Which retirement account is better: a traditional tax-deferred account or a Roth account?
A lot of advisors say: “it depends.”
They’ll say, if you believe taxes will be higher now than later, then contribute to a traditional account and get tax deductions now. If you believe taxes will be higher in the future, contribute to a Roth, take the tax hit now, then enjoy tax-free withdrawals later.
Whether taxes are higher now vs. later, of course, has a lot to do with how much you earn now vs. how much you expect to earn later / in retirement, plus what tax rates are now vs. what you expect them to be in the future.
Well, this is a false choice.
Today I’m gonna show you that contributing to a traditional account upfront is ALWAYS superior for nearly all taxpayers, especially those who plan like I do to retire early.
The key is this: after contributing to a traditional upfront, you then slowly convert to a Roth IRA AFTER you retire. This lets you get the best of both worlds. It means you avoid taxes on money going in, avoid taxes on growth, avoid taxes on conversion (if done right), and again avoid taxes on withdrawal.
Why you should care about this at all
For most workers, taxes are your single biggest expense. You may not notice it because they get withheld from your paycheck. But when you look at the size of your tax withholdings, you see they dwarf all other expenses — including housing.
Taxes comprise more than ONE-THIRD of my gross income, and no other expense comes close.
That’s why it’s super important to do efficient tax planning. And tax-advantaged retirement accounts are a key strategy for achieving this.
In fact, the strategy I’m gonna show you is one of the rare few that’s universally true for nearly everyone. Plus, it snowballs over time: follow this strategy early in life and you WILL accelerate your retirement by YEARS.
Quick recap on the different types of tax-advantaged accounts
When I talk about tax-advantaged accounts, I’m talking about them in a generic sense.
“Traditional” simply means funding with pre-tax dollars and deferring all taxes until you withdraw. Investments grow tax-free, but they get taxed entirely as ordinary income upon withdrawal.
“Roth” simply means funding with post-tax dollars, but everything is tax-free thereafter.
Both traditional and Roth accounts come in different types, such as:
- 401(k) Plans for company employees
- 403(b) Plans for teachers
- 457(b) Plans for state and local government and non-profit employees
- Thrift Savings Plans for federal government employees
- Simplified Employee Pension Plan (SEP)
- SIMPLE IRAs
- Roth IRAs
- Roth 401(k) Plans
- Roth 403(b) Plans
- Roth 457(b) Plans
- Roth Thrift Savings Plans
It doesn’t matter which type you have. What matters for tax planning is which bucket — traditional or Roth — it falls into.
How this strategy works
We mentioned above that traditional wisdom says if your taxes are higher now, go with a traditional account; if your taxes will be higher in the future, choose a Roth.
Let’s take a look at how a traditional is always mathematically better when you have earned income, especially if you plan to retire early.
Step 1: Contribute pre-tax to a traditional account during your working years
First, if you can afford it, I strongly recommend maxing out your traditional contribution every year. Currently the max annual contribution is $18,000 ($5,500 for IRAs).
To fund $18,000 in your account, you’ll need $18,000 of earned income, which you’ll deduct from your paycheck and you won’t pay taxes on that.
To fund $18,000 in a Roth, you’d need as much as $29,800 of earned income (if you’re at the 39.6% marginal bracket), since you’re using after-tax dollars.
This means you literally end up with more dollars in your pocket when you choose a traditional over a Roth.
In fact, if you earn $100,000 income, you’d have ~3% more dollars in your pocket at the end of the day, shown here:
(This assumes you’re married filing jointly with no kids.)
The extra dollars you save by shielding contributions upfront from taxes can now be reinvested in a regular, taxable account.
If you do this every year, your taxable account will grow a lot faster than the Roth dude’s taxable account. And over many years of compounding, this gap will get big. We’ll show you how big in a second.
Step 2: Do a “Roth ladder” once you retire to withdraw conversions tax-free
Maybe you’re thinking, “Hey, all well and good, but now you owe taxes on the traditional when you withdraw…”
The year after you retire (hopefully early), you’re gonna start doing a Roth ladder conversion. A Roth ladder is a technique where you convert a little bit each year from your traditional account to your Roth IRA.
How much should you convert? Well, conversions are taxable events. But if you convert just under the standard deduction and personal exemptions limit ($20,700 in 2016 for married filing jointly with no kids), then you can move that money into your Roth IRA and pay zero taxes.
Moreover, unlike Roth IRA contributions, which are capped at $5,500 annually and subject to income limit phaseouts, Roth IRA conversions have no cap and no income limits. Win.
Now, the rules have always let you withdraw original contributions to a Roth IRA tax-free and penalty-free. But when you do a Roth conversion, there’s a twist: you have to wait 5 years before you can withdraw those original contributions.
That’s where the “ladder” comes in.
You can structure your conversions and withdrawals like this:
Each year you convert an amount exactly equal to the standard deduction and personal exemptions. Five years later, you start withdrawing those contributions tax-free.
But wait, actually the IRS usually increases the standard deduction and exemption amounts each year to account for inflation.
If inflation is, say, 2.5% per year on average, our Roth ladder will actually look something like this:
Step 3: Cover your first 5 years of expenses from other sources
Because the Roth ladder has a 5-year waiting period, you’ll have to cover your expenses for the first 5 years from other sources.
You’d probably have to do this anyway unless your total expenses are less than the standard deduction and personal exemption amounts.
You can cover your expenses with:
- Unemployment benefits
- Withdrawing prior original Roth contributions tax-free and penalty-free
- Rental income
- Side hustle income
- Dividend income from your taxable account
The last one is especially attractive, because qualified dividends and long-term capital gains (up to $75,300) are taxed at zero if you’re in the 10% or 15% ordinary tax bracket.
So, theoretically, you could live off $75,300 in tax-free dividend income, and convert $20,700 tax-free from traditional accounts to Roth accounts every year (with annual IRS increases for inflation).
Five years after starting your ladder, you can then begin withdrawing your ladder conversions tax-free. (Any earnings on Roth investments, however, must stay in the account until you’re 59.5.)
This means you enjoyed:
- Tax-free contributions
- Tax-free growth
- Tax-free conversion to Roth
- Tax-free withdrawals
Putting it all together
So, my strategy is to:
- Contribute the max $18,000 to a traditional account every year until I stop working
- Once I retire, convert the standard deduction and personal exemption amount each year to a Roth IRA
- Live off other spending sources for the first 5 years of retirement; qualified dividends will be taxed zero assuming I stay within the 15% tax bracket
- If I earn any ordinary income during early retirement, which is a real possibility (e.g., rental income or side hustles), I’ll make traditional contributions with it to shield against taxes…eventually that money will get laddered into my Roth IRA anyway
- After 5 years, start withdrawing Roth ladder contributions tax-free and penalty-free
- Pay zero taxes on everything
And…what if side hustles or rental income STILL push you above the 15% bracket even after you max out traditional contributions?
You can actually push your traditional contributions “beyond the max” by opening a Solo 401(k). With a Solo 401(k), you can contribute up to 20-25% of your side income ON TOP of your $18,000 max individual contribution, up to a ceiling of $53,000. $53,000 for one person!
If you’re hitting that ceiling…um, your side business is earning a LOT, like upwards of $175,000.
…I guess you’ll have to start paying taxes. That’s a good problem to have, consider yourself lucky.
(Note: if your side income is location independent, you could actually exclude most of that income from taxes by living abroad and using the Foreign Earned Income Exclusion.)
The Solo 401(k) is a beautiful thing, but deserves its own post, so I won’t get into the guts of it here.
So…what the result of all this?
Results after 30 years
Let’s say you and your spouse currently earn a combined $100,000 and you want to retire in 12 years. Assuming you plan to have 2 kids in a few years and you max out your retirement accounts every year, the gap becomes significant after 30 years:
In fact, using these assumptions:
…after 30 years both traditional and Roth dudes have the same amounts in their tax-advantaged accounts, but the traditional dude has $232,814 more in his regular, taxable account than the Roth dude has in his.
Results after 60 years
Across a lifetime, the gap becomes REALLY big.
At 60 years, the traditional dude has $1,772,239 more in his taxable account than the Roth dude:
That, my friends, is because of the magic of compounding.
Now it’s your turn
Try it for yourself.
First grab the spreadsheet:
Next, punch in your assumptions:
Now switch over to the “Analysis” tab to check out the charts:
You can see the exact dollar gap in the “Analysis” tab, too:
More reasons to convert to a Roth IRA
If the tax advantages alone weren’t enough to convince you about the glorious benefits of contributing traditional then laddering to a Roth IRA, maybe a few other considerations will…
First, while both accounts let you withdraw penalty free when you turn 59.5, traditional accounts REQUIRE you to start withdrawing at 70.5, whether you need to or not.
Roth IRAs don’t have such a requirement. You can keep your Roth money in the account as long as you want, and even bequeath it to heirs when you die. So another Roth benefit, aside from taxes, is no deadline for when you have to withdraw.
Plus, remember you can always withdraw original contributions from a Roth tax-free and penalty-free, regardless of purpose. (You just can’t take out earnings.) You can’t do that with a traditional account. The only time you can withdraw from a traditional account penalty-free is when:
- You’re paying college expenses for you or a family member
- You have medical expenses exceeding 7.5% of AGI if you’re 65 or older or 10% of AGI if you’re younger than that
- You’re buying a home for the first time (limited to a $10k withdrawal)
- You’re paying for a sudden disability
With a Roth, you can even take out earnings penalty-free and tax-free before 59.5 for disability or a first-time home purchase, assuming you’ve had your Roth open for 5 years. But you only get penalty-free earnings withdrawal for medical or college expenses.
Pre-59.5 Roth earnings withdrawal rules can get nuanced, so talk to an advisor if you really need to understand them.
The point is, both account types have benefits, but you get the holy grail when you merge the two and get both benefits.
Does the Roth IRA conversion strategy work for non-IRA accounts like 401(k)s?
Yes, but with an extra step. If your money is NOT in an IRA, then you’ll have to roll it over into an IRA first, and then convert it into a Roth IRA, to avoid taxes and penalties. You can’t convert directly from a traditional non-IRA into a Roth IRA.
So, we’ve seen that the key strategy of a Roth ladder is making traditional contributions to shield against taxes upfront, reinvesting the extra dollars in a taxable account and watching them grow faster than would be possible had you made Roth contributions upfront.
This puts more dollars to work for you without working any harder or earning any more, simply by keeping those dollars out of Uncle Sam’s hands in the first place!
So, unless you’re earning no income, never contribute to a Roth outright.
If you’re earning nothing AND you also have no traditional funds that need laddering, then by all means contribute to a Roth all day long…assuming you don’t need that money for living expenses.
But if you have ANY earned income, do yourself a favor and contribute to a traditional first, then later convert to a Roth IRA when circumstances are tax-favorable.
Discussion: Have you used this strategy before? Any interesting twists or variations you’ve found? Leave a comment and let me know!