Academic journal article Financial Services Review

IRAs under Progressive Tax Regimes and Income Growth

Academic journal article Financial Services Review

IRAs under Progressive Tax Regimes and Income Growth

Article excerpt

Abstract

This article investigates the choice between a traditional IRA and a Roth IRA in the presence of a progressive tax regime, income growth, and exogenous retirement income. These factors affect the tax rate that applies to deductible IRA contributions and taxable distributions and can therefore influence the optimal choice. Assuming constant income tax rates or exogenously determined tax rates for working years and retirement years, which has been popular in the literature, may lead to misleading conclusions. For aggressive savers enjoying high rates of return or high levels of other retirement income, the Roth IRA can be a better choice than a traditional IRA.

© 2009 Academy of Financial Services. All rights reserved.

JEL classification: D91; G11; G2; G23

Keywords: Retirement planning; Saving; Tax planning; Progressive tax rate; Income growth

1. Introduction

Choosing between savings vehicles with front-end loaded tax benefits (such as 401(k) plan or traditional IRA) and those with back-end loaded tax-benefits (such as the Roth IRA or Roth 401(k)) in the presence of market frictions and government regulations can be challenging. Reichenstein (2006, 2007), Reichenstein and Jennings (2003), and Horan (2007a, b) show how the portions of principal effectively owned by, returns received by, and risk borne by individual investors may vary depending on the saving vehicle they use. A substantial body of literature has emerged to understand these savings vehicles and their effectiveness as savings vehicles (see, for example, Horan (2005) for a summary of literature). To make the problem tractable, however, authors make simplifying assumptions that may inadvertently lead to suboptimal decision making. In this article, we focus on the importance of incorporating progressive tax rates, income growth, and exogenous retirement income in comparing the performance of savings vehicles with front-end and back-end loaded tax benefits, such as the traditional IRA and Roth IRA, respectively.

Retirement planning requires careful consideration of the accumulation phase as well as decumulation, or withdrawal, phase. Much of the literature has focused on the accumulation phase (see Horan (2005) for a review). Analysis of the withdrawal phase, when the savers retire and tap into their retirement resources, is equally important but has received less attention. Notable exceptions include Zaman (2008), Horan (2006a, b), Kaplan (2006), Spitzer and Sandeep (2006), Caliendo and Lewis (2002), Hughen et al. (2002), and Spitzer, Strieter, and Singh (2008) who discuss the importance of withdrawal patterns.

A proper analysis of traditional IRAs and Roth IRAs is predicated upon their usefulness in the context of both accumulation and the decumulation phases, which requires a consideration of other sources of income during retirement, such as social security, defined-benefit pension plans, and defined contribution plans. These alternative sources of income determine the marginal tax rate in retirement and hence the relative value of a traditional IRA compared to a Roth IRA. Ignoring them may therefore lead many savers choose the wrong savings vehicle. Early work assumes marginal tax rate in working years and retirement years are equal (e.g., Crain and Austin (1997), Krishnan and Lawrence (2001)). Subsequent studies incorporate tax rates that vary from working to retirement years (e.g., Horan, Peterson, and McLeod (1997), Horan and Peterson (2001), Horan (2005), and Reichenstein (2003, 2007)), but the process of determination of the marginal tax rate is not considered.

In reality, savers face progressive tax rates during working years as well as retirement years. Horan (2006a, b) shows that progressive tax rates can affect a retiree's optimal withdrawal strategy from tax-deferred or tax-exempt accounts. Progressive tax rates may affect the optimal choice of accumulation vehicles (e.g., traditional IRA or Roth IRA), as well. …

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