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 [email protected]%&! 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.
I see your point, but you are going with almost “wort case” scenario. If you go with a “best case” scenario, meaning you have enough money to get the 401k match and maximize your Roth IRA when you are young and at a lower tax bracket, by the time you retire you’re going to have a lot of money saved up and definitely in a bigger tax bracket. In this case, the Roth is a much better deal.
Share some data to make your case, if you believe you are right and I am wrong.
What percent of people do you think actually make more income in retirement than they do in their working years? I shared the data that 75% of those nearing retirement (age 50-64), have less than $30,000 in their retirement accounts to begin with.
Maybe you are one of the rare few that has a shitload of saved up cash for retirement to receive income higher than working years, but I think that describes far less than 5% of the population. That’s your ‘best case’.
I studied the rules of the endgame of retirement. If you have too much money, required minimum distributions are heavily taxed. You only want enough money in those accounts to fill the lower taxed tiers, then fill funds with Roths. The kicker is to plan correctly for growth. Two secrets to life made this happen. I lived like “The Millionaire Next Door” and learned that happiness and the good life don’t depend on the amount of money I blow.
Friday, I gave notice that I am quitting. I don’t need to work anymore. The real point is you are making a choice to be relatively poor in your later years. I made the other choice at your age and am middle aged and independent financially.
While I agree with you that a Roth is not right for everyone, but I have questions. First, have you considered the taxes on the earnings from a traditional IRA? Second, you say, “I’d rather have a higher quality of life right now” — well then you aren’t really saving at all and the choice is moot.
Firstly, as somebody who has been following this blog for a few years now, I feel the need to go to bat for GE. This guy sets the standard for personal savings, so ease up with the blanket statements.
Secondly, the “higher quality of life” issue is very nuanced and complicated. There are things to weigh on both sides of the save/spend decision for each person. For instance, you could eat only rice and multivitamins now and save for retirement, but who would want to do that?
I think you probably have quite a zeal for saving and admire that, but please stop and think before making an accusatory statement. It makes the comments a little more pleasant for all of us.
I wasn’t being accusatory at all. I was asking two simple questions.
On your first question – the AFTER TAX earnings are nearly identical (traditional + invested tax savings versus Roth), if both are invested in the same manner, with the Traditional account coming out slightly ahead (~2% over 35 years). There are Roth vs. Traditional calculators out there to crunch the numbers, if you’d like to see. I didn’t cast this as a negative of Roth’s, b/c the numbers are so close, but Traditional is NOT worse in this regard.
When I say “higher quality of life right now”, I’m referring to the fact that the tax savings from contributing to a traditional give you more money today, which allows for more room for life + investing. I think it’s still a valid point, even if you don’t save every last bit of tax savings (I do, but many people won’t).
Yes, the math still works out in favor of traditional IRA in most cases, even when you consider taxes on the earnings. Your initial investment is lower with Roth since it’s taxed first, so it doesn’t benefit as much from compound interest
As Tom said, G.E. is definitely an avid saver so I don’t think he’s advocating for people not to save. His point (I think) is that it doesn’t make sense for a person who makes $50K a year now to save crazy vigorously so that they can withdraw $100K a year in retirement. What’s the point in surviving on rice-a-roni from age 25-65 so that you can eat lavishly from age 65-85? Live a healthy, enjoyable, sustainable lifestyle in your prime and save enough so you can continue a healthy, enjoyable, sustainable lifestyle in your old age.
i definitely agree that traditional ira and 401k is a better choice than a roth ira or roth 401k, if it’s an either or situation.
that being said, it should not be forgotten that after you max out your traditional ira or 401k, you can still contribute to a roth if you are under the income cap.
i can’t think of a reason to save and/or invest over putting in a roth and investing, assuming you won’t need the capital before 65.
I agree with the first satement you’ve made, but there’s an error in you logic. You can contribute to the Roth only if you are under the max allowed (you can’t max one and go to the other). If you’ve contributed $18,000 to traditional 401k, the Roth 401k is not an option; same with Roth IRA vs. Traditional.
@amanda hauf hmmm. i’ll have to check with my CPA, but for years i’ve been maxing out my 401k through work [17,500 in 2014], and then have on top of that been contributing to my roth IRA.
each year i call my CPA and ask what i’m eligible to contribute. sometimes its the max [$5500 in 2014], sometimes not.
perhaps we’re conflating traditional and roth.
What you’re doing is totally legit; this is not how I interpreted your statement: “after you max out your traditional ira or 401k, you can still contribute to a roth if you are under the income cap.”
The total limit with IRA’s -> $5,500 and 401k’s -> $18,000 (this year). Once you use the traditional 401k, you can still stash money in the IRA (if within the limits), but you can’t max a traditional IRA then switch to a Roth IRA.
One benefit of the Roth IRA for an early retiree is the tax free withdrawals up to the initial investment. If I put $50,000 in the account in 10 years, then decide to hang up my hat, I can immediately pull up to $50,000 out of the account. You can’t do that with your 401k. If there’s $25,000 in investment earnings, that cannot be touched without penalty before retirement age (and then, only if the account has been held less than 5 years).
I am in the boat of maxing out a 401k (traditional because I want my MAGI down!) and teetering on eligiblity for a Roth IRA. I didn’t realize I was here until after I put money into my Roth IRA last year, so I had to pull that money out without penalty, or leave it there and pay a ridiculous fee. If I had known about this issue, I could have put the money in a traditional IRA without the tax benefits (since I’m not eligible for them) and reclassified the investment as Roth. Some crazy back door thing, that I’m still unsure of, but I know others do it regularly.
The backdoor conversion is not as painful as it sounds. If you have an investing relationship with an existing provider, they can easily help you perform this without any issues.
I am approaching that income limitation as well. I choose to use my traditional 401k contributions to keep my MAGI in check instead of having to perform acrobatics to get some money into a Roth IRA.
I don’t personally agree with you conclusion but that being said, this is a matter of preference. I appreciate you sharing your preference and logic with us.
I think there are pros and cons to both a traditional and Roth vehicle (401k/IRA). The way I look at this argument is really with a risk management standpoint. I think we can agree that no one recommends investing all of your assets in one stock/mutual fund/ETF. Diversification protects us from unanticipated noise in the market. I believe this same concept applies to the vehicles one uses to save for retirement. I wouldn’t consider those who contribute to a Roth to be “gambling” but rather hedging against the largest retirement expense (taxes)without assuming that their tax rate doesn’t change in retirement. That is a very big assumption… what happens if someone needs to go to a nursing home? What happens if they have a bout with cancer? What happens if you develop dementia and require special assistance? Chewing up a traditional vehicle for these at the time you need the money could push you well into a different tax bracket. My final point on tax brackets is that believe it or not… we’re at a historical low for tax rates. Rewind 30 years, I would have been in a 38% marginal bracket vs. a 25% bracket. See http://taxfoundation.org/sites/taxfoundation.org/files/docs/fed_individual_rate_history_adjusted.pdf for the details on historical inflation adjusted tax rates.
All this being said, it comes down to preference and risk tolerance. I do not want to put all of nest eggs in one savings vehicle.
Ben, great link to the historical inflation adjusted tax rates. Agree with you 100%, the tax rates for 2018 is pretty much at an all time low historically:
Rate Individuals Married Filing Jointly
12% $9,526 to $38,700 $19,051 to $77,400
22% 38,701 to $82,500 $77,401 to $165,000
24% $82,501 to $157,500 $165,001-$315,000
32% $157,501 to $200,000 $315,001-$400,000
Right now I’m only investing in a traditional 401K, though my employer does offer both a traditional and a Roth option. I too decided I’d rather have lower taxes now as you never know what the future may hold.
Nothing you said is incorrect, but in regards to your argument about people who would benefit from a Roth (young, low income, negative savers) – do you think these people utilize any form of 401K/IRA in the first place, let alone about make a conscientious decision about which benefits them the most? I am young, a relatively high earner, and use both a Roth 401K and IRA, as I don’t ‘need’ the tax benefits now. This isn’t tooting my horn; more of a point that perhaps the title should have been “A Roth account is Overhyped for Certain People”
There’s also a segment of the population that makes too much money to deduct contributions to a traditional IRA and are stuck choosing between a standard brokerage account and a Roth IRA. The Roth is a no-brainer in that case! I’m in that situation now. Sure, I’d rather dump the money into a traditional IRA, but it’s not an option. Though I’ll admit that it’s a good problem to have!
One thing to point out is that the income limiations for contributions are effectively different. There are a lot of people who make too much to contribute to a Traditional IRA but can still contribute to a Roth IRA.
Another aspect is the more subtle difference between a Roth and a Traditional IRA. For a Roth you pay only on the contributions, NOT the gain on those contributions. Unless I’m mistaken, with an IRA you must pay on your withdrawals, so you need to pay tax on both the contribution AND the gain on those contributions. That difference could make a Roth better maybe even if your take rate is lower in retirement, if you have a sustained period of high growth between contribution and retirement.
Matt beat me to the punch on my first comment, but my second paragraph is still valid…
Valid, but I’m pretty sure G.E. accounted for that when he went through the math. Yes, Roth earnings grow tax free, BUT since they’re taxed up front, your initial investment is smaller than with a traditional. Let’s say you have $1000 (before any taxes) to contribute, are in the 25% tax bracket, and the investment gets 8% interest annually. With a Roth account, you are taxed $250, invest the other $750, and it grows to ~$7500 in 30 years. With a traditional, you defer taxes, invest the whole $1000, and it grows to ~$10,000 in 30 years. When that $10,000 is withdrawn in retirement, it’s all taxed. If the whole thing was taxed at 25%, you’d be left with $7500 (same as with the Roth). But, as G.E. mentioned in point #2, your initial investment with the Roth is taxed at the highest level. The withdrawal from a traditional would not all be taxed at the highest level, so the effective tax rate be lower.
Somewhat surprisingly, the numbers work out in total after tax savings in favor of the traditional over Roth (if you invest the tax savings). It’s not a huge amount (~2% over 35 years), but Traditional wins there too.
Can you give a little more detail on what you ran to get the 2% number? When I run my numbers (marginal rate ~22% and effective rate ~11%), I get more like a 14% edge for the traditional.
It’s true that you are taxed on the gains in a traditional and you are not taxed on the gains in a ROTH. However, something people usually overlook here is that if you are not maxing out both 401(k) AND IRA, you could have invested more money in traditional accounts, so there will be more money total if you go the traditional route.
For instance, let’s say someone contributes $10,000 to a Roth 401(k) and maxes out a Roth IRA for another $5,500. These are pretty respectable amounts. However, assuming they are in the 25% tax bracket, they could have invested ~$20,500 in traditional accounts vs the $15,500 in Roth accounts. Getting to invest an additional $5000 early in your career can result in very considerable money after 20-30 years invested. So even if you do have to pay tax on the earnings, your accounts grow a lot faster if you go the traditional route.
Now, if you are already maxing out both accounts, this isn’t as much an issue, but a LOT of people aren’t. And for those people, I would definitely agree that traditional is the best way to go.
bd, i’m not following your logic. it seems to assume that once you put your $$ in a retirement account you aren’t able to invest it as aggressively as in a regular brokerage account.
all my accounts roth, rollover, etc, save my 401k are held through a brokerage that allows me to invest in the same things as if it were a regular brokerage account. additionally, though my 401k is held at fidelity and my company has limited what funds i have access to, there is a product called ‘brokerage link’ that opens it up to manual investing. you just have to ask to sign up for it.
Zee, sorry for the misunderstanding. I’m not saying that you can invest more aggressively in one account vs the other. I’m saying that, keeping your take-home pay constant, you have more money to invest if you go the traditional route.
Essentially, the money you save in taxes today by going the traditional route could be reinvested, giving you a larger nest egg 20-30 years down the road. Yes, the gains will be taxed, but would you rather have $30 and pay $8 in taxes, or have $25 and pay $5 in taxes. In the first case, you pay more in taxes, but still end up with more money.
Hopefully this clarifies my previous comment. Cheers!
Nothing in this argument is incorrect, but it also makes the questionable assumption for most of the population that savings rate is a function of after tax take home pay. As GE has frequently pointed out, the savings rate for the average American is not impressive. Give the average American a $500 take home increase (due to tax break or whatever) and they may end up with more cable channels or a larger capacity iPhone, but I doubt they utilize the savings to increase retirement savings. And if they actually DID save it then I predict they have substantial personally savings like many of the readers of this blog and like me, stand to have noticeably higher after retirement income due to min requiremented distributions after 70-1/2.
Trent, this is exactly my sentiment. For me, I make decent money, I’m in a pretty low tax bracket and in my 20s. I’m a big saver, but a few hundred bucks is not going to go into retirement savings for me; I have everything moving on automatically and only adjust with raises and at certain times of the year. I’d rather just stick with the Roth because I do in fact feel like it’s more likely that my tax bracket will be higher in retirement. If that’s not the case, I won’t sweat ~2%.
Now what GE’s saying is totally correct from what I can see of his rationale, but since personal finance is personal…I have no qualms. I doubt he would be disappointed if a 20something chose to invest in a roth over a traditional…after all that’s a 20something whose saving!
As was mentioned above, the deduction phaseout for the traditional IRA is much lower than for the roth. While I agree that if you are in the 25% tax bracket you would be better off with a traditional IRA, what you will find is that the number of people who both:
a. Have a marginal tax rate of 25% or more, and
b. Have an AGI below the phaseout threshold for the traditional IRA
is actually quite small. In 2015, For a married filing jointly return, assuming a standard deduction and two personal exemptions, your AGI would need to be at least $95500 to be in the 25% bracket. The phaseout for traditional IRA deductions begins at an AGI of $98000. That’s a pretty narrow window. For single filers it’s a little wider: $47750 to $61000. Of course, if you itemize or have kids the window shrinks even further or becomes nonexistent.
I’ve posted on this issue before. I think the Roth is a nice forced savings vehicle if you have kids (or are planning to have kids) that will likely go to college. It offers far more flexibility than a 529, plus you have the gains (and, hopefully, compounded returns on those gains) stashed away for retirement. In a 401k vs Roth scenario, I think the 401k wins every time. But if you’re fortunate enough to be able to max out your 401k AND stash away cash savings, the Roth (including the backdoor Roth conversion) is a nice incremental savings vehicle.
One consideration I have made that I’m interested in feedback on:
I am maxing out my Roth IRA in my first two years of true savings in earnest in order to accomplish dual purposes: 1) I want to save for a home/potential student tuition/worst case emergency 2) save for future compounding.
If I need the money in the future for one of those major events, I can pull from my Roth IRA. If I don’t-I can continue to contribute and receive the rewards down the line. I like the flexibility the roth gives me in case of emergency or changing goals in the future to keep that 10k in a place I can get to it. Sure, I could put it in a savings account, but that’s not going to get me too far is it?
I think GE raises a good point about the benefits of a regular 401ks/IRAs, but I do not feel comfortable socking away money in an IRA long term when I personally had little liquidity beyond my emergency fund and short term goal savings at this time. I started at 0 savings two years ago, and have built up a true emergency fund, a decent 401k chunk, and now a growing Roth IRA.
I think after maxing out the Roth IRA a second time next year, and continuing to increase my current 9% 401k contribution, I will move towards pre-tax-only savings, but for myself, I appreciate the peace of mind that I can pull back from the Roth IRA in the near term if I need to (even if I hope not to).
I think that is really the major advantage.
Peace of mind.
I definitely yield the floor to GE on the fact that a Traditional IRA is a better option and I appreciate him pointing it out.
I’m personally trying to max out my 401K and a ROTH IRA. I get a good amount of pre-tax savings and still have a very liquid / “investable” account.
Great article GE and many of the comments have been great!
I am a financial advisor, and stumbled upon this website today. I think this is a truly good website for people looking for financial advise from what I have read so far. This article however (while not being inaccurate) is not one that I agree with. Retirement planning is more than just investing. There is no “one-size fits all” vehicle, and your plan needs to updated consistently over however many years you plan to work. For young savers the greatest reason to use a Roth IRA is the ability to withdraw your cost basis at anytime without a penalty or tax implication. For older investors the Roth provides tax security. They can control their taxable income in retirement for things like qualifying for senior benefits.
Sorry forgot to click notify me for follow ups so had to post again.
I might be in a small group when it comes to my situation. I’m in the military and contribute to the Thrift Savings Plan (TSP) which is the government’s 401(k) plan. Since I am active duty, I don’t get any match at all due to the possibility of retiring after 20 years (pension). I contribute the max and I also max out a Roth IRA. Now, one thing that I didn’t see in the article was comparing a 20-40 year account that is a Roth to one that is a Traditional 401(k) in terms of paying taxes on the full vested amount. With the Roth account, you just pay taxes on contributions now and get tax free withdrawals on those contributions and the gains (which over 20-40 years could be the majority of the account makeup due to compounding). With the Traditional account you pay taxes on everything, including the gains, which may be more than paying the taxes on just the contributions in the Roth case.
For example, if a 25 year old started this year and invested the max into a Roth 401(k), he would pay taxes on $18,000. After 40 years, he would have payed taxes on $720,000 that he contributed into his Roth account. In retirement, his account (assuming a 6% return) since day one would be worth $2,987,236. Assuming a 7% return, his account would be worth $3,937,220. And assuming an average of 10% returns, his account would be a whopping $9,486,119. With a Roth, I would rather pay taxes on $720,000 and enjoy millions tax free than have to pay taxes on $3 to $10 million with a Traditional account.
Great point, Al!
Great points, Al. I believe the Roth TSP is the best deal for most military servicemembers. A large percentage of military compensation is in the form of untaxed allowances or combat zone tax exclusion (CZTE) pay. With the Roth TSP you “pay” taxes of 0% now and then withdraw the contributions and earnings tax free in retirement. Definitely an amazing hack for life-time tax free investing.
I say max out the pre-tax account before you put anything into the Roth or post tax account.
But you make a good point that contributing to both can be a bit of a hedge on future tax rates.
I feel that the biggest variable is what congress will change our tax rates to whenever we’re retired. Even though it’s never fun to pay taxes, we’re historically in a very low tax environment. With a large national debt, will our tax brackets be much higher in retirement? Who knows. Many people choose Roth because they believe it’s better to pay the devil they know than the devil you dont.
Too bad we don’t have a crystal ball, then the decision would be much easier. :)
The deficit as a percentage of GDP has shrunk quite dramatically in recent years. Despite what some alarmists might say on this, the sky is not falling. Could rates go up? Perhaps. But for those who plan to make less in retirement than in peak working years, you’re going to be in a lower marginal bracket to offset any increases.
Incidentally, I think it’s inappropriate to characterize those who are concerned about the incredible expansion of national debt (from 10 trillion to 18 trillion) as “alarmists” particularly from someone who purports to promote prudent financial behavior.
That sort of ad hominem attack weakens your argument.
If I were a millenial today I would be extremely concerned about an 18 trillion dollar debt that will continue to be an anchor on the US economy that under less stressful circumstances is a tremendous engine of growth.
As a retiree with a satisfactory nest egg I will do fine and could just tune out. But I am very concerned for my son and ALL young Americans, and their children, who will be called upon to pay for the excesses of this and previous administrations who have been fiscally irresponsible.
The real problem is we have developed an elitist “political class” in Washington that worries mainly about re-ekection and is entirely decoupled from the common citizen who must pay the bills and feels increasingly helpless to change the course of politics as usual.
Without economic freedom, there is no freedom.
Good article G.E. A Roth IRA only makes sense to start off with for me, as I’ll (hopefully) never be in a lower marginal tax bracket. A deduction today won’t do much for me. A Traditional IRA would make more sense later. However, that Roth IRA, even if I only end up contributing a small amount now and do not add to it after, will have the most time to grow. Not being forced to take so much out is icing on the cake.
At the very least, in retirement I know I can use Roth WITH a traditional IRA if I have a major expense and would have to take distributions large enough to put me in a higher tax bracket, as that way only part of it is taxable income.
Another consideration is for high earners, if you make over $70k (MAGI) you cannot take any deduction for a traditional IRA contribution so Roth IRA is the way to go.
Nice work. My employer just started offering a Roth 401k this past year. My CPA wife and my trusted financial advisor both agreed Roth was always superior. I crunched the numbers back and forth on an excel spreadsheet. IF you take the money you save in taxes by going the traditional route and reinvest those dollars instead of spending then the traditional wins hand down for me. I have been looking for related articles for a while but yours is the only one that agreed with what I calculated myself. Thanks for taking the time to spell this our sir.
@Fatchance, you make good point about reinvesting the taxes. Many don’t do it, but it makes sense.
Have you considered the effect a Trad’l IRA distribution has on Social Security benefits? I’ve seen many of my clients save into their Trad’l 401ks in their 50’s at a 15% tax bracket to then pull it out in their 60’s at the same 15% tax bracket. To make matters worse….the additional income from their IRA caused their Social Security benefits to become taxable – where otherwise their income would have been low enough to receive SS benefits tax free. I call this the “double whammy”. Not only are clients paying 15% tax on their Trad’l IRA distributions…they’re also paying additional tax on their SS benefits. Roth IRA distributions, however, would not cause additional tax on Social Security benefits. And yes, we can debate whether SS will be there for us in 20-30 years. But let’s assume it will be….the Roth might be better.
p.s. Judging by the responses it appears you have (and likely will) create a decent amount of buzz by your article. I cringe to think your opinions/arguments were biased for that reason. But attacking the Roth is a bit like attacking religion (per your opening remarks). Going to draw some attention.
I’m still not sure of the math around your Traditional vs. Roth (~2% Traditional advantage vs. Roth) returns. Does this assume that you only have X amount of money to put towards retirement AND taxes? For example, does the scenario assume (making this number up) that I:
A) can put $1,000 in a Traditional IRA and only $750 in a Roth IRA (assuming 25% tax bracket)OR
B) can put $1,000 in either IRA (but would have to have $1,250 in order to put that in the Roth IRA)
I would assume the 1st scenario is where the Traditional IRA comes out slightly ahead of the Roth IRA (your example), but the 2nd Scenario is where a Roth would provide a benefit over the Traditional. The 2nd scenario would see the same exact amount invested, but the earnings AND contributions would be taxed in the Traditional (when withdrawn) vs. only the contributions being taxed in the Roth (when originally invested).
So in short, if you are able to max out IRA or 401k, it would be more beneficial to invest in a Roth vs. Traditional in the long run (assuming tax rates stay the same since we don’t know otherwise).
Great info but if a person wants to retire at age 55 (I’m that person), wouldn’t the Roth IRA be the better option since he can withdraw his contributions without penalty? Another great option for a Roth is using it for my kid’s college fund. I don’t think a regular IRA allows that.
Actually, there is a way to take early retirement without the ten per cent penalty. It involves taking equal payments from 55 to 59.5 years old. I am not exact on the details, but know that I can be done.
For anyone looking for more information about this, it’s called a 72(t) distribution. I’m sure the great Google machine can tell you everything you want to know about it :).
The real answer is not either/or, but both.
At 72, RMDs kick in. At current taxes, a married couple can spend and/or $100,000 per year to Roth’s at the 25% bracket. Look up tax tables to the top of what YOU are willing to pay for taxes.
Work backwards from 72 years old to your age, and divide by 2 for every 10 years. This accounts for growth. The Rule of 72 and assuming 7.2% growth are my assumptions. $1,200,000 can be converted to Roths from T IRA’S over the ages 59.5 to 72. For every ten years younger than 60 you are, divide that $1.2 million by 2. Ie: 50 is $600,000, 40 is $30 0,000, 30 is $150,000. Once your investments exceed the amounts you can roll over, you are better putting money into Roths.
My returns averaged slightly less than 10% so my doubling rate worked back by 7 year increments. HUGE difference in compounding and suddenly, my small savings added up.
Actually you have to take RMDs from IRAs and 401Ks once you attain 70-1/2. The exception is that you don’t have to take from a 401K until you stop working.
I agree traditional IRA’s are better, but with additional reasons. The amounts of the personal exemption and standard deduction are steadily increasing year by year, making more income shielded from taxes the older you get. At age 20, you do not know what the amount of the personal exemption and standard deductions will be at retirement, but we can assume that based upon past experience with inflation, that they will be substantially higher than they are now (shielding more income in the future.) At age 65, you and your spouse get an additional deduction, shielding more income from taxes each year from then on (also an additional deduction if either of you go blind.) In the event of a market crash that wipes out half or more of your account, with a standard IRA, you have lost only pre-taxed income, that then never gets taxed, if you use the money in the account before the market recovers, but you have received the benefit of the tax credit for the full amount invested. Particularly those who convert to a Roth closer to retirement, if your Roth takes a 50% hit, you are potentially losing after tax dollars, money coming right out of your own pocket. The only tax-free money is the gains, since you have already paid taxes on the amount deposited. Finally, a bird in the hand is worth two in the bush. I do not trust Congress not to change the rules relating to Roth IRA’s as they find out they need more money in the future. They will be very tempted to at least tax the “higher income” people with Roth accounts or with higher balances. People who diligently save for their own retirement, and do not depend upon the government, must be punished, don’t you know.
I agree that personal exemption and standard deduction will probably adjust with inflation. Marginal tax brackets will likely rise at similar rate. However, overall cost of living will also rise, meaning need for additional dollars to live on during retirement. The tax cost on taking these dollars out of 401k or Traditional IRA will most likely even out with the standard deduction/personal exemption.
I think a balanced approach makes sense, because there are so many unknowns in the future. Having savings in each taxable, tax-deferred, and tax-free provides for maximum flexibility in retirement. RMD’s can be a killer if all savings are done in tax-deferred accounts.
When using monte carlo simulations, the added flexibility of having a tax-free account to withdrawal from usually increases the likelihood that retirement goals are met.
One thing I would like to mention, putting money into a traditional ira/ or a traditional 401k reduces your AGI for taxes. It also allows you to qualify for earned income tax credit and also savers credit. Both of those credits are phased out at higher income levels.
This is a good point. In some cases, you may even be able to get your AGI low enough to claim the traditional IRA tax deduction. Many people see that deductions for traditional IRAs start phasing out at $61,000 and think, “well I make more than that, so I can’t take the deduction.” But, in reality, you can make $89,300 and still take a full deduction assuming you contribute the full amount to a traditional 401(k):
I think the biggest thing here is your second point (lower taxation). I make about 55K a year, am married, and live in SC. My marginal tax rate between state and fed is 22%. So let’s say that I invest equal amounts of money (out of pocket) into a Roth and a traditional IRA. So I am actually putting 22% less into the Roth, but it has the same effect on my wallet. To have nice round numbers, let’s say the Roth grows to 780K, and the traditional grows to 1M (same growth rate). Most of what I’ve read online makes it sound like these are worth the same amount, BUT THEY AREN’T. The 1M in the traditional will not be taxed at my marginal tax rate, it will be taxed at my effective rate (~11% right now). So in reality, that 1M is worth about 890K after taxes. I would have to think that my effective tax rate was going to DOUBLE in the next 40 years or so in order for a Roth to be a good bet.
Is there something horribly wrong with my numbers? I feel like the difference between marginal and effective tax rates are not usually mentioned, but the difference is staggering (even more than the 2% that G.E. mentioned above).
Let’s assume you have a mostly rigid salary (e.g. fluctuating tips, commissions, or bonuses aren’t a large enough chunk of your income for it to factor into your financial planning). With a Roth IRA, you know exactly how much money you’ll have to invest into other vehicles each month after putting $ into it. With a traditional IRA, unless it’s automatically deducted from your paycheck, you won’t get the money back into your pocket to reinvest until you file taxes. So you’d still be investing the same amounts during the year, but getting a larger refund later, which you can reinvest once a year, delaying additional investments up to 16 months (depending on when you invest, file, and receive your refund).
GE, does this factor into your calculations? That if you’d take advantage of a traditional over Roth IRA by investing the tax savings today, the investment is delayed, and therefore returns are diminished?
When one retires, their taxes on social security are determined by their provisional income- i.e. funds from traditional IRA’s, Pensions,401k’s , etc. If one’s provisional income is over the threshold (Somewhere around $40,000) then they are taxed on their Soc. Sec. etc, and the both the tax brackets and amount of Soc.Sec. Deemed taxable change as their provisional income goes up. Roth payouts do not count against provisional income. I realize you are writing for a different demographic, but I am now minimizing my 401(k) to the match only, and moving to the Roth while I can. The real question is “Do you honestly think your personal tax rate is going to be less in the future than it is now?” The answer to that in my reality is NO. Thiswas a well argued post and I am going to follow you, to calibrate and challenge my thinking.
I invest the max in my 401K and the Roth. Tax free income is very appealing along with no mandatory RMDs for the Roth. The 401K will be converted to a rollover IRA so I get the best of both worlds.
The Roth is an amazing savings tool. I don’t really feel like going through hypothetical calculations but here a few points of interest.
1. Growth is tax free. Setting your time-frame at 35 years is all well and good but the reality is that most people will be annuitizing their retirement plan and not taking a lump sum at exactly 35 years thus they will have many more years past 35 to have their earnings grow tax free.
2. Your tax rate isn’t likely to be higher: Yeah obviously there is no way to predict that so your point has merit. However, marginal tax rates are at one of the lowest rates in history. I am fairly certain it won’t stay that way (https://www.savantcapital.com/uploadedImages/Savant_CMS_Website/Blogs/Sample_Blog/US-Income-Tax-Marginal-Rates.png).
3. Estate planning. Sure if you’re someone that plans to leave nothing to kids/grandkids that’s your right and more power to you for bringing your assets down to zero at the exact moment you die. If you are someone that wants to leave something to children, a tax free asset that will continue to grow tax free (with current legislation) is such an amazing inheritance.
4. No RMD on Roth IRAs. The government (right now) won’t force you to take out savings so they can restrict your tax free growth and legacy asset.
5. If you take Social Security before FRA and are withdrawing from your IRA those social security benefits could be taxable, whereas with a Roth there would be no AGI increase.
6. You can contribute after 70.5 as long as you have earned income.
7. Increasing your different tax buckets opens up strategies in regards to withdrawals. It’s never a bad idea to have options.
8. I can’t stress enough how important of a tool it is for estate planning. With the exception of life insurance it is one of the best if not best estate planning tools out there.
In the end, agree to disagree. I just think you are doing many people a disservice by not having a counter “Traditional is the devil vs. Roth posts”.
Thank you for your excellent blog. I love your work,
Interest points, GE. I contribute to a Roth for two main reasons:
1.) I have the ability to save more now by maxing out a Roth 401(k). I.e. $17,500 (already taxed) >> $17,500 (pre-tax). If I couldn’t max out my 401(k) contributions, this would be a negligible point.
2.) To diversify. My company only introduced Roth 401(k) options in 2013, and due to my tax bracket I cannot currently contribute to a Roth IRA (Traditional only). As a result of these factors, much of my savings is tied up in traditional 401(k) and IRA funds. I look to hedge my tax rate risk in retirement by balancing retirement funds across tax deferred and Roth contributions.
Ideally I will be able to leverage my mix of taxed retirement funds to minimize my marginal tax rates in retirement. I don’t know what the tax code will be in 2050, so a little diversification should provide great upside opportunity and minimal downside.
Your second point is spot on and exactly what I was going to comment on. We don’t know what the tax rate is going to be in the future, but we can hedge on it by mixing roth and traditional plans and decide later which makes sense to withdraw from in retirement.
Thanks for your comment.
I also favor the traditional I.R.A. for the same reasons as G.E., plus you get a larger personal exemption at 65, or if you or your spouse goes blind, which will shield some of the income. The amounts of the personal exemption and standard deduction also increase every year, which shields more and more income. Other losses may offset the income when withdrawn, e.g. up to $3,000/year in capitol losses, whereas, you are being taxed on every dollar now, with the Roth. I do not trust Congress to not change the rules, as they need more and more money and they see those Roth accounts just lying there, not generating any tax money. I could see new rules in the future punishing “rich” Roth account holders with some sort of tax on their wealth. Punishing the “rich” is very popular.
The main thing, however, is to try to maximize contributions to one or the other every year, starting as soon as you have earned income. (At least invest something in an I.R.A. or Roth every year.) There is nothing like the Government leaving you alone for 45-50 years and letting your money grow without a large (any) portion of it being raked off in taxes, while it is accumulating in the account. That is your best opportunity to have enough money to live on in retirement and to possibly retire early. It is a lot easier to grow wealth if the I.R.S. is not constantly grabbing its “share.” Particularly, those earliest dollars invested are the most important in accumulating wealth over the long term, the double-whammy of compounding plus the earnings not being taxed until withdrawal, or at all in the case of the Roth.
I think you missed the most important reason why ROTHs are overrated and are less beneficial than traditional IRAs. (Some of your points are valid but the bottom line….) Should I invest a few thousand in a ROTH or the traditional IRA? My few dollars that could go into a ROTH (the limits are such that you would have to contribute for many years to have much of anything!) will earn less that the traditional. Consider $1,000 invested both ways. $1K invested in a traditional IRA means you save the 10-15% taxes on that amount now or the year in which it was earned and that extra amount can be invested…imagine, you are investing government taxes (or would be taxes on that $1K) over a long period before you pay taxes when you withdraw some (many) years later when it has an opportunity to really grow. The Opposite would be to pay the taxes first then get an ROTH. Your money will be less now and when you take it out or cash in the ROTH than the IRA, much less. Here’s the math—of the $1K in a traditional IRA, at 15% tax bracket, you are putting in $850. That total of $1K multiplied over and over again earns you money on the government’s 15% every year in addition to the $850 you put in. BUT YOU ONLY PAY 15% ON IT111. When you take it out, assuming you pay 15% in taxes on all of it, the governments’s 15% has also grown substantially and yet you only pay taxes on it at 15% rate.
I am not following how the two (theoretically) have different outcomes:
Traditional (using 1 dollar as basis) invested over years and doubling every so often:
32 x .36 = 20.48 any tax rate less and you win big.
Then look at the Roth with identical behavior (start with 64 cents after taxes)
20.48 = tax free — any tax rate lower and you are worse off
The doubling represents a growth rate. The important thing is that both types experience identical growth rates.
What factors do I overlook? Obviously, given the results of others giving traditional advantage, some other math occurs.
There are quite a few distinctions that make a difference:
1. No RMD — important if you are consuming your taxable accounts first
2. you can take out contributions if needed (not advisable)
3. can’t think of others
I came to a similar conclusion before I came accross your article. Another advantage I discovered is at the opposite end of the age curve. I am 68 and working part time. I originally thought it would be a good idea to start making Roth contributions on my reduced earned income after my wife and I became eligable again. After running some calcluations both ways I have come to a different conclusion. Just based on the tax savings from the Traditional vs Roth contributions it looks to be about a wash if I live another 25 years. However, one benefit I did not anticipate is that depending on your social security and other income the traditional contributions may reduce the taxable portion of your social security benefits. Another factor to consider, particular if your earned income is from self employment is the additional FICA/Medicare tax. Since you are still paying this on income used for the Roth contribution when you look at this along with possibly more taxable social security benefits the long term (whatever long term at age 68 is) tax savings on Roth contributions don’t look so great.
Getting as much $$$ into a Roth IRA as soon as possible so it can grow Tax FREE forever is a good financial goal. From age 10 (paper route, baby sitting or other earned compensation) to graduating from college when you will want to minimize your AGI/MAGI is a no brainer. When you get into a higher TB (tax bracket) & need to reduce your AGI/MAGI then using tax deferral via a 401k/403b/457 is appropriate. In addition to the max deferral you get from a 401k you can also get $$$ into a Roth IRA via contribution or Back Door Roth and that $$$ will grow Tax FREE forever. In a 401k you can ONLY invest in mutual funds that your plan allows. In a Roth IRA you can invest in indivisual stocks, ETFs, REITs, and mutual funds. If you are conservative and invest wisely the POTENTIAL for growth in a ROTH IRA is greater than in a limited investment scope 401k.
GE: Side note on Back Door Roth (BDR). #1 A BDR is completely legal. There is NO IRS regulation that prevents a BDR and NO IRS regulation that can be pointed to that can result in a fine, tax, or other financial loss. Obama presented a request to congress to close the so called Back Door Roth Loophole. [ http://www.cnbc.com/…/obama-may-end-back-door-roth-ira-conversions.html ]( Note: It is not a loophole it is a legitimate way to get $$$ into a Roth IRA for high income earners.) You can only have a recommendation to close a Loophole IF the Loophole is ALREADY legal. #2 When the Roth IRA was first put in place people were contributing to a traditional IRA and then converting the contribution to the Roth IRA (i.e., the BDR) to get around the 10% penalty (pre age 59.5 withdrawal) for early withdrawal from the traditional IRA, so they could withdraw from the Roth IRA WITHOUT the 10% penalty. The IRS did not like this and proposed to Congress that a new ‘5 Year Rule’ be put in place on EACH conversion so people could not use that Loophole (again not a Loophole just smart people taking advantage of the existing IRS rules.) So the BDR has always been legal and did not become popular until 2010 when the $100K income limit on conversions from IRAs (under TIPRA) was removed. [Congress wanted more tax $$$ so they made it OK for high income earners to convert as much $$$ as they wanted.]
What about people that are over traditional IRA limits but under Roth IRA limits? If we cannot make a deduction, would it not be better to contribute to the Roth?
I think the premise that you will have more money to save with a Traditional 401K is theoretically true, but it doesn’t work out in practice. The folks who will benefit from the difference, i.e. lower earners, only put enough money in to hit the match maximum. I run payroll at my company, so I see the behavior. I think of the Roth as enforced savings (as paying now saves taxes later) which is super helpful for most people, though not most people who interested in this blog. And in that case, they are still hedging because the match goes into the traditional 401K.
I was skeptical of the 2% difference so I ran my own numbers. Please check my math.
Let’s say you start with $5,500 you want to invest in either a traditional or Roth IRA. Let’s also say you’re in the 30% tax bracket, you accrue 8% interest for 30 years, and at the end you’re still in the 30% tax bracket.
$5,500*0.7 = $3,850 due to the current 30% tax. I ran this # through a bankrate compounding interest calculator to get $38,741. This will be tax free distributions at the end of the 30 year period.
$5,500 through the bankrate calculator (30 years, 8%) yields $55,344. Now we get the 30% tax: $55,344*0.7 = $38,740.80, a difference of 20 cents over 30 years in favor of the Roth! (Actually, they should be identical, I think this was a rounding issue in the bankrate calculator)
Here’s where it gets dumb, the IRS allows $5,500 per year in either Roth or Traditional, your pick. Let’s say you had extra cash and put $5,500 all in the Roth. At the end of the 30 years, you have all $55,344 in tax-free distributions! Roths have a hidden higher contribution amount because of this fact. G.E., you’re my man, but I have to agree with Father Finance on this one.
I disagree with the poster of the article because human behavior works much differently in reality.
Currently, we save as follows:
Me: $19,000/year into Roth 401(k).
Wife: $25,000/year into Roth 401(k).
Me: $6,000/year using Backdoor Roth IRA.
HSA: $7,000/year (family amount).
Here is how the math works. We will have a TON of money.
The reality is, no one ever gets to retirement and says they wish they had less tax free money and more in Traditional. It just doesn’t happen. People state repeatedly they wish they had saved more in Roth.
The poster leaves out the following things you need to also consider:
1. The Traditional savings impact on Social Security taxes.
2. The Traditional savings impact on Medicare Premiums.
3. You may think you will be in a lower tax bracket in retirement, but for those of us who are married, one spouse will almost always die fore the other, meaning you will then be filing your taxes as a single and thus, your tax rate will not be as low as you thought it would be.