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Switching to a traditional IRA

October 2nd, 2014 at 05:12 am

Up until now, I've been using Roth IRAs exclusively. I just followed the extremely typical advice for young people to use a Roth, because it's better to pay taxes when one is younger, making less income, and thus in a lower tax bracket.

I also thought that the math worked out better, at least if one assumes a constant tax bracket. In a Roth, you pay your taxes up front, but everything after that grows and is withdrawn tax-free. It's a very simple FV calculation. In a traditional IRA, the same contribution amount goes in and grows tax-free, so you wind up with the same FV as the Roth, but the withdrawal is taxed.

This seems like a bad deal until you remember that you get to keep the taxes that you would've lost with the Roth. If you also invested the amount that you would've paid in taxes, and let that grow over time, it essentially makes up for the withdrawal taxes on the IRA itself, at least if the tax rate is the same. However, that investment with the saved taxes is outside of the IRA, so it is not tax-advantaged, so you actually wind up with less FV than if you'd just gone Roth to begin with.

So I managed to think through all of that, but for some reason, I never questioned the implicit assumption that my tax bracket in retirement would be the same as now (or higher). I guess I wanted to make sure that I "could" withdraw as much as I wanted in retirement, so I didn't see the harm in accepting that I'd have a high income in retirement.

Now that I'm properly thinking through my current income and expenses, it has become abundantly clear that this assumption is false. My savings rate is in excess of 50%, so I am spending nowhere near my current level of income, and my expenses are expected to drop even further once the mortgage is paid off. There is ZERO need for me to replace my current income, so I will be in a LOWER tax bracket in retirement -- and that's a good thing, because it makes FIRE that much easier to achieve.

So it seems like Roth has been the wrong way to go all along. I should've been using a traditional IRA and taking the tax break right now. Oh well.

I've gone and made myself a traditional IRA in Vanguard, and I'm swapping over to it. I may even inquire about recharacterizing this year's contributions. This just goes to show that always assuming a worst-case scenario can cost ya.

(I also have another reason why I'm interested in switching to traditional, and that has to do with the Roth Conversion Ladder, which I'm learning about right now. Maybe I'll write it about it later, after I've got it worked out in my head.)

2 Responses to “Switching to a traditional IRA”

  1. Firstofmanysteps Says:

    Hmmm...have you run some numbers to get an estimate of how much the difference would be? I used to contribute to ROTH, despite expecting to be in a low tax bracket in my old age, simply because I was in the lowest tax bracket and the tax advantage wasn't that much. Also, ROTH makes for a very convenient EF.

  2. amberfocus Says:

    I have not run the numbers explicitly (taxes are not my strong suit, so I'm not even sure how to do this), but I believe I'm in the 25% income tax bracket currently, and I expect to drop down to the 10% bracket in retirement. I'm slumming it ERE-style, so I only need to replace ~15% of my current gross income, so even without quantitatively deriving the differential, it's probably safe to say that the tax deduction would be way more useful to me now than it would be in the future. As for an EF… I've already got $15K set aside in money market, so I should be covered. And if not, I've still got the previous decade's worth of Roth contributions to draw from. Smile

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