Why open a Roth IRA? (3/X)
Two questions I like to ask my clients: 1. What will your marginal tax rate be, exactly, when you retire? 2. Given our national debt (big) and historical marginal tax rates (almost all-time lows currently), do you think tax brackets will have increased, decreased, or stayed the same by the time you’re retired?
I would argue that you don’t know what your marginal tax rate will be in retirement. Unless, of course, you plan on retiring in 2025.
Why is that? Income tax rates change relatively often and our current tax law known as the Tax Cuts and Jobs Act is slated to sunset on Jan 1, 2026. If congress does nothing between now and then, we *all* will have higher tax rates and lower standard deductions, leading to a higher tax rate on a higher taxable income amount. While it’s possible that the law is extended, especially if Republicans take the House, we’re working based on what we know today.
For ease of illustration, let’s assume someone filing their taxes as a single filer that has an adjusted gross income of $50,000 in 2024 and 2025. Currently, the standard deduction for single filers is $14,600, putting them in the 12% tax bracket and bringing their taxable income to $35,400. They could owe as much as $4,016 in federal taxes.
If Congress changes nothing, in 2026 this same person making the same income would owe more in taxes. The standard deduction could drop to as low as $6,350, increasing their taxable income as high as $43,650 and their tax bracket to as high as 15%, bringing their total potential tax bill to $6,081.25, a $2,000+ difference.
Why does this matter? Every dollar you contribute to Roth at a lower tax bracket saves you money down the road. Roth contributions could cost you more in 2026 than they do now. Similarly, the money you withdraw from your pre-tax (non-Roth) retirement accounts will be taxed at your income tax level at that time you withdraw them, whatever it is, whenever you do. As we have illustrated, those numbers could be higher, and you could pay more in taxes as a result.
Now let’s assume the possible scenario that the TCJA is extended and we keep our tax brackets as low as they are: a Roth IRA still saves you money in taxes. Investing in a Roth IRA or doing Roth conversions from a traditional to a Roth IRA makes it so you pay tax on an investment now and allow it to grow tax free: you pay tax on a smaller bucket of money and likely end up saving a lot in tax dollars in the long run.
For the sake of illustration, assume someone filing their taxes as single paying an effective tax rate of 15% with an income of $50,000. Assuming a contribution of $5,000 to a Roth IRA this year, they would pay $750 in taxes on that $5,000. Assuming a growth rate of 7.2%, after 10 years their investment would be worth double: $10,000.
If they wait until year 10 to pay tax on that same investment, and still have even the same effective tax rate of 15%, they will owe twice as much in tax: $1,500. Even after accounting for inflation, they pay more in taxes by waiting than by paying today.
In my next post, we'll compare and contrast a Roth IRA and a Roth 401(k) and the advantages/disadvantages of both. Stay tuned!
See Thrivent.com/social for important disclosures. Thrivent and its financial advisors and professionals do not provide legal, accounting, or tax advice. Consult your attorney or tax professional. Hypothetical example is for illustrative purposes. May not be representative of actual results. Past performance is not necessarily indicative of future results. Concepts presented are intended for educational purposes. This information should not be considered investment advice or a recommendation of any particular security, strategy, or product.
