Military Finances 201: Roth vs Pre-Tax Revisited
Retirement FundingI belong to a few financial groups on Facebook and routinely, the Roth versus Traditional (more correctly pre-tax) discussion comes up. You hear a few different things in these conversations.
The most common thing I hear is, "Do a Roth, otherwise you'll pay too much in taxes." I hate paying taxes as much as the next guy, but it's not about how much you pay in taxes. It's about how much you put in your pocket. Let's peel that back a bit.
Current vs Future Tax Brackets
Assuming that when making a contribution to a Roth account you pay taxes first, subtract that from the amount you had available to invest and invest the remainder and that when you contribute to a Traditional account you can contribute the whole amount (investment + taxes not paid) and tax rates remain the same, it doesn't matter which one you contribute to. You'll get the same amount in your pocket when you take the money out of the Roth or take the money out of the Traditional account and pay the taxes.
So, then it comes down to how will tax rates change in the future? And, in what direction? No one can accurately predict that, but we can make some assumptions...I think.
If you're on Active Duty, you're probably in what I'll call the upper lower tax bracket. After your retirement and when you start receiving Social Security, you'll probably still be in an upper lower tax bracket.
If you've retired from the military and are working in a second career, you're likely in a pretty high tax bracket now. Even if rates go up in the future, your income and resulting tax bracket will likely be lower in retirement than it is now. In this case, I'd lean towards the Traditional instead of the Roth.
One other data point on future tax rates. I did see the results of a study that indicates for households with at least $100,000 in assets, that marginal tax brackets decrease from 22% to 12% in retirement. But I'm not sure whether a military pension would change that.
Taxes are currently on sale. It is worth noting that under the Tax Cuts and Jobs Act that rates are lower now than they have been for some time and are subject to sunset in 2026. In the short-term this might tip the scales towards the Roth, especially if you're in the 22% or lower tax bracket
State Income Taxes May Be the Real Big Deal
Most analysis of Roth versus Traditional talks only about Federal taxes. Make sense, as most these articles are written for a mass audience. I think this is a mistake. State income taxes can compose upwards of 20% of your total tax bill and that's a big deal.
That means if you're on Active Duty and a resident of TX, FL, AK, etc. and don't pay state income tax, the Roth becomes a better deal. This is especially true if you plan on moving back to CA, NY or some other state with an income tax when you retire, retire. If that happens, you save all the state taxes you would have paid on distributions from a Traditional account. As mentioned above, you might be saving 5% or more of a total tax burden of 30%.
Conversely, if you've retired from the military and working in a state with an income tax and you know you're going to move to FL or TX or some other state without an income tax, then the Traditional makes more sense. You get a 5% or so deduction now (out of a 30% or more total tax load) and don't pay any state income tax when you take it out (By the way, states with an income tax really hate this).
This doesn't have to be an all or nothing decision either. If there is a difference of a few percentage points between the state where you are now and where you will be when you take it out, the same tax arbitrage can apply.
Let's go back to the beginning of this article and review...it's not how much tax you pay, it's how much money you put in your pocket. When figuring that out, do your best to predict how the future tax rates will compare with your present tax rates. But, in my opinion pay the most attention to the difference in tax rates between the state where you are now and the state where you will retire.
Military Finances are Different
If your financial advisor isn't aware of your unique situation when it comes to state income taxes, he or she may not even consider your current situation when recommending Roth vs Traditional. That's why we think you should work with a Financial Planner that works with Active and Retired Senior Military Officers and NCOs each and every day. If you'd like to hear more about how we work with that group give us a call or use the button below to schedule a free initial consultation.
If you found this article useful, you might like the following blog posts:
Military Finances 101: Should I Use My Roth IRA as an Emergency Fund?
Retired Military Finances 401: The Widow(er)'s Penalty
Roth TSP in a Combat Zone: Almost a "No Brainer"