When advising new clients, one of the most common discussion points I make is about IRAs. I talk about the general misconception of pre-tax savings and specifically the inadequacy of the traditional IRA.
While I praise clients for doing such a good job of saving for retirement, I also give caution about the one-size-fits-all misguidance of conventional wisdom on tax-deferred savings vehicles.
What Kills the Traditional IRA
The general advice to build the retirement nest egg with a traditional IRA is based on the supposed advantage of pre-tax savings. The whole idea of tax deferral is to “defer” current taxes until retirement, when the client will presumably be in a lower tax bracket. But this advice ignores the worst enemy of the long-term investor — inflation.
Consider this example: Let’s say a couple with 30 years to go until retirement is wanting to increase their retirement savings with a traditional IRA:
- Their household gross income is $50,000, which matches that of the average U.S. household and places them in the 15% federal tax bracket.
- They get a modest raise in salary each year of 4%, which is a rate just barely above that of average inflation.
- They also contribute 6% of their income (just enough to receive the “company match”) to their 401(k).
- When they reach age 50, they increase their pre-tax contributions to the current maximum, which is $13,000 ($6500 each).
- After 20 years of saving, the couple’s gross income is $111,000. After deducting IRA and 401(k) contributions, as well as other deductions, their taxable income is easily below $80,000.
- Tax brackets and standard deductions increase with inflation over time (I calculated 3.3% average annual increase since 1994), which means the couple is still in the 15% tax bracket after the first 20 years.
- At the beginning of retirement, 30 years after starting their IRA savings, their gross household income has grown to $165,675. Using the conventional 80% wage replacement rate, their first year’s IRA withdrawal is $132,540.
- Based upon historic tax rate data found on the Tax Foundation website, and a few simple keystrokes on my financial calculator, the inflation-adjusted federal tax rate for the couple is still in the 15% bracket.
Inflation Not the Only Threat to Traditional IRA Savings
In summary, after modest increases in annual income, and after including inflation-adjusted annual increases in tax rates and standard deductions, one can see how so many otherwise smart savers and investors are not receiving the expected tax-deferral benefits of the traditional IRA.
In fact, some savers can end up in a higher tax bracket in retirement, especially if the IRA is the sole source of retirement income. But even if the retiree receives Social Security payments, which could then reduce taxable distributions of an IRA, there is no assurance they they will be in a lower tax bracket than in their savings years, which again is the whole premise of pre-tax savings in an IRA!
Also, the previous example does not assume that tax rates will go up, which is possible, considering tax rates are now lower than they were 30 years ago and high government spending in recent decades puts pressure on tax rates to move higher in future decades. Therefore, inflation is not the only potential killer of the traditional IRA — higher tax rates may also be a culprit, at least at some point in the future.
Best Alternatives to the Traditional IRA
Fortunately, there is another piece of conventional wisdom that makes sense for retirement savers: If the individual has a 401(k), it is best to contribute just enough to receive the employer match (never give up “free” money!). If the saver can afford to contribute money above that amount, they can put after-tax dollars into a Roth IRA, up to the maximum contribution amount, which is $5500 in 2014 for individuals.
If they are fortunate enough to have money above that amount, they can consider saving in a variable annuity, which, similar to a Roth IRA, is funded with after-tax dollars and grows tax-deferred. However, keep in mind that annuity withdrawals are taxed on a last-in, first-out (LIFO) basis, so earnings are taxed first as ordinary income, while any amount in excess of earnings is taken from the principal amount and is nontaxable.
Personally, I rarely see cases where the traditional IRA makes sense. Even those savers who are now in higher tax brackets are priced out of contributing pre-tax dollars because their income is too high. Those individuals with the best chance of benefiting from the tax-deferral of a traditional IRA are the ones that remain just above the 15% tax bracket (paying 25%) during their saving years and their lifestyle in retirement enables them to drop back down to the 15% rate, during the distribution years.
But how many people does this benefit? Very few, in my experience. If the traditional IRA isn’t already dead, it will be soon enough.