Austin's post-tax-season reflections yesterday got me thinking about another tax filing issue: whether to make retirement plan contributions on a Roth or Traditional basis. This is one of the most common questions I hear, actually, so I know there's a lot of confusion out there about the topic. While we've written about it before, I thought I'd take a moment to highlight a couple of aspects that I think are often overlooked when comparing these two options.

Rather than re-hash all of the basics of Traditional and Roth IRAs, I'm going to simply point those who aren't familiar to an in-depth primer we wrote a year ago titled Making Sense of Your IRA Options and jump right to the main points I want to discuss today.

One of the huge problems of the Roth vs. Traditional decision is that people are routinely told to compare the two options using at least one assumption that is typically unrealistic. This is the main problem with most calculators and other evaluation tools, in my opinion. Specifically, it's that most comparisons assume the extra money saved each year on taxes by contributing to a Traditional IRA (or 401k) is saved in a separate taxable account.

In other words, a comparison calculator might compare 1) investing $5,500/yr in a Roth IRA for 20 years against 2) investing $5,500/yr in a Traditional IRA for 20 years plus investing your $1,375/yr tax savings in a taxable account.

The problem, of course, is that most people don't actually get around to investing the additional tax savings, which totally distorts the whole analysis! If you don't invest the extra savings, the Roth is the runaway winner.

Roth 1, Traditional 0.

But there's a counterpoint. I think most people fundamentally misunderstand the way IRA assets are likely to be taxed in retirement. And that misunderstanding leads people to overweight the value of the Roth in their analysis. This is particularly an issue when it comes to Roth conversions, where relatively hefty tax bills are sometimes paid up front in order to convert Traditional accounts to Roths.

This one is a challenge to communicate well, but we've tried to lay it out clearly in the article Traditional IRA vs. Roth: Which Maximizes Retirement Income?

The problem boils down to the critical fact that when you convert assets over to a Roth or make a Roth contribution, you are paying taxes at your highest (or marginal) tax rate for this year. If my income puts me in the 25% tax bracket this year, my Roth contribution or conversion is effectively being taxed at 25%. For most people, their income "fills in" multiple tax brackets each year: the first $18k (roughly) is taxed at 10%, the next $55k is taxed at 15%, and the next $75k is taxed at 25%. But if my income is $80k and I contribute to or convert a Roth, that whole contribution/conversion amount is taxed at 25% (this assumes that the conversion amount doesn't bump me into an even higher tax bracket, which would be even worse).

Contrast this treatment of contributions — always taxed at the highest rates — with what happens when I withdraw IRA assets in retirement. At that point, most people are going to have some Social Security income, maybe a pension (less and less common), and whatever they withdraw from their investment accounts. For a married couple filing jointly, that combination of income has to reach roughly $73k before anything gets taxed at 25%. If $30k- $40k of that first $73k of income is coming out of a Roth IRA or 401k that could have instead had taxes paid at the lower 10% or 15% rates if it had been a Traditional, that's a shame.

To restate it a little differently: There are a lot of retirees who are paying higher tax rates on their Roth contributions and conversions while they are working than their average tax rate would be if they were withdrawing from a Traditional IRA in retirement and "filling in" those lower tax brackets with IRA income.

I totally understand the argument that it's great to eliminate expenses — including taxes — prior to retiring. I also agree with the fact that we're likely to see higher tax rates in the future, so the difference in rates may not be that extreme anyway.

But this "filling in the lower tax brackets with IRA income" issue makes me think that many older workers might be better off using Traditional IRAs and 401k plans than Roths. And it's less obvious that Roth conversions for older workers are a great idea.

Roth 1, Traditional 1.

I still love Roth IRAs. But I think the enthusiasm for them has perhaps led some people to a misunderstanding of the relative merits of Roths vs Traditionals. Hopefully, this helps even up the score a bit.