taxes have been assessed already, so that all of the side account values in the tables below are after-tax.
Taxes on asset appreciation involve both the US federal and state income tax systems and the generally lower tax rate long-term capital gains federal tax system, which can affect capital assets held for at least one year. Bond returns are generally taxed at federal and state ordinary income tax rates, but stock returns may be taxed at long-term capital gains tax rates, if there is a tax realization event, such as a qualified distribution or a sale of appreciated capital assets held long-term.
Between ages 30 through 74, only traditional retirement account must incorporate taxes on appreciation, because traditional retirement assets benefit from the buildup of side account assets due to the tax shield. Roth assets have no such tax shield side account. VeriPlan automatically projects federal and state income taxes, as well as federal long-term capital gains taxes, while it also takes into account any asset tax basis. Therefore, the age 75 starting values imported from VeriPlan are all after-tax asset values.
For perspective, the compounded effect of these asset taxes from ages 30 through 74 is to reduce the gross pretax asset value of the traditional retirement asset tax shield by 21% by the beginning of age 75. In effect, recurring asset taxes moderately reduce the initial value advantage of traditional retirement assets. Nevertheless at age 75, Roth assets must still be behind in comparative after-tax valuation.
From ages 75 to 100, asset taxation on traditional versus Roth side accounts diverges, as well. Because the age 75 to 100 models below are separated from VeriPlan, side account taxation instead must be calculated based upon marginal federal and state income tax rates. In addition, federal long-term capital gains tax rates must be assessed on qualified long-term distributions, when applicable. The tax calculation details will be avoided here, so as not to stress the reader further.
For the traditional retirement assets side account in this case study, RMDs from ages 75 to 100 consistently provide enough additional taxable income to increase this couple’s marginal income tax rates. Furthermore, these increased income levels also have the effect of subjecting them to a 15% federal capital gains tax rate on realized long-term stock asset capital gains. The compounded effect of these traditional side account asset taxes from ages 75 to 100 is to reduce the gross pretax asset value of the traditional after-tax side account by 14.6% through age 100.
In contrast, for Roth assets there are no RMDs. Therefore, this couple’s taxable ordinary income is lower from ages 75 to 100. In this case study the effect on asset appreciation taxation in the Roth side account is quite different. Because their taxable income is lower, their ordinary marginal income tax rates are lower. Lower taxable income also reduces their long-term capital gains tax rate from 15% to 0%. The compounded effect of asset taxes on Roth side account asset taxes from ages 75 to 100 is trivial. Asset taxes only reduce the gross pretax asset value of the Roth side account by 2.9% by age 100.
The federal ordinary income tax system and the federal long-term capital gains tax systems are connected. The amount of taxable annual ordinary income can affect the long-term capital gains tax rate that would apply to any taxable long-term capital gain. While federal long-term capital gains tax rates are generally much lower than marginal ordinary income tax rates, taxpayers’ ordinary taxable income is considered first and can push up the federal long-term capital gains tax rate. For example in this case study, if this couple had a substantial private retirement pension, that private pension in addition to their Social Security retirement benefits could have pushed their federal long-term capital gains rate from 0% to to 15%.
For more information see:
How Long-term Capital Gains Taxes are Calculated
https://www.theskilledinvestor.com/VeriPlan/3593/how-long-term-capital-gains-taxes-are-calculated/Note also that investment management costs are not taken into consideration in these modeling exercises. To the degree that this DIY investor couple would implement a fully diversified, passive, and very low cost index fund investment strategy, their investment costs would have relatively minor effects on these case study projections. Investment costs would not change any of the relative comparisons or conclusions made in this article. However, the higher the investment costs paid out of one’s portfolio, the more that one’s personal investment portfolio will be “shared” with the financial industry. The degree of that sharing increases through compounding with the passage of time.
VeriPlan allows users to project investment costs associated with their current portfolio. VeriPlan automatically projects and compounds the effects of particular and total investment costs across a lifetime. VeriPlan also easily allows users to compare their current investments costs with that of a very low cost lifetime investment model.
Year after year, the average investor unnecessarily pays grossly excessive investment costs to the financial industry. These excessive costs reduce rather than increase the returns of the average investor. A passive, very low cost index investment strategy is the only practical way to avoid unnecessary sharing of your portfolio’s returns with the financial industry.
C) Decisions about traditional retirement contributions versus Roth retirement contributions or conversions
This couple wants to understand rationally whether, throughout their working careers, they should either:
A) make 100% tax-deductible traditional retirement contributions and pay taxes on RMDs in retirement, or
B) make 100% non-deductible Roth retirement contributions and pay no taxes in retirement.
In addition, they want to understand rationally how to think about the alternative of making only 100% tax-deductible traditional retirement contributions while working and then planning Roth conversions in early retirement to reduce their future income taxes on RMDs. Under current law, if this couple would own any traditional retirement assets, then they would first be subject to RMDs at age 75.
Given that this couple intends to work until age 67, they expect that their Social Security benefits will cover more than half of their annual expenses in retirement. To maximize both of their Social Security checks, they also intend to delay the first receipt of those checks until age 70. They also understand the oddities of federal Social Security benefit income taxation and expect that 85% of their Social Security retirement benefits will be subject to federal and state income taxation from ages 70 to 100.
In all of this couple’s model comparisons, their Social Security retirement benefits and other income are sufficiently high, such that 85% of their Social Security benefits would be taxed federally from age 70 onward. As a result, the various projection models isolate and compare the long-term impacts of federal and state income taxation related to traditional retirement contributions versus Roth retirement contributions and conversions. Taxing 85% of Social Security benefits was chosen, because most people who accumulate substantial retirement account assets are higher earners are much more likely to be subject to taxation of 85% of their Social Security retirement benefits.
If this couple had lower Social Security benefits, income taxation of their Social Security benefits could have been lower. In such situations, if Roth conversions were done, the breakeven age on Roth conversions could increase! Not only would federal and state income taxes on any Roth conversion amounts have to be paid, but doing those Roth conversions would cause more of their Social Security benefits to be subject to income taxation, as well. Roth conversions add to taxable income and can easily cause 85% of Social Security benefits to become taxable, when otherwise, those benefits might not have been taxed or might have been taxed at a lower rate.
Prior to 1983, Social Security retirement benefits were not subject to federal or state income taxation. Starting in 1983, up to 50% of Social Security benefits would be taxed federally, if overall taxable income exceeded $32,000 for married couples, filing jointly. In 1993, a federal law was added to tax up to 85% of Social Security benefits, if taxable income exceeded $44,000 for married couples, filing jointly. Tax revenue for both laws is credited to the Social Security trust fund. These income limits were not indexed for inflation, and therefore, more and more people have had to pay tax on Social Security benefits with the passage of time.
Some US states incorporated these federal Social Security tax provisions by passing state level tax legislation, but many US states did not. All VeriPlan projections automatically take into account these variation in state income tax laws with respect to Social Security retirement benefits. Furthermore, VeriPlan will automatically analyze differences between state income taxation of Social Security retirement benefits, if you use VeriPlan’s features that evaluate a planned future move from your current state of residence to a different state.
Since this couple expects Social Security retirement benefits to cover at least half of their retirement expenses, they also understand that they will also need additional financial assets to cover about half or up to $50,000 of ordinary expenses during retirement. Therefore, they have set a goal of saving $1,000,000 within either a traditional retirement account or a Roth retirement account by age 75. Any additional savings will be held in taxable investment accounts. Because this couple had the benefit of understanding this article and its various lifetime projections, this couple expects that they will be able to save $1,000,000 in retirement assets and will also be able to save at least $1,000,000 in additional investment assets held in taxable accounts.
To achieve their target of $1,000,000 in retirement assets by age 75, this couple has decided that they will contribute a constant annual dollar amount from age 31 to 67, to an employer-sponsored contributory retirement plan — such as a 401(k), 403(b), 457, or Federal Thrift Savings Plan that would allow either tax-deductible traditional contributions or non-deductible Roth contributions. With the other financial parameters described above they expect that an annual contribution of $8,535 to this retirement plan from ages 31 to 67 would, with the miracle of financial compounding, result in a $1,000,000 retirement account asset balance at age 75. The rest of their savings over the years would compound in their taxable accounts and would be expected to exceed $1,000,000 by age 75 in all the scenarios considered in this article.
D) DIY financial decision software to model the lifetime tradeoffs between traditional and Roth retirement assets
How can we know the accumulated value up until age 75 of the tax savings shield associated with 100% traditional retirement contributions while working? That is where the VeriPlan DIY lifetime financial planning software comes in. If you input into VeriPlan the various parameters described in this article, VeriPlan will automatically develop a chained series of annual projections through age 100. VeriPlan does all of this analysis automatically. Then, to project the lifetime differences between the effects of making either 100% traditional contributions versus 100% Roth contributions, all you have to do is change 100% to 0% in one place within VeriPlan.
While VeriPlan can develop much more sophisticated lifetime projection models customized any family’s unique financial situations and plans, for this article VeriPlan is just being used to project asset values to the beginning of age 75. VeriPlan accumulates and compounds annual real dollar investment asset values, while automatically taking into account income, expenses, various taxes, debts, investment appreciation, strategic assets allocation and rebalancing, etc. Therefore, it can easily project asset accumulation differences between traditional and Roth contributions or Roth conversions at any age up to 100.
The remainder of this article provides detailed projection case study tables for various traditional versus Roth retirement account decisions for age 75 to 100. These tables demonstrate the required analysis in detail. While VeriPlan would automatically perform this analysis through age 100, for this article VeriPlan’s age 75 projection values are transferred into these external comparative models, so that you can fully understand how a complete and proper analytic comparison works with appropriate side accounts.
In the sections that follow, you will find detailed projection tables for ages 75 to 100, which are designed to provide a detailed understanding of the economics of the various trade-offs between traditional and Roth contributions and traditional contributions with Roth conversion taxes paid up to the 10% or 12% federal income tax breakpoints. Age 75 was chosen as the starting point, because age 75 is the first year of this couple’s RMD. Age 75 is the earliest year when the financial payback can begin to recover income taxes related to either Roth contributions or Roth conversion taxes paid earlier in life.
E) Breakeven age: When would after-tax savings on Roth conversion taxes paid in retirement exceed the after-tax value of the lost traditional contributions tax shield?
The remainder of this article compares these three strategies for this couple
1) 100% tax-deductible traditional contributions (Section F) versus 100% Roth contributions over a working lifetime and throughout retirement (Section G);
2) 100% traditional contributions over a working lifetime with Roth conversion taxes in early retirement paid below the 10% federal income tax bracket ceiling (Section H); and
3) 100% traditional contributions over a working lifetime with Roth conversion taxes in early retirement paid below the 12% federal income tax bracket ceiling (Section I).
In the horse race up to age 75, traditional assets are always “worth more” after-taxes than Roth assets, because of the accumulated value of the tax shield savings on tax-deductible contributions. These tax shield savings accumulate and compound in a taxable side account, and Roth contributions have no such side account until age 75. Whether the $8,535 annual contribution made by this couple from ages 31 to 67 is made into a traditional retirement account or a Roth retirement account makes no difference. The asset dollars in either type of retirement account would be the same, since there is no taxation on appreciation within either type of retirement account. The only way that Roth assets can outweigh the value of traditional retirement accounts plus their tax shield savings side account is for Roth assets to accumulate their own RMDs income tax reduction side account from age 75 onward.
To cut to the chase, here are the results of the three strategies:
E-1) 100% traditional retirement contributions after taxes versus 100% Roth contributions after taxes
Column B above divides the 100% Roth valuation model including the after-tax side accounting by the 100% traditional model with its after-tax side accounting for each age from 75 to 100.
The shaded cells at age 90 indicate the point at which overall Roth retirement assets after taxes become “more valuable” than traditional retirement assets after taxes. In effect, it takes fifteen years from ages 75 to 90 for a 100% Roth contributions strategy to overcome the loss of the valuable tax shield provided during this couple’s working years with 100% traditional tax-deductible contributions.
Age 49 was the midpoint of this 36 year series of either traditional retirement contributions or Roth retirement contributions between ages 31 and 67. Therefore, age 49 will serve as the average initial age for determining how many years it would take to reach the financial breakeven point collectively for the Roth contributions strategy alternative. These 100% traditional contributions versus 100% Roth contributions models had an average exposure window of 41 years. (Age 90 minus age 49 — the average of 31 and 67 equals 49). This is a very long time to reach breakeven. They might not live long enough to break even.
Sections F and G below provide the details on comparative values from ages 75 through 100. These are the asset values projected by VeriPlan up until age 75. If traditional tax-deductible contributions were made, then annual federal and state income taxes would be lower. Therefore, annual cash flow would be higher and investment balances in taxable accounts would increase and compound. Each year from age 31 to 67 additional tax savings would be added to taxable accounts. The result would be a certain total value of financial assets.
With these modeling parameters and 100% traditional contributions, the total financial asset balance at the beginning of age 75 was $221,747 higher than the model with 100% Roth retirement assets. Thus, the 100% Roth contributions strategy by age 75 would put this couple into a $221,747 financial hole at age 75 that can only be overcome through Roth tax savings after age 75. The projections indicated that it would take 15 years beyond age 75 to breakeven, before Roth assets would be “worth more” after taxes at age 90.
Note that this is a “relative” financial hole. In either circumstance, at age 75 this couple would have $1,000,000 in either traditional or Roth retirement assets. In addition and in either case, they would have at least $1,000,000 in taxable assets. However, the traditional retirement account contribution tax shield would increase their total projected taxable account assets by $221,747.
E-2) 100% traditional retirement contributions and Roth conversion taxes in early retirement paid below the 10% federal income tax bracket ceiling
Column C in the graphic above divides:
A) the after-tax projection model for 100% traditional contributions over a working lifetime with Roth conversion taxes in early retirement paid below the 10% federal income tax bracket ceiling
by
B) the 100% traditional model including its side account.
Column D is associated with this comparison and shows the Roth asset percentage of overall retirement assets from ages 75 to 100.
By constraining Roth conversions to stay below the 10% federal income tax bracket, this couple would convert $396,000 into Roth assets. However, taxes on these conversions would be quite modest. At age 75 total financial assets would be projected at only $16,106 lower than the 100% traditional contributions with no conversions model.
Since this couple planned to defer Social Security benefits to age 70 and expected to have other assets to pay living expenses, they would enable some of their Roth conversions to be taxed at 0% federal and 0% state income tax rates due to the $29,200 annual ‘married filing jointly’ standard tax deduction.
For perspective, these are this couple’s annual Roth conversion amounts made to the nearest thousand dollars that stayed within the 10% federal income tax bracket: $48,000 (age 67), $48,000 (age 68), $46,000 (age 69), $46,000 (age 70), $51,000 (age 71), $52,000 (age 72), $52,000 (age 73), and $53,000 (age 74), which total $396,000 in Roth conversions.
Age 70 was the midpoint of this seven year series of Roth conversions between ages 67 and 74. Therefore, age 70 will serve as the average initial age for determining how many years it would take to reach the financial breakeven point collectively for these Roth conversions. Roth retirement tax savings on RMDs would require about seven years to reach the payback breakeven point and be “worth more.” Note the shaded cells at age 77 in Columns A, C, and D.
E-3) 100% traditional retirement contributions and Roth conversion taxes in early retirement paid below the 12% federal income tax bracket ceiling
Column E in the table above divides:
A) the after-tax model for 100% traditional contributions over a working lifetime with Roth conversion taxes in early retirement paid the 12% federal income tax bracket ceiling
by
B) the 100% traditional model including its after-tax side accounting.
Column F is associated with this comparison and shows the Roth asset percentage of overall retirement assets from ages 75 to 100.
For 100% traditional contributions with early retirement Roth conversions done below the 12% federal income tax bracket ceiling, this couple could convert $859,000 into Roth assets. Their total projected financial assets would be $89,389 lower than the 100% traditional contributions with no conversions model. In that case, over 98% of the retirement assets were converted into Roth assets by age 75. Compared to the 10% federal bracket model, the larger amount of taxes to pay back is due to converting over twice the amount of traditional retirement assets into Roth assets and paying a weighted average rate of 13% in combined federal and state income taxes.
For perspective, these are this couple’s annual Roth conversion amounts made to the nearest thousand dollars that stayed within the 12% federal income tax bracket: $119,000 (age 67), $120,000 (age 68), $118,000 (age 69), $118,000 (age 70), $123,000 (age 71), $123,000 (age 72), $123,000 (age 73), and $15,000 (age 74), which total $859,000 in Roth conversions.
Age 70 was the midpoint of this seven year series of Roth conversions between ages 67 and 74. Therefore, age 70 will serve as the average initial age for determining how many years it would take to reach the financial breakeven point collectively for these Roth conversions.
Despite the $89,389 taxation deficit being over 5 times the 10% federal bracket projection, Roth retirement tax savings on RMDs would require about eleven years to reach the payback breakeven point and be “worth more” after taxes. Note the shaded cells at age 81 in Columns A, E, and F.
F) The economics of 100% tax-deductible traditional contributions over a working lifetime with Required Minimum Distributions (RMDs) in retirement and no Roth contributions or Roth conversion taxes
This section details the analytical projection model for the 100% traditional retirement contributions alternative for ages 75 to 100. We focus on valuations beginning at age 75, because this couple’s RMDs would begin at age 75. The only way that any Roth asset alternative can make up for the loss of the initial tax shield provided by traditional contributions is to reduce RMD taxation from age 75 onward. This projection model assumes that this couple exactly achieved its retirement savings objective, which is represented by the $1,000,000 value in Column C at age 75 below.
Note the importance of this 100% traditional retirement contributions model. This 100% traditional contributions model with no Roth retirement contributions or conversions assets is the baseline model for comparison with any of the other models that involve Roth contributions and/or conversions. By dividing the age 75 to 100 values of any model involving Roth assets in the numerator by this 100% traditional assets only model in the denominator, we can calculate the breakeven age when the real, constant purchasing power value of one strategy exceeds the other.
Columns C, D, E, and F in the table below project the value of financial assets within the traditional retirement account. Column C is the yearly beginning value and Column F is the yearly ending value. Column D adds annual asset appreciation based upon the 95 year compounded real dollar portfolio appreciation rate of 4.659% for a 40% treasury bonds and 60% stocks strategic asset allocation rebalanced annually.
Column E subtracts the gross annual RMDs that must be taken from the account for taxation. The amount of the RMD is calculated by dividing Column C by Column B. Column C is the account value at the end of December for the prior year. Column B is the RMD divisor from the IRS Uniform Lifetime Table III. This is how age-related RMDs are calculated for annual income tax purposes.
Age 75 to 100 economics of 100% tax-deductible traditional contributions over a working lifetime and RMDs in retirement
The middle group of Columns G, H, I, J, K, and L perform the tax calculations. Column G is their taxable income without any RMDs, and Column H calculates their combined federal and state income taxes for their income without RMDs. Column I adds gross pre-tax RMDs from Column E to the taxable income in Column G. Column J calculates their combined federal and state income taxes for their Column I total income including RMDs. Column K subtracts Column H from Column J to calculate the incremental federal and state income taxes that are associated with their RMDs. Finally, Column L subtracts Column K from Column E. Column L equals the net RMD assets after taxes that would be deposited into a taxable side account.
Columns M, N, and O accumulate these after-tax RMD assets in a taxable side account. Column M is the beginning value and Column O is the year ending value. Each year additional after tax RMD assets will be added to the side account from Column L. Similar to Column D, Column N adds annual asset appreciation based upon the 95 year compounded real dollar pre-tax portfolio appreciation rate of 4.659% for a 40% treasury bonds and 60% stocks strategic asset allocation rebalanced annually. Pretax asset appreciation is then reduce by taxes on asset appreciation as discussed above in Section B.
Finally, Column P totals Columns F and O. This total represents the as yet untaxed assets within the traditional retirement account plus the assets in the after-tax RMD side account. For each year from ages 75 to 100, Column P is the total real dollar value of the 100% tax-deductible traditional contributions while working strategy.
G) The economics of 100% Roth contributions while working and no income taxes in retirement
This section details the analytical projection model for the 100% Roth retirement contributions alternative for ages 75 to 100. The table begins at age 75, because this couple’s RMDs would begin at age 75. The only way that any Roth contributions alternative can make up for the loss of the initial tax shield provided by traditional contributions is to reduce RMD taxation from age 75 onward.
In this model, this couple would make 100% Roth retirement contributions while working with the objective of accumulating $1,000,000 in real constant purchasing power dollars by the beginning of age 75. This projection model assumes that this couple will achieve its retirement savings objective exactly, which is represented by the $1,000,000 value in Column B at age 75 below.
Columns B, C, and D project the real dollar value of financial assets within this Roth retirement account. Column B is the beginning asset value, and Column D is the ending value. Since there are no RMDs associated with Roth assets, the only annual adjustment to Roth values would be associated with expected compound asset growth. Column C adds expected annual asset appreciation based upon the 95 year compounded real dollar pre-tax portfolio appreciation rate of 4.659% for a 40% treasury bonds and 60% stocks strategic asset allocation rebalanced annually. Pretax asset appreciation is then reduce by taxes on asset appreciation as discussed above in Section B.
Age 75 to 100 economics of 100% non-tax-deductible Roth contributions over a working lifetime and without RMDs in retirement
Columns E, F, G, and H present the annual federal and state income tax savings associated with owning Roth assets without RMD taxation. From the 100% traditional contributions strategy model discussed above, Column E transfers the federal and state income taxes that would be due if these were tradition retirement assets subject to RMDs. Column G calculates federal and state income taxes without RMDs based upon the taxable income in Column F. Column H is the difference between Columns E and G. Column H is the annual federal and state income tax savings from no RMD taxes. These tax savings will be credited to the 100% Roth contributions strategy side account.
Columns I, J, K, and L present the values of the 100% Roth contributions side account. Unlike the 100% traditional contributions side account, which accumulates after tax RMD assets, the Roth side account begins as a deficit account. The value of the deficit is the age 75 accumulated value of the lost tax shield that could have been provided through reduced taxable income and reduced federal and state income taxes while working, if this couple had instead made 100% traditional contributions.
The tax shield deficit amounts are explained and detailed for the various models considered in this article above under the major heading; “B) Case study: modeling the relative value of tax-deductible traditional assets versus Roth assets over a lifetime.”
For the 100% Roth contributions while working model, the lost tax shield deficit is a negative $221,747 and can be found is the table below in Column I for age 75. Columns I and L are the side account’s annual beginning and ending values, respectively. Column J adds the annual Column H federal and state income tax savings from not having RMDs. This is the RMD tax saving credit that Roth assets have earned. However, the size of the initial lost tax shield deficit will determines whether this couple is likely to overcome this rather large initial tax shield deficit.
Unfortunately, Column K works against the RMD tax savings in Column J. Column K is the negative annual appreciation based on their 40% bonds and 60% stocks asset allocation, which is applied to Columns I plus J. You might ask how can a deficit side account be subject to a lost asset appreciation charge?
Remember that these analytic side accounts are the means to properly track the after-tax financial effects of various retirement contributions decisions. The choice to make Roth contributions and forgo the tax shield provided traditional contributions, affected VeriPlan’s projections of this couple’s other non-retirement taxable account assets. Choosing to make Roth contributions resulted in $221,747 less taxable account assets elsewhere in this couple’s overall portfolio. We must capture the lost value of potential appreciation. as well. The Roth contributions decision caused the $221,747 reduction in taxable account assets. If this couple still had those $221,747 in taxable assets, they also would have benefited from the potential appreciation of those assets.
Column J shows escalating RMD tax savings amounts due to the declining divisor associated with age and RMD calculations. However, the tax savings of Column J take until age 85 to overtake the lost appreciation of Column K and therefore the lost tax shield in Column L becomes increasingly negative from age 75 to 85 and then reverses that decline.
Column M totals Columns D and L and is the total real dollar after-tax value of the 100% Roth contributions while working strategy. Despite the fact that Column L is always negative from age 75 through 100, the 100% Roth contributions model can eventually overtake the 100% traditional contributions model, because Roth assets in Column D are appreciating without any RMD reductions.
Valuation summary comparing the 100% traditional contributions strategy while working with the 100% Roth contributions strategy while working
Extracted from the detailed charts above, this chart summarizes the age 75 to 100 comparative values of the 100% traditional contributions strategy while working versus the 100% Roth contributions strategy while working.
H) The economics of 100% traditional contributions over a working lifetime with Roth conversion taxes earlier in retirement paid below the 10% federal income tax bracket ceiling
In this projection scenario, this couple would make 100% traditional contributions while working with a target of accumulating $1,000,000 in their retirement account by the beginning of age 75.
Using their baseline VeriPlan projection model with 100% traditional contributions while working, they then used VeriPlan to analyze the impact of making a series of Roth asset conversions between ages 67 to 75 up to the 10% federal income tax bracket. (While the could have refined their VeriPlan conversion model down to the dollar, this couple chose to project to the nearest thousands of dollars of traditional retirement assets they could convert into Roth assets each year — while staying below the 10% federal income tax bracket ceiling.)
As a result, this couple planned to convert $396,000 into Roth assets from ages 67 to 75. With these Roth conversion taxes, their VeriPlan model projected that at age 75 their total financial assets would be only $16,106 lower than the 100% traditional contributions with no conversions model.
Even with the partial Roth conversions of about 40% of retirement assets, Roth retirement tax savings on RMDs would require only about seven years from age 70 to age 77 to reach the payback breakeven point and be “worth more” after taxes. Since they both planned to defer Social Security benefits to age 70 and expected to have other assets to pay living expenses, some of their Roth conversions would even be taxed at federal and state 0% tax rates due to the standard married filing jointly deduction.
Below you will find the two tables needed to project the values for this scenario. Each of the two tables is modeled just like the 100% traditional contributions model is Section E above and the 100% Roth contributions model in Section F above. If you need an explanation of the meaning of the various columns, please refer to the discussions in Sections E and F above. The traditional asset portion table below has all the same columns as the 100% traditional contributions while working model.
The reason why two tables are needed is that this couple would own both traditional retirement assets and Roth retirement assets following Roth conversion taxes paid within the 10% federal bracket ceiling. The first table below shows the $600,606 traditional retirement assets portion of their $1,000,000 in retirement assets at the beginning of age 75. The second table below shows the $399,395 Roth retirement assets portion of their $1,000,000 in retirement assets at the beginning of age 75.
The $600,606 traditional asset portion of the retirement portfolio after Roth conversions of $396,000 with Roth conversion taxes paid in early retirement below the 10% federal income tax bracket ceiling
For the Roth asset portion table below, the tax calculation tables differ from the 100% Roth contributions model. Column E transfers in the total potential tax saving column from the 100% Roth contributions model. Column F calculates the RMD taxes associated with the unconverted traditional retirement assets. The differences between Column E and F in Column G is the tax savings associated with the converted Roth assets.
The $399,395 Roth retirement asset portion of the retirement portfolio after $396,000 in partial Roth conversions are done in early retirement below the 10% federal income tax bracket ceiling
In the second table for the Roth asset portion above, you will also see that the accumulated Roth conversion tax cost of $16,106 is entered in Column H at age 75. The impact of this Roth conversion scenario is very different than that of the 100% Roth contributions while working model. This $16,106 financial hole is about 13.8 times smaller than the $221,747 hole created by the lost tax shield in the 100% Roth contributions model. The conversion tax savings in Column I quickly overcome the conversion tax costs plus appreciation.
This couple’s Roth conversions amounted to about 40.9% of their total retirement assets at age 75, because they restrict their Roth conversion taxes to stay within the 10% federal tax bracket ceiling. Nevertheless, over time, the Roth portion of their assets would increase to 53.3% by age 85 and 73.0% by age 95. The lesson is that a partial conversions can have a quicker payback and their Roth retirement assets can still rise with time.
The combined value of traditional and Roth retirement assets and side accounts when 10% federal income tax bracket Roth conversion taxes are paid
These are the traditional and Roth asset and side account totals when partial Roth conversions are done in early retirement below the 10% federal income tax bracket ceiling
I) The economics of 100% traditional contributions over a working lifetime with Roth conversion taxes earlier in retirement paid below the 12% federal income tax bracket ceiling
In this projection scenario, this couple would make 100% traditional contributions while working with a target of accumulating $1,000,000 in their retirement account by the beginning of age 75.
Using their baseline VeriPlan projection model with 100% traditional contributions while working, they then used VeriPlan to analyze the impact of making a series of Roth asset conversions between ages 67 to 75 up to the 12% federal income tax bracket. (While the could have refined their VeriPlan conversion model down to the dollar, this couple chose to project to the nearest thousands of dollars of traditional retirement assets they could convert into Roth assets each year — while staying below the 10% federal income tax bracket ceiling.)
For a 100% traditional contributions model with early retirement Roth conversions within the 12% federal income tax bracket ceiling, this couple could convert $859,000 into Roth assets. After conversion taxes, projected total financial assets would be $88,389 lower than the 100% traditional contributions with no conversions model.
In that case, over 98% of the retirement assets were converted into Roth assets. Despite the $88,389 tax loss deficit being over 5 times the 10% federal bracket projection in the section above, Roth retirement tax savings on RMDs would still only require about seven years to reach the payback breakeven point and be “worth more” after taxes. The larger number to payback is due to converting over twice the amount of traditional retirement assets into Roth assets, while paying a weighted average 13% combined federal and state tax rate.
Just like the section above for the 10% federal tax bracket conversion model, below you will find two tables that project the values for this 12% federal tax bracket conversion scenario. Each of the two tables is modeled just like the 100% traditional contributions model is Section E above and the 100% Roth contributions model in Section F above. If you need an explanation of the meaning of the various columns, please refer to the discussions in Sections E and F above. The traditional asset portion table below has all the same columns as the 100% traditional contributions while working model.
The $15,343 traditional asset portion of the retirement portfolio after $859,000 in assets are converted and Roth conversion taxes are paid in early retirement below the 12% federal income tax bracket ceiling
For the Roth asset portion table below, the tax calculation tables differ from the 100% Roth contributions model. Column E transfers in the total potential tax saving column from the 100% Roth contributions model. Column F calculates the RMD taxes associated with the unconverted traditional retirement assets.. The differences between Column E and F in Column G is the tax savings associated with the converted Roth assets.
The $984,658 Roth retirement asset portion of the retirement portfolio after $859,000 in assets are converted and Roth conversion taxes are paid in early retirement below the 12% federal income tax bracket ceiling
These two tables are needed because this couple has both traditional retirement assets and Roth retirement assets following Roth conversion taxes paid within the 12% federal bracket. The first table below shows the $15,343 traditional retirement assets portion of their $1,000,000 in retirement assets at the beginning of age 75. Restricting Roth conversions rounded to the nearest thousand dollars annually to stay with the federal 12% bracket tax bracket ceiling, resulted in a small, residual amount of traditional retirement assets.
The second table below shows the $984,658 Roth retirement assets portion of their $1,000,000 in retirement assets at the beginning of age 75. In the second table for the Roth portion, you will also see that the accumulated Roth conversion tax cost of negative $88,389 is entered in Column H at age 75. The financial hole is 5.5 times larger than the $16,106 financial hole created by Roth conversions below the 10% federal tax bracket ceiling. Nevertheless, compared to the $221,747 hole created by the lost tax shield in the 100% Roth contributions model, it is much easier and quicker for this couple to climb out of a much smaller financial hole.
The Roth conversion taxes savings in Column I is always greater than the absolute value of the lost annual appreciation, so it is inevitable that with time the Roth conversion taxes costs would be paid back, which occurs at about age 92. However, since 98.5% of retirement assets were Roth assets at age 75, residual taxable RMDs were nil. Thus, the assets in the Roth account could appreciate without RMDs and yield an overall breakeven in the seventh year at age 77 (age 77 minus age 70 equals 7 years to the break-even point).
The combined value of traditional and Roth retirement assets and side accounts when 12% federal income tax bracket Roth conversions are done
These are the traditional and Roth asset and side account totals when partial Roth conversions are done in early retirement below the 12% federal income tax bracket ceiling
J) Are traditional or Roth retirement assets better for a large financial emergency during retirement?
The answer is that traditional retirement assets are probably better. The comparison of the 100% traditional versus 100% Roth contributions case studies above yielded a rather advanced breakeven age of 90. Because of their financial structure, traditional retirement assets have some built-in advantages in financial emergencies in retirement.
In all of the projection model scenarios discussed in this article, this couple is expected also to have more than $1,000,000 of taxable investment assets at age 75. These taxable investment assets would be in addition to the projection of exactly $1,000,000 in traditional and/or Roth retirement assets. For a moment, we will set aside the fact that this couple is projected to have such substantial assets in taxable accounts to tap in an emergency.
Focusing only on this couple’s $1,000,000 in retirement assets, what would happen if they needed $250,000 at ages 75, 80, 85, 90, 95, or 100? If you evaluate the 100% traditional contributions model, you will see that this couple starts with a $221,747 asset balance is a taxable tax shield side account at age 75. These taxable assets would not exist if this couple chooses instead to made 100% Roth contributions, while working. Alone, that traditional contributions tax shield account could provide the vast majority of the $250,000 they need.
Note that the modeling above shows the $221,747 in traditional tax shield assets on the Roth accounting spreadsheet as a negative entry. This design illustrates how only RMD tax reductions can overcome the tax shield advantage of traditional contributions. In reality, the actual assets would be held by this couple in a taxable asset account only when they made 100% traditional contributions, while working.
This $221,747 tax shield side account also would be expected to appreciate through ages 80, 85, 90, 95, or 100. For example, after 20 years at age 95, with this couple’s expected annual real dollar portfolio appreciation rate of 4.659%, this account would be valued at $552,150 after appreciation taxes. This represents a 20 year compound growth factor of 2.49 times. The 100% traditional contributions model provides substantial emergency funding assets without forcing further withdrawals to be taxed at marginal federal and state income tax rates.
Furthermore, the 100% traditional contributions model provides additional assets in taxable accounts that could be tapped for large financial emergencies. After RMD taxes are paid each year, the net proceeds would also be deposited into the taxable asset account. For example, the 100% traditional contributions table above indicates that those additional after-RMD-taxation assets would be worth $557,939 by age 85 and $1,510,264 by age 95.
Now let’s look at the 100% Roth contributions model from the standpoint of funding large emergency cash needs in retirement. Since there are no taxable assets held in Roth side accounts, the source of assets to cover emergencies is the Roth account itself. Because there are no RMDs and no RMD taxes, assets in the Roth account are expected to grow more rapidly than traditional assets. If there is a financial emergency, then of course, Roth assets could be used.
However, there is a problem. When Roth assets are removed from the account prior to the breakeven age in comparison with the 100% traditional contributions strategy, then those Roth asset withdrawals can significantly undercut the compound appreciation needed to reach breakeven. The argument that Roth assets are better in emergency situations, simply because there are no taxes, can be quite deceptive.
Professor McQuarrie’s article addressed this question in a section titled; “The worst case: early distribution of converted funds.” While he was focused on modeling Roth conversions rather than contributions, the logic is the same related to Roth assets obtained through contributions, when the tax-deductible traditional contribution alternative was available. Professor McQuarrie’s analysis also focused on much more affluent, more high earning taxpayers who would accumulate significantly more retirement assets and be subject to higher tax rates. Nevertheless, the same concepts apply to the case analysis in this article.
Professor McQuarrie stated: “Early distributions prevent compounding from gathering steam; and Roth conversions cannot pay out unless funds are left untouched for decades. By the nature of exponential processes, the benefits of compounding are necessarily backloaded. That is why the payoff from Roth conversions takes so long. Moral of the story: Roth conversions are designed to increase financial wealth. If used instead to increase consumption wealth, they can blow up.” (McQuarrie, Ibid, page 15)
Now, we return to the fact that this couple is also projected to have substantial assets in taxable accounts to tap in an emergency anyway. As observed, this couple is projected to have more than $1,000,000 of taxable investment assets at age 75, in all of the different models already discussed in this article. These taxable assets are in addition to the $1,000,000 of retirement account assets that we are analyzing.
I modified the baseline VeriPlan model for this article to reduce substantially this couple’s projected non-retirement account taxable assets. To do this, I adjusted VeriPlan to minimize taxable assets while still accumulating $1,000,000 by age 75 in Roth assets through 100% Roth contributions while working. Then, I switched to 100% traditional contributions while working to assess differences.
Reducing this couple’s expected wage and salary income from $150,000 to $137,000 and increasing annual retirement contributions from $8,535 to $9,890 allowed me to target close to $1,000,000 in Roth retirement assets by age 75. However, it was not possible to reduce all taxable assets to zero by age 75 with this method. Why?
This projection modification exercise illustrated the problem raised by Professor McQuarrie. Problems arise when retirement account assets are needed in the interim to fund negative cash flow or consumption. When retirement assets are needed for consumption, financial investments tax optimizations can be distorted and undermined.
To optimize taxation related to traditional versus Roth retirement investment strategies requires that this couple or any couple accumulate separate retirement assets in taxable accounts. If retirees do not have at least some modest taxable assets to buffer their retirement assets, then negative cash flow years earlier in retirement would require that Roth retirement assets be tapped for negative cash flow consumption expenses.
Between ages 67 and 75, this couple experiences negative cash flow (income plus taxes minus expenses). If they have insufficient taxable assets to cover negative cash flow, then their traditional or Roth retirement account assets must be used. If they only have Roth retirement assets to cover consumption needs, this can undercut their wealth tax optimization objectives.
Remember that the 100% traditional contributions baseline model provided a $221,747 tax shield side account at age 75 when compared to the 100% Roth contributions model. Adjusting VeriPlan with a lower ($137,000) working income parameter and a higher ($9,890) annual retirement contributions parameter enabled a significant reduction in accumulated taxable account assets by age 75.
With these adjusted parameters, when the taxable asset difference between 100% traditional contributions versus 100% Roth contributions while working was projected it actually increased to $275,836 after taxes by age 75! Because of their lower working income, the value the traditional contributions tax shield should have been reduced. However, now there is an additional factor that widens the difference between these 100% traditional versus 100% Roth contributions strategies.
In effect, the tax shield provided by 100% tax-deductible traditional contributions increases the family’s taxable accounts and acts like increased “working capital.” These greater taxable assets can cover negative cash flow and fund consumption during negative cash flow years without requiring retirement account withdrawals.
With a 100% Roth contributions strategy they reach their $1,000,000 Roth assets target by age 75, but their taxable accounts have far fewer assets. Their taxable account assets continue to dwindle and would run out by age 81. Then, all they would have to live on is Social Security and Roth assets. Expected negative cash flow would force substantial annual Roth withdrawals thereafter. In this modified VeriPlan model, this couple -owning only Roth retirement assets – would never break even compared to the 100% tax-deductible traditional contributions model.
In contrast, when this modified model is switched to 100% traditional contributions, their greater taxable account assets are sufficient to protect their traditional retirement assets. In fact, in this case they exceed $1,000,000 in accumulated traditional retirement assets by age 71 rather than age 75. In addition, instead of eventually being exhausted, their taxable account assets reverse their decline at age 75 with the deposit of after-tax RMD assets and increase thereafter.
As Professor McQuarrie stated above: “Roth conversions are designed to increase financial wealth. If used instead to increase consumption wealth, they can blow up.” (Ibid, page 15)
That is what happens here. It turns out that 100% traditional retirement contributions while working strategy would much better enable this couple to cope with a financial emergency in retirement that required a lot of money.
Summary
If you made it to the bottom of this article, you deserve some sort of medal. In summary, tax deductible 100% traditional contributions are the winning strategy while working. Roth contributions while working are not a contender, because the traditional retirement contributions tax shield is so valuable.
After retirement, retirees might still have the opportunity to grow their retirement asset pie with Roth conversions. It all depends on when the breakeven point would occur.
Oh, and by the way, after-tax Roth retirement assets are not necessarily more valuable than after-tax traditional retirement assets. The notion that non-taxable Roth retirement assets are consistently more valuable than traditional retirement assets with RMDs just does not pan out.
Just comparing the assets inside traditional and Roth retirement accounts is highly deceptive. You must also consider the after-tax side effects associated with getting those assets into and out of these retirement accounts. It is easy to fool yourself.
