Disadvantages Of The ROTH IRA: Not All Is What It Seems

Passed Out Drunk Vomit Oozing From Mouth For years I’ve been an opponent of the ROTH IRA after the government came out with its tricky dick way to let us all do a “one-time” conversion from our traditional IRAs. The government was so successful in getting people to pay huge sums of taxes on their IRAs during the financial crisis that I just shook my head in disbelief.

As a personal finance blogger who wants to help you achieve financial freedom sooner, rather than later, it’s my duty to write this post to help you see the error in contributing or converting to a ROTH IRA if you have not maxed out your 401(k).

Of course if the choice is between NOT SAVING and saving via a ROTH IRA for your future, then the answer is that one should open up a ROTH IRA rather than piss their money away on stupid stuff that depreciates in value. However, do know that you are still pissing money away by giving some of your money to the government. And if the choice is between choosing a traditional IRA over a ROTH IRA, choosing the traditional IRA is hands down the way to go.

Please read the reasons why a ROTH IRA is not a good idea for the large majority of you. I really hope this article will wake you up to the tremendous government brainwashing that is being conducted to get you to part more with your hard earned money. If you’re still in favor, at least you know the other side of the story and Uncle Sam thanks you!

DISADVANTAGES OF A ROTH IRA – NOT ALL MILK AND COOKIES

* The government is inefficient. I’m all for patriotism, but if you think the government is efficient with your money, then you are simply not paying attention to the enormous budget deficits on a state-wide and country level. By participating in a ROTH IRA, you are paying your taxes up front, thereby giving the government more of your money to waste! Would you give an alcoholic a beer? Would you give a drug addict some meth? Would you eat a double cheeseburger in front of an obese person who is trying to lose weight? No, no, no! There is a reason why there are $2,000 staplers and $10 staples in the government bureaucracy! Why do you think the Social Security system is so underfunded? The government wastes your money, so don’t give it more.

* The government is smarter than you. The government realizes people are bad with their money, which is why they set up a withholding tax system to make sure people pay throughout the year. If it was up to everybody to pay their year-end taxes at the end of the year, all hell would break loose because people are not disciplined to put money away to meet their obligations!  The country would go into instant default. As a result, the government has pushed propaganda on the masses to get them to pay MORE TAXES UPFRONT, hence the introduction of the ROTH IRA. They will spend millions on marketing to highlight why converting to a ROTH and participating in a ROTH IRA is a great idea. Yes, it’s a great idea for them, not for you!

* You allow asymmetric reward or punishment between equals.  Not everybody can participate in a ROTH IRA. Only those fortunate enough to make less than $105,000 a year/$165,000 for married couples (it’s always changing). After making more than $122,000 a year for singles, you are shit out of luck!  No soup for you. Sorry, but the government doesn’t believe you have the right to save in this way. Discrimination is not OK, just because you aren’t being discriminated against. We need to fight for equality for everybody!  The income cap for contribution is too low. The irony is, the government is actually saving people who make more than $105,000-$122,000 a year from paying more taxes and getting tricked into entering the Borg. Unfortunately, there are income limits for contribution on an IRA as well, which are even more egregious at around $66,000 for single filers.

* The math is the same whether you pay now or later. Whether you pay taxes now and let your investment grow tax free, or you let your pre-tax investments grow, and then tax it upon retirement results is more or less the same! Don’t believe me? Do a calculation yourself. Here’s an equation: Y = A * B.  Re-arrange to A = Y / B.  Or Y = A * B is equal to Y = B * A.  Trust me, I was a rock math star in the 2nd grade!

* What will $5,000 do for your retirement? A max contribution of $5,000 a year isn’t going to get you to the promised land. If you are already maxing out your 401K (pre-tax contribution up to $17,000), and you are eligible for a ROTH IRA maximum contribution for a single filer ($105,000 income or less), you probably will get more out of spending your $5,000 on life now. I am a big proponent of aggressive savings, however, if you are only earning up to $88,000 a year in gross income after maxing out the 401K, I’d rather you not tie up that $5,000 in a government savings vehicle until 59.5. Spend it, save it in your own investment account, or keep it liquid.

* You may never reap the fake rewards. Let’s say the math wasn’t the same, and you continue to contribute to your ROTH IRA because you believe in the tax benefits. Unfortunately, you die at age 59. You’re screwed! All those taxes you paid upfront to the cunning government, and you’ll never once get to utilize the returns on your ROTH IRA. What a shame. Guess what? Over those 37 years, the government has happily spent your tens of thousands of dollars on themselves. That makes me sick, and it should make you sick as well. But maybe not, since you are a patriot.

* Withdrawal penalty. The are no withdrawal penalties for the after tax money you contribute to your ROTH IRA. However, if you decide to withdraw money that has been earned from your after tax contributions, then will be penalized by 10% + your normal tax rate. For example, if you contribute $10,000 to your ROTH IRA and it grows to $15,000. There is a 10% penalty on the $5,000 + your normal tax rate.  Just don’t be naive to put it past the government to one day tax your after-tax ROTH IRA contributions again upon exit. Look at Social Security, for example. They raised the base case age for full retirement from 62 to 67 for those born after 1960!  That’s five long years more one has to wait to receive full SS benefits.

* You chop off your legs and fingers. America is a free country where we can relocate at will. If you live in one of the 43 States where there are State income taxes, then it behooves you not to pay more State income taxes. In California, our state income tax is 8-10.4% and we’ve got a huge budget deficit!  There’s no way I’m giving 10% of my hard-earned retirement income to the politicians up in Sacramento to waste. Instead, once I retire, I plan to move to one of the 7 no income-tax states (Nevada, Washington, Wyoming, Florida sound reasonable), and avoid paying 10% state taxes altogether. You have the power to save on taxes just by moving.

CHOOSE THE TRADITIONAL IRA OVER THE ROTH IRA WHILE MAXING OUT THE 401K

If you are a recent college graduate who is at the beginning of their earnings power, then choosing to participate in a ROTH IRA is less egregious than someone who is older and makes more money (up to ~$122,000). It is a good assumption you will make more money in your 30’s, 40’s, and 50’s than in your 20’s and therefore pay more taxes as a result. However, even though you are in the lower tax bracket and assume to make more, go with a traditional IRA and never give more money to the government than you need to.

Do the math. Let’s say you make $50,000 a year and contribute to a ROTH IRA.  At $50,000, single, with no deductions, your Federal Tax bill is estimated at around $6,250, equaling an effective tax rate of 12.5%.  However, you are squarely in the 25% Federal Tax bracket.  Let’s say you are hot stuff now and make $100,000, the very income edge of where you can still contribute to a ROTH IRA. Your Federal Tax bill is now around $18,900, or an effective tax rate of 18.9%. You are in the marginal tax bracket of 28% now.  What’s your saving?

Your savings really is nothing, because it’s not about moving up and down the Federal Tax Brackets. It’s about what you think future tax rates will be at for income levels below $105,000, since any more and you get phased out and can’t contribute completely after $122,000! The $122,000 and below income level for single filers is the protected middle class where no politician dare assaults. The middle class is what puts politicians in office and therefore, taxes will unlikely ever go up for this income group!

To humor you, let’s do the math anyway. $5,000 X (18.9%-12.5%) = $320 “savings” or $5,000 X (28% – 25%) = $150 “savings” per year. If these savings were real, they would be somewhat meaningful, but not really.  This math is absolutely wrong and therefore, the “savings” is irrelevant.

Final Important Point: If you are a middle income person who generates $122,000 a year or less for your entire life, and is therefore able to contribute to a ROTH IRA, do you really think when you retire, your income will now be more than $122,000 a year, putting you in a higher income tax bracket during withdrawal ceteris paribus? Be realistic. At today’s 10-year risk free rate of ~2.9% (as of 1/18/2014), you need $4.3 million dollars to generate $122,000 a year in income!

2014 INCOME TAX BRACKET – GIVE ME MORE OF YOUR MONEY!

2014 Income Tax Bracket

You never want to give the government more money than you need to. We are all idealists in college and just out of college.  However, once you start paying attention to what’s going on up in the various State capitols and in Washington DC, you will realize how manipulative our politicians are. If allowed, the government will take you for all you’re worth.  Power is addicting and you must help fight Capitol Hill’s addiction by holding on to your own money.

You know what’s best for yourself. You have the power to make a good living. Don’t be fooled by the government and administrators who want to make money off of you. Fight on and open your mind!

Recommendation For Increasing Your Net Worth

The best way to build wealth is to get a handle on your finances by signing up with Personal Capital. Be the captain of your own ship. They are a free online tool which aggregates all your financial accounts on their Dashboard so you can see where you can optimize. Before Personal Capital, I had to log into eight different systems to track 28 different accounts (brokerage, multiple banks, 401K, etc) to track my finances. Now, I can just log into Personal Capital to see how my stock accounts are doing, how my net worth is progressing, and where my spending is going.

One of their best tools is the 401K Fee Analyzer which has helped me save over $1,700 in annual portfolio fees I had no idea I was paying. You just click on the Investment Tab and run your portfolio through their fee analyzer with one click of the button. Their Investment Checkup tool is also great because it graphically shows whether your investment portfolios are property allocated based on your risk profile. There is no better free online tool that has helped me stay on top of my finances more than Personal Capital. It’s important to aggregate all your accounts to get an entire overview of your net worth to make proper changes. It only takes a minute to sign up.

Updated as of 2014

Regards,

Sam

Sam started Financial Samurai in 2009 during the depths of the financial crisis as a way to make sense of chaos. After 13 years working on Wall Street, Sam decided to retire in 2012 to utilize everything he learned in business school to focus on online entrepreneurship.

You can sign up to receive his articles via email or by RSS. Sam also sends out a private quarterly newsletter with information on where he's investing his money and more sensitive information.

Subscribe To Private Newsletter

Comments

  1. Jeremy says

    Unless you are making less than $59,000 MAGI a year, Traditional IRAs are, to put it bluntly, absolutely terrible. You wind up paying taxes on the front and back end.

    You also are insistent on maxing out a 401(k), when that makes absolutely no sense prior to maxing out an IRA. There are many IRA accounts available with no fees, where you will likely be paying 1%/year on a 401(k).

    Also, if you are trying to maximize your tax savings, you can have a much larger effective tax advantaged Roth IRA than you can a Traditional IRA ($5,500 after tax money is worth more than $5,500 before tax).

    The order you should be going in is as follows:
    Maximize Employer Match
    Max out Roth IRA
    Remainder to 401(k)

    For illustration, we’ll do an example. Somebody makes $50,000 per year (we won’t bother figuring in raises). Lets say we determine $10,000 of that is available for retirement. Assuming your employer does a 50% match up to 6%, according to you, you should simply just put all $10,000. You will wind up with $11,500 invested each year. Knowing the stock market averages about 10.5%, you should make about 9.5% per year after fees. You will wind up with $40,000 taxable income per year (~$36,000 after tax and investment dollars), and a $4.445 million nest egg with taxable distributions (assuming 40 years).

    Instead, lets say you just max the employer match, then max the Roth IRA, then further pump money into the 401(k). To get the same ~$36,000 after tax and investment dollars, you can put $3,525 into 401(k) (+$1,500 match), and $5,500 into a Roth IRA. The $5,025 will grow at 9.5%, and the $5,500 will grow at 10.5% (no fees, remember). You will wind up with a $1.942 million taxable nest egg, and a $2.790 million nontaxable nest egg.

    So what is the difference?
    100% 401(k)=$4.445 million taxable distributions
    401(k) max match + max roth IRA + remainder 401(k)=$4.732 million, only $1.942 million of which is taxable.

    So Mr. Financial Samurai, even if the tax rate is only 15%, you just lost these poor investors $662,000 (after tax). Wow.

    Now, regarding Traditional IRAs. If you instead put $5,500 into a traditional IRA, you are left with $4,500 (+$1,500) for the 401(k). You will wind up with $2.790 million from the IRA, and $1.739 million from the 401(k), for a total of $4.529 million of taxable distributions (still higher than the 401(k) option, but still worse than maxing out a Roth IRA by a LONG shot).

  2. JC says

    Sam….many arguments here are saying the ROTH is better because your distributions are tax free and the traditional is taxed at income bracket. Well, what about the retiree who has most of her assets in tax free muni bonds? They will have a very small tax bill and hence low tax bracket. Therefore shouldn’t worry about traditional IRA distributions being taxed at say 10% vs. today’s income bracket of I’m certain much more.

  3. Justin Winters says

    I am no expert, but the government is GOING to get there taxes one way or the other. Correct me if I am wrong, but you are going to be paying taxes on a a traditional IRA or 401k when it is withdrawn and also can only roll your 401k to a traditional IRA to begin with but can be converted to a Roth IRA by adding the money into your income the year you convert it and will pay ordinary income tax on the amount rolled over. But would you want to pay taxes on that lesser amount vs in the future when you could possibly be in a higher tax bracket and with more money being taxed if you kept it in the traditional or 401?

  4. Ryan says

    I’m late to the party, but wanted to comment on such a strange post from you, FS. Certainly you make some good points in there that I agree with wholeheartedly (like the futility of converting Traditional to Roth). But other points just don’t seem to hold water. Here’s a few I would challenge you to reconsider:

    #3) Asymmetric Reward/Punishment – You seem to be suggesting that since not everyone can participate in Roth IRA’s we should boycott them and instead participate in Traditional IRA’s. But Traditional IRA’s are limited to an even smaller subset of the population, so, uh, … what was the argument again? I must have missed it.

    #4) The Math Is The Same Before and After – Well its only the same if your income stays the same and the tax code stays the same. I agree with you that our incomes will likely be lower in retirement but I fully expect the tax rates to be higher. Who can predict the net result? Not me.

    #5) What Difference Will $5000/Year Make? – The question you ask is easily answered. Compared to just filling the 401k, an extra $5k/year would increase your savings by over 28% and hence it would increase your nest egg by 28% if done over your investing lifetime. Not insignificant at all. And really this underestimates the impact since the 401k money gets taxed as it comes out while the Roth money does not.

    But you go so far as to recommend, for singles making $66k to $105k, that they should blow the money before putting into a Roth IRA??? (“you probably will get more out of spending your $5,000 on life now.”) Then you imply that the same is not true for the single making less than $66k because to them you say “CHOOSE THE TRADITIONAL IRA OVER THE ROTH IRA WHILE MAXING OUT THE 401K”.

    So in the first case, if I’m making more money and maxing the 401k that’s fine, stop there, after saving 17% – 26%. But in the second case I’m making less money and saving 27% isn’t enough, I should be saving 34% or more (($17.5k+$5k) out of $66k). Doesn’t make sense.

    You could had said “go ahead and invest the extra $5k, but do it in a taxable account”, which would have been a tough pill to swallow since it would mean giving up the ability to pull the gains tax free. Yet I can buy into the idea of having some money that’s accessible rather than tying it all up for decades. But the idea that I’d be better off blowing $5k than saving $5k goes against other posts you made which recommend an ultimate savings rate goal of 50%.

    For individuals in the $66k to $105k range who want to save more than $17.5k for retirement, the 401k + Roth IRA combo is universally accepted as the best option out there for the typical American. As a bonus, it provides you with two separate pools of money that are taxed differently. So when you retire you can decide where you want to pull from first to get the best tax efficiency. You’ve added tax diversification to your portfolio instead of trying to predict what Uncle Sam will be up to decades from now.

    When choosing between Roth vs. Tradition, I can agree that Traditional wins. But if its Roth vs. nothing then Roth wins every time. You are showing an unreasonable bias against the Roth.

  5. dasmb says

    Some good points. My feeling on the Roth has always been that if it’s really effective, we’ll see an increase in the sales tax.

    I think an argument might be made about effective tax rates on the young being far lower than effective tax rates for the old (due to mortgage and student load deductions as well as child tax credits), but that’s not too helpful in this case — I may have an effective tax rate of 18% because i’m so busy building a family, but if I make an extra $1000 I’m only going to keep about $600. Shifting savings from the 401k to the Roth is going to be taxed at that top dollar rate.

  6. Grace says

    Hello,

    I have a question for you all, I am a 44yo single mom of 3. I’ve been divorced now for a few years & to be very honest was left with pretty much nothing after everything was said & done. I am a waitress as a profession, I do ok but definitely dont make boat loads of money. My kids are also teenagers & really dont ask for much so I do have a little at the end of the month.
    My question is what would be the smartest way to invest that extra money & for how long?
    Would a Roth IRA still be a good choice for me even though I have no other savings?
    If so what should I invest monthly to yield the greatest return by retirement age?

    Thank you for your time : )

Leave a Reply

Your email address will not be published. Required fields are marked *