Reader Question: Should my husband and I invest in tax-free or tax-deferred accounts?

A reader asked a question recently that touches on a number of points I’ve been writing on:

My husband has an account with Vanguard where he puts post-tax money and a retirement account out-of-work where he puts pre-tax money. I have a SEP IRA and have recently set up automatic debits for myself.  My question is, is there a reason to put more money into any particular account?

There are a lot of interesting angles to this question.  How do you get on the same page, financially, as your spouse?  What should you do to integrate tax and investment planning? But, in answering, I want to stick with the crux of the major question: when should I invest in a tax-deferred versus a tax-free account?


The Difference Between the Two  

Let’s start with a quick overview of pre-tax and post-tax accounts, or as I refer to them, tax-deferred and tax-free accounts.

Tax deferred accounts allow you to take a tax deduction now for your contributions. Meaning, if you invest $5,000 in that account, you get to subtract $5,000 from your taxable income. Taxes are deferred until you take the money out. 401ks, 403Bs, 457s and Individual Retirement arrangements (IRAs) all work this way.

Tax-free accounts, such as a Roth 401k, Roth 403B, Roth 457 or Roth IRA, don’t allow a tax deduction now, but that money grows tax free until you take it out and, critically, there are no taxes when you withdraw your money.


Why Would You Choose One Over the Other?

In theory, both options give the same tax benefit, as long as your marginal tax rate stays the same. Let’s say you have $10,000 to invest, which you could place in a company-sponsored 401k or Roth 401k.  You can put the entire $10,000 into your 401(k) as a pre-tax contribution.  But if you invest it in a Roth account, you’ll have to pay taxes first.  Let’s say your marginal tax rate is 25%.  After taxes, your $10,000 shrinks to $7,500.

Let’s keep it simple by assuming that that’s your only contribution and you earn a 7% average annual return, compounded monthly, for 30 years.  At the 30-year mark you have $81,164.97 in your traditional 401k or IRA and $60,873.73 in your Roth 401k. You’re probably thinking, I’ll take the 401k.

But remember, while you have more in the 401k, you’ll have to pay taxes on that money that you take out.  Thus, if you’re marginal tax rates stays at 25%, the value of your traditional 401k ends at $60,873.73 ($81,164.97*.75).

Again, if your tax rate remains the same, it makes no difference.

The problem is that tax rates don’t stay the same. Income tax rates could go up to compensate for the national debt and yearly deficits (although the government could increase revenue in other ways besides income tax). You could require more money in retirement as you make more money and your cost of living increases, so that you’re bumped into a higher tax bracket. Or you may become a nomad and not require much income at all when you retire, putting you in a lower tax bracket.

Given current changes in your situation, you should choose whichever vehicle gives you the biggest tax advantage. If you think you are in a higher tax rate now than you will be in the future, then you should invest in the tax-deferred account and pay lower taxes when you take the money out. If you think your tax rate will rise, then take the hit now and use the money tax free later on.

It sounds simple, but it’s hard to implement.  You just don’t know what your tax rate will be 30 years into the future.


How to Make Your Decision

When making this choice, I suggest you careful consider your current marginal tax rate. The higher your current tax rate, the harder it will be to make that Roth contribution worth it.

You should also assess how much money you will need in retirement given your goals and the different types of income at your disposal to help fund those dreams. A good advisor can help you map out a strategy for meeting your needs through withdrawal strategies that can limit your future liability (e.g., future conversions).

That being said, the Roth offers advantages even for higher earners:

  • You won’t have to make Required Minimum Distributions, so you’ll have more control about when you take money out of your account.
  • You may pay taxes on your Roth contributions with outside funds, increasing the amount that you can save via this vehicle.
  • Your heirs won’t have to pay income tax on withdrawals from the Roth IRAs you leave for them.  They will have to make required minimum withdrawals. However, these required withdrawals are small enough that families often find they can earn tax-free gains for many years after the estate settles.


So What’s the Answer to My Reader’s Question?

Without further information, I honestly can’t say.  I’d need to know the particulars of her current situation — such as her current tax rate, her income (tax benefits for Roth and Traditional IRAs phase out at higher incomes) and how much she and her spouse need to save for the future.  I would also have to consider income limits, investment options in their different plans and the right allocation and location for all of the couple’s investments.

I’d also have to re-evaluate her situation every year, especially if her income or marginal tax rate changed significantly.  For example, one of my clients recently was able to take a one-time deduction of suspended losses on a rental property he sold.  His income— and tax rate – went down, making it a great time to convert a traditional IRA to a Roth.

I can’t predict the future, obviously. But by weighing different factors and making educated guesses, I can help you make the most beneficial decision about where to put your hard-earned savings.