Last week I began the story of Farmers John and Jane, who were faced with the decision whether to pay tax on their seed - as happens with a Roth IRA - or defer the taxes and pay on the crop – as happens with a traditional IRA. John chose to have his seed taxed and Jane chose to pay on the crop. So let’s return to the story.
The harvest is now complete, the taxman has come and collected his 20% tax on Jane’s crop, and now the two stand looking at their respective stockpiles of corn to see which one made the best decision. Having paid tax on the harvest, Jane paid significantly more in taxes than John did since he only gave up a small amount of seed. But Jane’s ability to plant more seed produced a larger crop. In the end, all that really mattered to these two was, who had the most corn in their barn when the harvest was over and all taxes were paid.
I have heard many opinions on the Roth vs Traditional argument as to which will produce the highest return to the retiree but in the surprising end to our story, as John and Jane looked at their respective piles of corn, they found they both had the exact same amount. Using simple math, and assuming all things are equal such as tax rates, return on investment, etc., whether you pay taxes on the seed today, or on the crop tomorrow, the end result is the same.*
So if it doesn’t make any difference, why is there so much debate on this topic? The answer is quite simple and it is that our fable assumes that all things are equal. Most importantly, it assumes that Farmer John and Farmer Jane are being taxed at the exact same rate – 20% in our illustration. But what are the odds of that happening?
I see the Traditional and Roth decision to be one that largely falls upon one simple, yet actually impossible question. Will your tax rate in retirement be higher or lower than it is now? Unfortunately, no one can know future tax rates so we are left to make an educated guess. Many assume their tax rates will be lower in retirement since they won’t be working, in which case the Traditional IRA makes sense. But my experience has often been the opposite of that. Many of my clients who are still working and have children, mortgages and other deductions, have very low tax rates compared to their retired parents.
Additionally, there is always the risk, (some would say “likelihood”), that tax rates may rise in the future. For what it’s worth, it has been my personal preference to pay my taxes now, when I know what they are and while I have lots of family deductions. I choose not to let some future politician decide what my tax rate will be, but that’s just me. Call me a farmer John. What type of farmer are you?
Hi, I'm Dan. I'm a CFP® Professional.
Securities and advisory services offered through Commonwealth Financial Network®.
Member www.finra.org / www.sipc.org , a Registered Investment Advisor. Wyson Financial, 375 E Riverside Dr, St. George, UT 84790
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