Me: Forgive me father, for I have sinned.
Father Finance: You are in a safe place to share your sins, my son. What would you like to confess?
Me: I think Roth retirement accounts are very overrated and over-hyped.
Father Finance: What the $@%&! You shall burn in hell for eternity! Leave this place now, never to return!
There, I’ve said it.
I know this is not going to be a particularly popular opinion – but I think the benefits of Roth IRAs and Roth 401Ks are extremely over-hyped and are inferior to Traditional IRAs and 401Ks for most individuals. I haven’t contributed to one in years. And my opinion on this has only gotten stronger with the more that I have learned about both.
Before I dive in to why, a quick recap for beginners on the key difference between the two types of accounts:
- Roth IRAs and 401Ks: you are taxed on your contributions now, but you don’t pay taxes when you withdraw.
- Traditional IRAs and 401Ks: your contributions are tax deductible now, but you pay taxes upon withdrawal.
It has been said that the primary demographic that can benefit from Roth retirement accounts are younger income earners who are in a lower tax bracket. Theoretically, I do not disagree with this. You are going to be taxed at some point, so why not be taxed at a lower tax bracket now versus a possibly higher tax bracket later? After all… TAXES SUCK!
It is that anti-tax sentiment, right there, that is why Roth IRAs have exploded in popularity. Just the possibility (people love to gamble) of paying less taxes makes them the more attractive option. The Roth brand has become so popular and revered that the Roth IRA spawned the Roth 401K just in 2006, yet 88% of employers already offer a Roth 401K to keep their benefit package competitive!
This explosion in popularity and the fear of taxation has resulted in widespread belief that the Roth accounts are superior to Traditional.
Here’s the thing. Those who have been said to benefit the most from Roths – those under age 35 – are the ones that have bigger problems than determining retirement savings account format. The millennial personal savings rate is negative 2% and Gen X (ages 35 to 44) isn’t much better, at 2.6%. These generations need every penny of tax deductions they can get RIGHT NOW in order to pay off their massive amounts of debt and to avoid additional debt.
Those who are in the lower tax brackets (10% and 12%) have significantly lower personal savings rates than what I just highlighted. In other words – they typically have no savings. In the rare case that they do, those extra dollars they can keep to pay off debt, build emergency funds, and avoid financial hardships are massively important in the present. And at this rate, their tax bracket in retirement will have little significance because they will not have much in retirement savings to be taxed. Among a bunch of depressing average retirement savings statistics, 55% of Americans over age 55 have less than $100,000 in their retirement accounts to begin with. And $100,000 or less (spread out over a number of years) isn’t exactly going to be pushing anyone into higher tax brackets.
Can we agree that those with no or very little savings could use more money right now for important things like cutting debt?
What about those younger workers who are in the higher tax brackets (22%+) who actually do have the money to save right now? I fit in to this category, and I can tell you that I would much rather get maximum tax deductions right now. Why?
- It’s a good bet. I know for certain that I am in a high tax bracket right now. I do not know exactly what the future holds, but there is a very good chance my tax bracket when I must start taking distributions will not be higher than it is right now.
- Lower taxation: if you invest $1 in a before-tax account (Traditional IRA, 401K, HSA), that dollar is taxed as the last dollar earned. In other words, it is taxed at our highest marginal rate. When we withdraw $1 from our accounts in the future, it is our first dollar. The first dollar is taxed at 0%.
- If, by some small chance, my tax bracket at the time of distributions is higher, then I will have more money than I will possibly know what do with and my tax bracket won’t really matter. This would be a great problem to have!
- Every additional dollar that is not taxed now can be saved and invested towards possibly early retirement. THIS IS HUGE!
- I’d rather have a higher quality of life right now, while I’m young and relatively healthy, than when I’m old and with probable health problems.
- There is no certainty in life. I could very well die before I ever touch a penny of those tax-free Roth savings. Roths won’t help you when you’re dead, but more savings now (while you’re alive) can help.
- A number of people commented on this, so I’ve added this point. The numbers (surprisingly) work out in favor of the Traditional options. If you invest Traditional tax savings and make equivalent contribution amounts, Traditional comes out slightly ahead of Roth(~2%) over a 35 year period, AFTER TAX (assuming an equivalent tax rate).
There is another (newer) reason you may or may not have considered that makes Traditional retirement accounts more appealing that Roths: the Affordable Care Act (ACA)! Yes, “Obamacare”.
If you have registered for a plan from a public health insurance exchange like healthcare.gov or a state exchange, your tax deductions from contributions to your Traditional IRA and 401K lowers your modified adjusted gross income (MAGI). Your MAGI is what determines the subsidy you will receive. This subsidy is available to people with family incomes between 100% and 400% of the poverty level, and the lower your MAGI, the higher your subsidy. In other words, more deductions can equal a higher subsidy. More on this here.
At this point, you may be wondering Roth retirement accounts consistently benefit anyone? Those who stand to consistently benefit the most are the rare few that meet all of the following criteria:
- are in a lower tax bracket many years.
- despite being in a low tax bracket, have an abnormally high personal savings rate to be able to make significant Roth contributions.
- work a LONG time to build sufficient savings for a traditional retirement and don’t really care about retiring early.
- don’t qualify for an ACA subsidy.
That’s a tiny segment of the population.
Now, to be fair, there very well could be years where contributing to a Roth versus a Traditional retirement account makes a lot of sense. And there’s no reason you can’t contribute to both, to balance out taxes. Hopefully all I’ve done here is dispel the myth that Roths always reign supreme over Traditional retirement accounts. They definitely do not.
Aside: if your income is above the IRA income limits, the Backdoor Roth IRA might make sense, particularly if you can’t make deductible contributions to a Traditional IRA. But that’s an entirely different scenario than what’s laid out in this post. And so is a mega backdoor Roth conversion.