Should you invest in a Roth or traditional? Whether we're talking about a Roth IRA vs. a traditional IRA or a Roth 401(k) vs. a traditional 401(k), it's not a slam-dunk decision because the benefits aren't immediately apparent.
With a Roth IRA or Roth 401(k), you invest after-tax money. It grows in the account and is generally withdrawn at retirement tax-free. We don't know what the tax rates will be in the years ahead, the argument goes, so why not pay tax at current rates in case they go way up? (With a Roth IRA, you don't ever have to take the money out. You can bequeath it to your progeny if you like.)
With a traditional IRA or 401(k), you generally get a tax deduction upfront, and the money grows in the account on a tax-deferred basis. You don't pay taxes until you withdraw it.
But what if you can save on a pretax basis and then get the money out without paying any taxes at all? This was the topic of a column penned by Fred Reish, managing director and partner of the Los Angeles-based law firm of Reish & Reicher. In his column, "Roth is wrong -- for some people" which appears in the August issue of Plansponsor Magazine, Reish makes the case that most people should save at least $400,000 on a pretax basis before contributing to a Roth. At retirement, assuming you withdraw 5 percent per year, or $20,000, you don't have to pay any taxes on the money you saved pretax.
His thesis was the subject of my blog, Roth retirement decisions, which generated several critical comments questioning the analysis. The main outcry: The calculation doesn't take into account Social Security or other earnings. I wondered about that and sent an e-mail to Fred Reish asking for his thoughts. It turns out that he did take Social Security into account. He supplied this work sheet, which shows how the IRS calculates Social Security and other income for the purpose of determining what benefits are taxable.
The work sheet illustrates the earnings of a couple. They received $15,000 in Social Security benefits, only half of which is subject to taxation. It also shows other income, which for purposes of illustration, consists of withdrawals from a traditional IRA. Because the combined income adds up to less than $32,000, the withdrawals are not subject to tax.
According to the Social Security Administration, "Some people have to pay federal income taxes on their Social Security benefits. This usually happens only if you have other substantial income (such as wages, self-employment, interest, dividends and other taxable income that must be reported on your tax return) in addition to your benefits."
What's substantial income? This is a little mind-numbing, courtesy of the IRS, so bear with me. For single individuals, if the total of one-half of your Social Security benefits plus all your other income is between $25,000 and $34,000, you may have to pay income tax on up to 50 percent of your Social Security benefits. If it exceeds $34,000, up to 85 percent of your Social Security benefits may be subject to tax.
For married couples filing jointly, if the spouses' combined income is between $32,000 and $44,000, then half of their Social Security earnings may be subject to tax. If it's more than $44,000, then up to 85 percent of Social Security benefits may be taxed.
To reiterate: In the example that Fred Reish supplied, a married couple who received $15,000 in Social Security benefits plus $20,000 in taxable income would not have to pay any tax. Social Security was taken into consideration when he penned that column.
As I said before, the tax system may change in the future. But for now it looks like those people who engage in retirement planning and who expect to live fairly modestly should think twice about the value of paying taxes up front via a Roth.
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