We see this question a lot, and more often than not we see it from people who want one group’s or another’s collective advice…and instead get a mish-mash of over-simplified or over-generalized opinions. Anyone’s best answer to this, of course, starts with, “It depends.” But what it depends on is where the hive’s “advice” tends to go off the rails, and for more reasons than are usually properly understood. The most common over-simplification is along the lines of, “If you’re making a lot of money now, you should make traditional contributions to your TSP/IRA, because you’ll be in a lower tax bracket when you take the money out.” Well, for starters, yes, those are two of the things you need to look at, but you only really know one of those things right now. If you assume you’ll be in a lower tax bracket (more on this later) when you retire, fair enough, but understand you may wind up wrong about that. As we learn in our military careers, we never have all the facts we need (or at least want) when it’s time to plan, so we have to fill in with assumptions so we can keep planning. But for every assumption we make, we also include what we call a branch plan in case that assumption winds up being wrong. And in this case, we can actually test our assumptions. What if you’re in a higher tax bracket when you start taking money out? Again, lots of people would say, “Just make Roth contributions then.” The truth is that both sets of advice have the potential to be wrong, for a variety of reasons. Here are the most common ones.
- When do you plan to take income from the account? As an entering argument, these accounts are designed to deliver income no earlier than age 59-1/2. If it’s a traditional account, we have to start taking money out no later than age 70-1/2. If it’s a Roth, we don’t ever have to take money out of it. The point, regardless of the kind of account, is that the more time we have to allow investment gains to compound, the likelier it is that your total tax bill may be larger later in life, even if you’re in a lower tax bracket. Here’s an example. If you’re 30 years old right now and in the 22% tax bracket, the tax due right now on a $6000 Roth contribution will be $1320. Let’s say you think you’re going to be in a 10% tax bracket when you start taking income at age 60. If that account grows at an average compounded rate of 7% over those 30 years, that $6000 will have grown to almost $46,000. Your tax due on that sum would be not quite $4600. With that same growth rate, but with 40 years to compound before you start taking income, that same $6000 contribution would grow to almost $90,000, and you’d now owe nearly $9,000 in taxes on it. You’re probably starting to get the picture, but there are other important things in play too.
- What do you think your investments’ returns are going to be…and what if you’re wrong? Let’s go back to that $6000 contribution with 30 years to grow, What if it returns 8.5% instead of 7%? You might think, “Well, it’s only 1.5%,” and ignore it. I’d urge you to reconsider. The math tells us “only 1.5%” is a pretty significant difference. 8.5% compounding over 30 years will grow that $6000 contribution to more than $69,000, for a tax bill a little north of $6900. So by now you’re probably starting to see the value of testing these things. But there’s one more big thing to consider.
- What do you think inflation will do? We know that inflation has typically averaged around 2.5% to 3% over the long haul, but a few warnings should leap to mind. The first one you’ve already seen here. “Only” one half of one percent compounded over time might be a really big deal. The other is a cursory reading of history. There’s no shortage of examples of multiple-year stretches when inflation was well north of that. The most significant example is the ten-year stretch 1973-1982, when it was never lower than 5.75%. So again, this is an assumption worth testing. Why is this important? Because inflation usually has the net effect of lowering your future tax bill. Going back to our first example, if inflation averages 2.5% over 30 years, the inflation-adjusted tax bill of a little over $6900 is less than half of that, at just over $3300. That’s still more than double the $1320 tax bill for the Roth contribution, but you can see how different inflation rates might alter some people’s decisions.
All of these things interact to make everyone’s answer a little different. And though we don’t really know that things will go how we think they will, the good news is that once we’re done filling in assumptions all that’s left is math. The even better news is that we put together a spreadsheet to do the math for you. (It’s the same one that did all the math for this article.) And because it’ll do the math for you instantly, you can fairly quickly play “what if” with your projections to see what changes if you find yourself in a much higher or lower tax bracket than you’d planned for later in life, or your investments do much better or worse, etc. The spreadsheet is available right here for free download. Paul and I were sailors long enough to know the value of it being fairly resistant to erroneous inputs, so we built it accordingly, The yellow boxes are your inputs, and all but one of them are drop-down menus. The blue boxes are the outputs, and the green box is the bottom line.
We’d love to hear from you if there’s anything you’d like to see in the calculator that isn’t here. And especially don’t hesitate to give us a shout if you encounter any difficulty with it.