Although the Roth IRA is an important tax-advantaged retirement account, there are also disadvantages of the Roth IRA that are seldom discussed. This ends now in this article that I wrote during the Obama administration and have now updated during the Biden administration.
For years I’ve been an opponent of the Roth IRA. After the government came out with its tricky way to let us all do a “one-time” Roth IRA conversion from our traditional IRAs, I knew something was up.
The government was so successful in getting people to pay huge sums of taxes on their IRAs up front during the financial crisis that I just shook my head in disbelief.
With so much stimulus spending to fight off the global pandemic, I’m afraid the government will do the same thing. The government needs to find a way to raise taxes. And President Biden is on a mission to do just that.
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 more 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 all the disadvantages of the Roth IRA to keep an open mind. You can contribute to a Roth IRA if you are in the 24% federal marginal income tax bracket or lower. However, there are strong arguments as to be made why you shouldn’t contribute to a Roth IRA.
Disadvantages Of The Roth IRA
Here are all the disadvantages of the Roth IRA. For those of you who are in the higher federal income tax bracket, you should be especially wary of contributing to a Roth IRA. For 2023, the maximum Roth IRA contribution, if you are eligible, is $6,500.
1) 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? No .Would you give a drug addict some meth? No. 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 budget.
There’s a reason why there is at least $64 Billion in fudged Army accounting every year. Why do you think the Social Security system is underfunded by ~25% and will remain underfunded forever? The government wastes your money, so don’t give it more.
Due to the global pandemic, the Federal Government is unleashing trillions of stimulus money to help support the economy. As a result, the government will eventually come for you.
2) 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!
3) You allow asymmetric reward or punishment between equals.
Not everybody can participate in a Roth IRA. Only those fortunate enough to make less than $144,000 a year as an individual or less than $$214,000 for married couples can contribute the full Roth IRA amount for 2022. After making more than $144,000 a year for singles and $214,000 for married couples, you cannot contribute to a Roth IRA. 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. If the protests in 2020 have taught us anything, it’s that 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 the Roth IRA maximum income limit for contributing from paying more taxes and getting tricked into entering the Borg.
Unfortunately, there are income limits for maximum contribution to a traditional IRA as well, which are even more egregious at $68,000 for single filers and $109,000 for married filers. Talk about a low income level cap to contribute to a traditional IRA.
4) 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. But just so you know, the math also depends on the future performance of your investments.
Let’s say you pay $2,000 in taxes to contribute $5,000 to a Roth IRA, and that $5,000 miraculously grows to $1 billion dollars. Your total tax bill will be around $400 million dollars if you had contributed the money to a 401(k) or IRA instead.
However, don’t forget about the opportunity cost of the $2,000 that would have also grown as well had you not paid $2,000 in taxes up front. The $2,000 would have grown to around $400 million.
5) What will $6,000 do for your retirement?
A max contribution of $6,500 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 $20,500 for 2022), and you are eligible for a Roth IRA maximum contribution for a single filer ($144,000 income or less), you probably will get more out of spending your $6,500 on life now.
I am a big proponent of aggressive savings. However, if you are only earning up to ~$100,000 a year in gross income after maxing out the 401K, I’d rather you not tie up that $6,500 in a government savings vehicle until 59.5.
Invest your money in a low cost investment account like Personal Capital, the leading digital hybrid wealth advisor today. Or keep your cash liquid, especially now that interest rates are rising.
6) You may never reap the fake rewards.
Let’s say the math wasn’t the same. 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.
Speaking of losing out on all the contributions, make sure you get married before you die before hitting the age of Social Security collection. If you end up paying FICA tax for 40 years and then die single, the government gets all your Social Security benefits! Again, the government is smarter than you.
7) 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.
Related: The Ideal Age To Withdraw From Social Security
8) 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%-13.3% and we’ve got a huge budget deficit, especially due to 4+ months of economic lockdowns! 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.
See: States With No Estate Taxes and The Best States To Buy Real Estate
Choose The Traditional IRA And Max Out The 401(k)
Hopefully you now recognize all the disadvantages of a Roth IRA.
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 ~$144,000).
Your tax rate is low. You might as well save and make a bet that you will make more money as you gain more experience. However, even though you are in the lower tax bracket and assume to make more, make sure you at least max out your 401(k) first.
For those of you in a higher marginal income tax bracket, doing a backdoor Roth IRA conversion could very well be a waste of time.
Always Do The Math Before Contributing To A Roth IRA
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. This equals an effective tax rate of 12.5%.
However, you are squarely in the 22% federal tax bracket. Therefore, the $6,000 you are contributing to a Roth IRA is paying a 22% federal tax rate, not your effective tax rate of 12.5%. 22% is OK, but don’t forget state taxes.
Let’s say you are hot stuff now and make $129,000. $129,000 is the very income edge of where you can still contribute to a ROTH IRA as a single in 2022. Your Federal Tax bill is now around $21,000, or an effective tax rate of 17%. However, your $6,000 maximum Roth IRA contribution is paying a 24% federal tax rate.
You’re not really saving 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 $144,000. Over $144,000 you start to get phased out.
The $144,000 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! In fact, Biden has promised he won’t raise taxes for any household making under $400,000. Not bad.
Final Disadvantage Of A Roth IRA
You will unlikely make more in retirement than while you are working. As a result, you will likely be in a lower income tax bracket in retirement. Let’s crunch the numbers.
Let’s say you make $140,000 a year or less for your entire life. As a result, you are able to contribute to a Roth IRA. Do you really think when you retire, your income will now be more than $140,000 a year, putting you in a higher income tax bracket?
Be realistic. At today’s 10-year risk free rate of ~2.8%, you need $5 million dollars to generate $140,000 a year in income! And that’s before taxes! OK, let’s say you can generate a more realistic 4% annual rate of return. To generate $140,000 gross a year in retirement income would require capital of $3,500,000.
$3,500,000 is a more achievable amount of investment capital to accumulate in retirement. But if you look at the data, the average net worth in America is closer to $500,000. And worse, the median net worth in America is below $70,000 according to the latest global millionaires report.
Therefore, you will likely NOT make more in retirement than during your working years. Stop being delusional! Even if you received the average Social Security benefit of around $18,000 a year, you will likely not make more in retirement than while working.
If you have not maxed out your 401k, please do so before even considering contributing to a Roth IRA.
The Bloated Government
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 you. You have the power to make a good living. Don’t be fooled by the government who want to make money off of you. The more money you make, the more you’ve got to get into the tax savings mindset. There are people out there who actually pay a higher percentage of their income in taxes than they save. Shocking.
Fight on and open your mind.
Thanks to all the wonderful feedback over the years, I’ve been less dogmatic about the disadvantages of the Roth IRA. People should diversify their retirement savings for tax reasons. However, be aware of higher taxes under the new administration.
The Only Reasons To Contribute To A Roth IRA
Why I Never Contributed To A Roth IRA By Why You Probably Should
Opening Up A Roth IRA For Your Kids Makes Sense
Build Wealth Through Real Estate
In addition to investing in stocks and bonds through your Roth IRA, I recommend diversifying into real estate as well. Real estate is a core asset class that has proven to build long-term wealth for Americans. Real estate is a tangible asset that provides utility and a steady stream of income if you own rental properties.
Given interest rates have come way down, the value of rental income has gone way up. The reason why is because it now takes a lot more capital to generate the same amount of risk-adjusted income. Yet, real estate prices have not reflected this reality yet, hence the opportunity.
The Best Online Real Estate Platforms
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Both platforms are free to sign up and explore.
I’ve personally invested $810,000 in real estate crowdfunding across 18 projects to take advantage of lower valuations in the heartland of America. My real estate investments account for roughly 50% of my current passive income of ~$300,000 so we can live free.
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Disadvantages Of A Roth IRA is a Financial Samurai original post. I’ve been helping people achieve financial freedom sooner, rather than later since 2009. Join 50,000+ others and subscribe to my posts or free newsletter for more financial goodness.
I have to disagree on thinking a Roth IRA is not tax efficient. I use my Roth for aggressive stocks & mutual funds, while my regular IRA has less aggressive stocks/mutual funds.
In my situation, I started contributing to a 401K Roth in 2007 when my company first introduced it. The company match was always put into the regular 401K by default. 10 years later, I was luckily able to retire early at 50 yrs old. I ended up contributing overall $146K to my 401K Roth, and calculated that I paid an additional $36K in upfront taxes based on my yearly tax bracket (generally the 25% bracket). Now it’s 2021, and the $146K in my Roth has grown to $567K and I’m 54 years old.
Since I can’t touch my money until 59.5 years, let’s assume I wait 7 more years and that $567K will be worth about $1.1M (assuming the rule of 72) – all tax free. Now with the Roth money, I can artificially keep my AGI in the lowest tax bracket (10%) until Social Security & RMDs kicks in at 70\72 years.
If I had only contributed to a regular 401K, now that $1.1M is taxed at a minimum of 10% – which means that is $110K in federal taxes, plus probably another 10% in state taxes. So that comes out to $220K in taxes I would pay with a regular 401K. With my Roth IRA, I paid $36K in taxes upfront.
The only way a regular IRA would have been better is if the lowest tax bracket drops below 3% – which will never happen.
Sounds good. I hope your Roth IRA does double in 7 years. Although that seems aggressive unless you are 100% in equities and our bull market lasts that long.
Don’t forget to calculate what the $36,000 in upfront taxes could have grown to as well.
I think the Roth IRA is a good way to diversify your retirement income, but only if you are in a lower tax bracket.
“5) What will $6,000 do for your retirement?
A max contribution of $6,000 a year isn’t going to get you to the promised land.”
$6000 per year invested for 40 years at 10% will net you 3 Million. That’s nothing to sneeze at.
Personally, I am dividing retirement dollars between Roth and my simple IRA plan at work.
I make 70K and contribute 3% to the simple which is matched by my employer for a total of $4200. I then max out Roth IRA’s for my wife and myself for another $12,000. That’s about 23% of my gross income.
We have 280k combined in our Roths and 135k in pretax IRAS. Having both types of accounts allows me to diversify between stocks and bonds with the more aggresive investments in the Roth and the more conservative in the Traditional. This should help to lessen my tax burden later on.
Additionally, If the tax structure remains relatively similar, having both types of accounts to pull from will actually allow me to withdraw a significant amount of my Traditional tax free due to standard deductions. For instance in the current tax year If a couple filing jointly needs 100k, they can receive 35K from Social Security, withdraw 21k from a traditional IRA and 44K from a Roth IRA and they would owe no taxes. If the same couple took 35K from Social Security and 65K from a traditional They would owe about $8k in taxes.
Yeah I fell for the Gov’s whole propaganda about stressing the importance of establishing an IRA for retirement. But as I dug deeper there’s really no reason to do it in the first place. It’s my money and I should be able to access my investment portfolio’s as I see fit! Why the hell is the Gov even saying oh it’s in your best interest to save until you’re 59 ½. Otherwise be prepared to face a tax penalty. Like wth, what is up with this bs?
Life happens and I should be able to sell some positions and withdraw from my retirement portfolio as I see fit. To hell with still getting the same taxes taken out on top of an additional 10%. I also read somewhere that it’s 25% if you have an IRA for less than 2yrs and decide to close it!
Im already using two brokers for personal stocks and crypto. Atleast with these they have the exact same growth opportunities as an IRA would if you had the same positions in the IRA like you did with your personal portfolio. I basically treat my personal portfolio as my own personal IRA. It’s an investment for a reason. I’m not delusional in the least bit, I’m not day trading unless I see a stock has a chance to gain some substancial gains. Otherwise I’m already investing for the long term. No matter how you look at it in this case, an IRA just has way too many drawbacks. Plus I don’t like the fact that the Gov dictates that I’m a bad investor for withdrawing early, so now I have to pay an additional 10% tax on top of what I’m already getting taxed. Well to hell with that.
So now I’m facing this exact conundrum. I started using Stash strictly for ETF’s. They just seemed to have a better platform for long term investments with etfs, bonds, reits, etc. They created some of their own etfs for you to choose from. I like their stock back reward program. Plus I use it as my bank account, but namely as a sort of secondary savings account. I was planning to set aside 20% of my income to my main savings, 15% to my personal portfolio, 15% to stash as a secondary savings and for ETF’s. I may switch it around here and there. But essentially I am wanting to deposit $500 a month in Stash so I would get a decent amount in compounding interest rates at a 5% annual growth rate.
So when I first created my stash they automatically put my in the highest subscription which was only $9 and had all.the bells and whistles. Well they took it upon themselves to start me an IRA. Well I caught it or so I thought and switched to the basic subscription that’s only $1 per month. Well unbeknownst to me it set it on the mid their subscription that’s only $3 a month. But they deposited $45 towards the IRA! I’m not sure how the hell this even happened to be honest. I had already deposited $400 in the personal portfolio for my etfs. I was planning to slowly sell of my stocks from my other portfolio’s in Robinhood, etc. I figured this could take awhile as I already have a substantial amount in my positions with my other brokers. I’m in no hurry but was looking forward in using Stash.
Anyways I’m not sure how they just automatically deposited $45 in an IRA? Apparently I was set up for $45 per week reoccurring deposits. I stopped it immediately when I found out. Fortunately it only chosen 1 etf which I already own in my other portfolio. So it only made a 2 cent gain. But now I have to go through the headache of having to sell the positions in the IRA and close everything out.
I’m glad I caught it early and this was because I was alerted when they withdrew the $45 from my bank account. I did hesitate for awhile and thought to myself wth maybe I should have an IRA. But then logic dawned on me and I said hell no! I do not like the fact that I have to wait a quarter of a century until the Gov deems me worthy enough to touch my money. Plus If I would of been indecisive and waited too long I’d just get penalized even more. So better to stop it immediately and just pay the damn 10% on the $45.02 that’s in the IRA right now.
I’m liking Stash so far besides this whole fiasco. But I’m willing to leave it up to this being a mistake of my own doing. I may of did this unknowingly while I was getting familiar with the app. It is what it is, it’s just bs now that they are going to tax me on my own money. Income that has already been pretaxed that alone is enough for anyone to be alarmed about getting an IRA. So if anyone is up in the air about getting an IRA don’t!
Just get you a pretty decent diversified portfolio. Make sure to get you a few stocks you believe in, some etfs, bonds and maybe a few reits even. Either way if you ever want to sell your positions for any reason. You can do so without worrying about getting penalized. Be smart with your money, most of don’t be giving it away to the Gov by getting taxed upon being taxed!
Hey, I am 74 and saved most of my retirement funds in my 401K at work. I am pretty financially savvy, but really struck out on how much appreciation my investments had, so now I actually have a higher income than I had working and am still stuck paying taxes at levels ABOVE what I did when I worked. I think the 401K is a TAX TRAP. I agree wholeheartedly w/you that our government deserves NOTHING. It is hell trying to figure out how to pay fewer taxes. I live in Illinois like one of your commenters, and I have been considering what he says he will do, but if you are not careful you will jack your Medicare premium up and never get it down. I help all my kids and their significant others invest and I am having them utilize the 401 K, but ONLY to their company’s match and then MAX the measly $6 K in their Roth. But if I only had had my Apple stock (from 1999) in my Roth instead of my 401K life would be good. Maybe my kids will turn their Tesla into a windfall of sorts. If we didn’t have such corrupt unions and politicians things would be better. Good luck to everyone!
Roth IRA Kick in the Gut
I haven’t seen anyone mention the fact that if you are not rich enough to pay for years and years in a nursing home for yourself, to the tune of probably $200k/year in a decade’s time, out of your assets, then you will go on Medicaid. Double that if you have a spouse that needs assistance too. How many years of spending $400k can you afford?
Medicaid rules vary by state and most states considered IRAs “countable” (things that you have to spend down before going on Medicaid, even if it is your spouse’s IRA). However, currently there are some states that do not consider IRAs as “countable” if they are in payout (RMD) status. I can’t post links, so you’ll have to search for this info yourself. Currently only three states don’t consider you and your spouse’s IRA as countable even if they are not in payout/RMD status.
So here is the kick in the gut – you and your spouse’s Roth IRAs are NEVER in payout/RMD status and therefore (in most states) ARE countable assets that you have to spend before you can go on Medicaid. So a good chunk or all of your years of contributing to Roths and filling your tax brackets by back dooring into Roths will be for naught if you are forced to spend it on assisted living or skilled nursing care – which ~70% of us will for some length of time. Remind me again which states allow assisted suicide?
This is definitely a concern, but this is easily fixed. Regardless of your state’s rules, you can keep a $600 S&W .357 Magnum around in case you deteriorate to the level of needing nursing home care. POOF! You’ll still leave behind an inheritance for your heirs and save yourself years of suffering.
Not a good idea to say things like this in a world where a fair chunk of people can be clinically depressed. It would be a service if you would delete your comment, which might just move some marginal soul to make a very bad “momentary” decision.
Sam
One question- assume you max out your 401(k), but make too much $$$ to contribute to a Roth IRA or to deduct from your taxes any contribution to a traditional IRA. In this scenario, would you (1) contribute to a traditional IRA, and (2) if yes, would you convert to a Roth IRA (you already paid taxes on the contribution anyway). Thanks
Also curious about this. My understanding is if I am maxing my 401k and not eligible for the tax deduction for giving to a traditional IRA, I may as well contribute to the traditional and convert to Roth.
With this, I pay taxes now but can let it grow tax-free and withdraw without paying taxes.
Seems like a no-brainer.
Scott — I can give you my answer. Yes I would do a backdoor Roth IRA by contributing to a non-deductible traditional IRA then converting it to a Roth IRA. There’s an aggregation rule that applies which treats all traditional IRA as a single IRA. So if you already have an IRA with only pre-tax money for whatever reason (even rollover IRA which came from a 401(k) from a previous employer), the backdoor Roth conversion can have tax consequence beyond just the increase between the time you invested into the non-deductible IRA and the time you convert to a Roth. Not sure if I explained it clearly enough, but this link may help. https://www.kitces.com/blog/the-impact-of-the-ira-aggregation-rule-on-after-tax-distributions-roth-conversions-60-day-rollovers-rmds-and-72t-payments/#:~:text=The%20IRA%20Aggregation%20Rule%20And%20Roth%20Conversion%20Strategies,Roth%20conversion%20is%20treated%20as%20a%20taxable%20distribution.
My company recently started offering tax deferred retirement accounts, where we can contribute a large amount of after-tax dollars and then immediately convert to roth. I’m paying tax up front on that money anyway, but this allows me to put away a lot more money towards retirement that I can take out tax free. I’m planning to max this out. Even though I’m a high earner I also mostly did Roth 401k at my company this year. My husband maxes out his Solo 401k so we get that tax savings for pre-tax. Is there any reason to not max out the tax deferral account if we can afford it (and convert to Roth?) This and next year are prob going to be my highest earning years for a long while.
Hi – I am not sure about the Roth/converting during high earning years. I find there are two major factors at play here, only one of which most people account for. The first one is optimizing your income + conversions over your lifespan in such a way to minimize the amount that is earned/converted at higher tax rates. For example, one might only convert in lower income years. I recommend many clients create a low earnings period after retirement by deferring SS and use this period to convert traditional IRAs => Roths. In short, there is no easy rule of thumb; it takes some analysis. The other angle is the value of the extra tax deferral on obtains when converting to Roth due to no RMDs. The value of this can be significant, but most plans and software I see ignore it.
Upon reading your reasons, the biggest take away I am seeing is “The government might change their mind”. Well yes, they might come and take all our gold like the 1930’s. They might decide that all 401k retirement accounts are now part of Social Security and distributed equally. However you still state that 401k is the best. I contribute to 401k and Roth, and each have their advantages and disadvantages. I am single, and that is unlikely to change, so that is my viewpoint.
With a Roth, I can take out my contributions if I want (tax free) and I cannot do that with my 401k/IRA. This is a big one for me, as if I want to retire before 59.5 I can have an additional place to get money if I come up short/hit a bad market, etc. With a Roth, I can pass it to my heirs, 100% tax free (cannot do that with a 401k/IRA, and is subject to the whims of the federal inheritance tax rules). Yes the taxes and opportunity costs might make sense from what you are saying (I didn’t hyper-analyze them), but at the end of the day, sometimes you pay a little more for more benefits.
I don’t know, I think that 1/2 your arguments are spurious and speculative, and the other half might not fit due to the financial situation you are in (income, life expectancy, life goals, etc.) Take it with a grain of salt I guess .. as I do with every article I read.
Correct. Folks have got to do what’s right for them. And if they want to pay taxes up front, even at above a 24% marginal income tax rate, that’s great. The country especially needs tax revenue right now with so much of the economy closed.
It is good to diversify retirement funds. If you are maxing out your 401(k) and get to contribute to a Roth IRA, then I say why not.
I don’t plan to make more in retirement than while I was working. Therefore, I will be in a lower tax bracket. But I’m proud of those who will make more in retirement than while working. That is an incredible feat.
Incredible? Hardly. JeffD has already nailed the point of contention here. We’re blind to the situation of others. FS advice makes sense for a high income earner from early career, which isn’t most people (by definition of average of course). For average earners who are successful in their investments over a long period, they’ll be withdrawing in the highest tax bracket when they retire, and they’ll be forced into RMDs that they’ve no control over. Now you can say “who are these average pay folks who amass large amounts” and call this incredible. But it’s not incredible, and in fact it’s the whole damn point of investing. Sometimes I think the financial advisor industrial complex mentally socializes everything, so that following their advice tends to defeat the purpose of investing. If we all get similar returns, then I guess we should all focus on attaining the highest yearly income since that’s the remaining differentiator among us.
Screw that. My portfolio is 65 times my payroll income and I’m not 60 yet. Because, um … compounding? It could conceivably be 90 or 100x times in a decade or two if I’m lucky. What’s that? I’m not average? Right, but my income is and will always has been and will be. Assuming others fit our own demographic profile isn’t wise. At the low end it doesn’t matter (if and when low income = low motivation), and at the high end it may not make sense. But in the middle income ROTH often makes a lot of sense, though diversifying pre and post tax is good and likely necessary for most.
Here is link to JeffD’s comment. https://www.financialsamurai.com/disadvantages-of-the-roth-ira-not-all-is-what-it-seems/comment-page-5/#comment-425015
And one more argument for the Roth that may finally change some minds:
Social security benefit payments are subject to taxation. Your Federal taxes are based on your adjusted SS income which is calculated as your taxable income plus one half of your social security benefit amount. If you are married, filing jointly, then your tax is 0%, since Roth IRA distributions are not taxable in this particular formula (look it up). That means you and your wife can earn a combined $63,999 in social security benefits without any Federal taxes if your income outside SS comes solely from your Roth withdrawls. Since most states do not tax SS benefits, that would make your entire SS distribution tax free. Combine that with the fact that the Federal government is likely to soon tax income at pre -1982 levels, and you are looking at gargantuan savings from using a Roth vs other investment vehicles.
Hey Financial Samurai,
I think this is a cool article, while everyone might not agree, I love the different view point you give. Question for you. Do you see any disadvantages in using some of your Roth IRA towards the 20% down payment of a first home.
I’ve read a number of articles on financialsamurai over the years. Some I found insightful, some less so, but always fairly sensible, working with a well-defined set of assumptions and drawing reasonable conclusions. It is only occasionally that a link sends me (or reminds me) of these bizarre anti-Roth tirades. They’re bizarre because they are utterly irrational. I’m not arguing that anyone should contribute to a Roth IRA (I think there are plenty of circumstances where it’s the right move, but that’s irrelevant for the present purposes). They just make no sense.
You argue that Roth plans are both a poor choice, and also that the tax policy is unfair because that poor decision is only available to some people. Are Roth plans bad because they don’t make financial sense? Or as part of taking an ethical stand? And I’ve never seen the same logic applied elsewhere, like, “You could worry about avoiding short-term capital gains taxes. But you shouldn’t, because long-term capital gains rates are unfair! Only people with capital gains can use them!”
You argue that the government is bad, so you shouldn’t give them taxes early, they will just waste them! But hypothetically, you are giving the government more money with a standard 401(k) or IRA, because in the intervening years, you will invest that additional capital more wisely than the government, and so when it comes time to take their cut (at withdrawal), there will be more to take. Yes, assuming your marginal tax bracket is constant, the amount you see at the end will be the same.
One thing you definitely get with part of your retirement being in post-tax funds is the ability to withdrawal funds according to your needs, attempting to keep constant the amount of pre-tax dollars you take out in a year to minimize the overall tax burden, regardless of changing cash flow requirements. So there are benefits to the Roth.
I’m in late 30’s in 24% bracket (married, with kids), and thinking of doing a conversion to Roth while staying in 24% bracket. I’m in Illinois, which doesn’t tax IRA distributions (even if they’re converted to Roth). Tax rate here is 4.95%. I’m already maxing out 401k on both of our accounts. I’ve already contributed 20k to kids’ 529 – that’s the max that the state income tax-deductible. I’ve also had a grandparent contribute 2k to each kid’s Coverdell account.
My reasons:
1. Taxes are historically low
2. Feeble attempt to time the market
3. Possibility of using the principal if such need arises (eg purchase of new residence, etc)
Am I missing anything?
No. You’re correct. I’d add these as well.
4. It’s easier to convert at within a reasonable tax bracket with a lower balance than a higher balance in the future. For this reason, even if you aren’t at your contribution limit, Roth often makes more sense.
5. How much of your social security income will become taxable depends on provisional income and filing status. Some relatively low income people are in insanely high income tax bracket because of this.
6. Obamacare premium credit is a stealth tax based on income if you are interested in retiring before age 65. It effectively adds about 15% on top of your normal tax below 400% of federal poverty level. So a 12% tax bracket might turn out to be 27% tax bracket making your conversion cost more if you wait until you retire early.
7. Income related Monthly Adjustment Amount (IRMAA) causes some people to pay more for Medicare Part B and Drug Coverage based on income and whether you are single or married. Remember, even if you are married now, one of you may die at one point before the other. For the moment, the cost is about 5% but with Medicare cost rising, I suspect it’ll be closer to 7% in the next 15 years.
8. 3.8% Net Investment Income tax thresh hold is not indexed to inflation so it’ll impact more people down the line.
9. State income tax.
10. State and Federal estate tax
11. Stretched IRA is largely dead. If you die with a traditional IRA, the heir has to distribute the balance with 10 years in most cases. The same rule applies for a Roth but at least they won’t have a tax problem when pulling money out at a time they might be earning good money.
12. The math isn’t the same if you start maxing out the contribution limit. If you put $6000 into a Roth, you paid tax to get it in there. If you put $6000 into a traditional, the tax deduction you had must be kept somewhere which presumably will be in a taxable account thus will not grow at the same rate of return even if your tax bracket stayed the same at contribution and at distribution. Some idea applies to Roth 401(k) if that is offered to you.
13. The first two reason ranting against the Roth of government being inefficient neglects the reasons to offer the Roth to begin with. They want to give some incentive to invest. Many will invest in U.S. stocks which the companies are hiring people, growing the economy, and pay U.S. tax. With people saving for retirement, they will spend more or at least not need government hand out later in life.
14. You can invest in a Roth at any income if you use a backdoor option by investing in a traditional IRA first then converting it to a Roth.
15. Argument for deduct at marginal and pay tax at average rate is flawed because most people have social security during retirement thus you’re actually going from deducting at marginal to paying at marginal.
16. Many places have property tax breaks for somewhat lower income seniors. The income limit varies even within a state. Often you will get a discount and/or frozen assessment as long as your income is within a certain range and don’t move.
I’d lean Roth with maybe a small amount in a traditional for those reasons. Many people think they’ll be in a lower bracket some point in their career or at retirement so far, with all the stealth tax and incentive to keep income level low, their tax bracket is often higher than when they were working.
I must be missing something here:
“Let’s say you pay $2,000 in taxes to contribute $5,000 to a Roth IRA, and that $5,000 miraculously grows to $1 billion dollars. Your total tax bill would be around $400 million dollars if you had contributed to a 401(k) and had to withdraw!”
I thought there is no tax on investment gains in a Roth IRA? Roth costs more up front but if you invest wisely and grow that account the gains will vastly outweigh that early tax loss, whereas in a traditional IRA you have to pay tax on everything. That seems like a huge difference to me, what am I missing?
Yes, you’re absolutely right and this a reason one would contribute to a Roth.
Yes, gains from Roth IRA investments are tax-free upon withdrawal.
It’s the opportunity cost of paying $2,000 in taxes up front. If you didn’t, and invested the $2,000 like the $5,000, it would have grown to $400 – $500 million.
Her’es what sucks about ROTH IRA.
In a regular IRA, you pay no tax now (you write off the amount contributed) but pay tax when you take it out.
In a ROTH IRA, you pay tax now and then the govt says you won’t have to pay more tax later.
The problem is, the government needs to steal your money to pay for welfare. What’s to stop them from double-taxing you by deciding in the future to steal part of your ROTH IRA?
At least with a regular IRA you get the benefit of the tax write off now, when you probably have a low or moderate income and need that tax savings. With a ROTH IRA there is no guarenteed tax benefit, since the govt can change their mind on tax schemes.
Don’t think they won’t do it, either. As soon as the dollar collapses or govt defaults on their debt or something else terrible happens and they need to steal more money, they will rob retirement accounts and probably bank accts as well.
I think you meant to pay for the military & subsidizing insurance companies. Please look up a government spending chart somewhere credible so you can educate yourself on where tax payers money actually goes.
FACTS!
Uh, pay for welfare? Apparently you don’t have the slightest idea where most of our tax dollars go. I’ll give you a clue: it ain’t to “welfare.”
First off I just discovered your site and really enjoy it – great work! I may not represent the situation you are describing, but I view a Roth as both a bet on myself (having high income in retirement), and a hedge against more progressive tax policy in the future. Am I off-base with this thinking?
I am a 30 yr old above-average earner who maxes out Roth 401k, plus the max allowable after tax contributions ($9k) w/ in-plan Roth conversion. I also max out Traditional IRA w/ Roth conversion (above the income limits for Roth contributions). I am also maxing out my company’s ESPP (~$8k), contributing to a 529 (I am the beneficiary until I have kids) and I have a modest taxable brokerage for some riskier conviction plays. I am also lucky to have a great pension plan at work, a high income earning wife, and a great company 401k match (5% of salary which will increase to 10% in a few years). Should I be diversifying my tax liability?
Matthew – You seem to be making good decisions and this probably explains why you are in such a good situation overall. Well done. I agree with your views and generally do not *diversify* tax liability. Speculative perhaps, but I advise and allow clients to chose. The only things I see missing from your statements are (1) the value of extra deferral a Roth can provide (no RMDs) and (2) the higher effective contributions you can make via Roth vs traditional ($X post-tax in Roth > $X pre-tax in traditional as it will eventually be taxed). Hope that helps, but wishing you continued prosperity!
If you retire early like I did at 48, you can Roth convert a big chunk of money from your traditional IRA every year into a Roth IRA. In my current tax situation, I am able to do this and pay $0 state and Federal taxes. Most people could do this paying at most 10% in taxes. Having the right balance between taxable and non-taxable investments while I was working is what has allowed me to keep my taxes so low. Developing a tax plan for your future is more than half the fun of investing!
I am totally baffled by this post. When you systematically contribute towards retirement, the overwhelmingly large part of your balance at retirement is GROWTH, not the piddly principal you have put into the account. I think maxing our your Roth 401K is best, followed by doing Backdoor Roths. In this way, the 95%+ of your account that is due to the growth in capital is tax free in retirement.
While the dollars you’re investing do have a high opportunity cost since they’re after tax dollars, I still think you come out WAY ahead because of all the tax free growth. Plus if you build up other non-retirement investments (think rental properties, non-retirement mutual funds, etc.), you also don’t have to take required minimum distributions.
To Sam’s point about dying before age 59 1/2, in that case, your heirs have a stepped up basis. They can liquidate tax free at your death, or they can reset the basis of the mutual funds.
What am I missing here?
Thanks,
BR
The key value of the Roth is for “average” earners who start their retirement savings in their early 20s. They will very likely be in a lower tax bracket while making their maximum contributions each year in their early career, and almost certainly be withdrawing in the highest tax bracket by the time they retire. In that case, traditional IRA or 401(k) contributions can leave a person “poorer” than they otherwise would be. Who is to say that the top brackets will be well north of 50% in the near future, like they were before the 1980s?
I am with you on your assessment. I’d rather pay taxes on ~5% of a Roth 401k account due to contributions and receive the other 95% of the account tax-free (regardless of what the government ends up spending it on).
Also, having a Roth IRA will then allow me to transfer from my Roth 401k to my Roth IRA to avoid RMDs (again tax-free since both accounts are Roth). This will allow the best flexibility for year-to-year planning in my golden years.
If you have a 401k, contribute.
If you can open a Traditional IRA and contribute, do it.
If you can open a Roth IRA and contribute, do it.
And now you can pick the best investments for each, like putting all of your REITs into your ROTH. Why?
REITs are required to pay at least 90% of their income, usually derived from rents, each year as dividends to their shareholders. Normally, these dividends are totally subject to taxes, at the ordinary-income rate. But not if they’re held in a tax-sheltered Roth…
Investing in something that gives you a tax break will almost always be preferable to investing inside a taxable account.
If you have tax advantage opportunities given to you (IRA, 401k, etc.) then why not take them? I rather have 6k in a Roth than in a brokerage account.
People talk about diversification for risk.. well I think of the retirement funds as tax opportunity diversification!
Putting diversified index funds in is not a bad move. It’s the simplest method. But it’s important to consider all of your accounts together. You might have a 401(k) at work, a Roth IRA, and a taxable brokerage account as well.
If you own domestic stocks, foreign stocks, bonds, and maybe some alternative assets, rather than spread them all equally in all of your accounts, you can get a better bang for your buck by prioritizing the least tax-efficient investments to put in your tax-free Roth IRA (think REITs in Roth IRAs, instead of brokerage accounts, etc.).
Also, you can follow me on instagram @arandomwalkdowninsta
Cheers
There’s no situation where the Roth IRA makes sense???
Just a few examples…
– teenagers with earned income who can enjoy decades of tax-free compounding
– business owners with incomes that continually rises until death
– retirees with RMDs generating significant taxable income
– super savers that have already maxed out traditional retirement accounts
I never said “no situation.” I highlight that those above the 24% federal income tax bracket should think twice about contributing.
Here are some good follow up articles:
The Only Reasons Where You Should Contribute To A Roth IRA
Why I Never Contributed To A Roth IRA But Why You Probably Should
Chris,
Yes, Roth’s are good for the edge cases. They aren’t good for the average person.
If you look at a bell curve, the situations you described above are not in the center standard deviation, they’re out at the edges.
Only 6.02% of Americans own their own business, which means the other 93.98% work for someone else.
Most people do not have incomes that exponentially increases (after inflation is taken into consideration). The average person is not in college studying to be a doctor or a lawyer.
The average person gets a 2.7% raise every year. Inflation is at 2% right now, the average person won’t be jumping tax brackets because remember those tax brackets are adjusted up each year for inflation.
For the vast majority of Americans, they will not retire with more income per year than they made while working. Most people, myself included, will exit the work force once my nest egg replaces my regular income. If I make $100k/year at a 4% withdraw rate that means I will need $2.5 million (present term value). I say present terms, because $2.5 million today will be worth significantly less a few decades from now because of inflation. If I need $2.5 million today, then next year I will need $2.55 million because of the 2% inflation.
Financial advisors tell their clients to aim for 80% income replacement. Most don’t even hit this mark.
Most people, once established, never leave their inflation adjusted marginal tax rate.
Only 13% of people max out their 401k. In fact, the average savings rate is 6.9%. Couple that with the average household income that’s in the high $50’s, and you can see the vast majority of people are no where near maxing out their 401k’s or being labeled a “super saver”.
My list of averages could go on and on and on. But you’re right, you’ve captured the edge cases in the bell curve.
If you’re in an edge case, then yes, the Roth makes sense. Keep investing in the Roth while you’re in the edge case. However, for most people the traditional 401k is far superior.
I disagree with this article and there’s also misinformation. It’s almost as if there’s a motive here.
1. If you make more than the income cap for a Roth, you can do a backdoor Roth, which is simply converting a Traditional into a Roth. You just can’t contribute to a Roth directly.
2. Why not have a combination of a Traditional and Roth? When Republicans are in power, convert a percentage of your Traditional’s account value into a Roth. When Democrats are in power and raise taxes, don’t convert.
3. If you’re young and anticipate a higher income in the future, why would you want to get taxed at a higher rate? Get that money taxed ASAP.
4. There’s uncertainty of where things will be years down the road. For all we know, taxes could be through the roof. Why gamble?
5. 401ks cannot outperform good decision in a Roth or Traditional. You have no control when to buy and sell in a 401k, which is why many Americans saw their 401ks tank and couldn’t do anything about it. Why not trade in a Traditional or Roth? Invest in some ETFs and companies that buy back their stock? When a crisis is unfolding, sell your shares and buy them back at a cheaper price.
What do you mean “You have no control when to buy and sell in a 401k”. Can you please explain.
Some 401(k)s give you a menu of ten crappy mutual fuunds to select from with zero ability to put your money anywhere else. You *must* allocate among the ten crappy funds.
There are a lot of reasons to put money into a Roth. For early career folks I do not believe that maxing out your traditional is a good choice especially if your employer offers a roth 401k. For people in this situation you can potentially put away $24k per year, while you are in the 12% tax bracket and then withdrawal it tax free when you retire in the 24% tax bracket. It may make sense for you to stop contributing to the roth and go to the traditional once your income gets close to your retirement income, but in the early years go for the Roth. I am not sure about all the points regarding lack of access and low contribution amounts either. You can always make backdoor contributions to a Roth or if you have a Roth 401k option you can contribute $19k just like all the traditional investors.
I’m a teenager working a summer job. I agreed to invest in a Roth IRA.
The thing that gets me confused, but I’ve slowly been getting more clarity on is if
1. you don’t make a ginormous amount of money (I’m between $30-35k, with side hustle of $5-10k/yr. Easily $2-3k of this is cash that I don’t report, whatevs. Not looking to expand greatly- I have 3-4 days off in a row per week, and both of my careers I love. Something to be said for quality of life)
2. you have PAYE student loans
If I can do my IRA (solo 401k, I’m self-employed) then that gets my taxes to a minimum for reporting purposes. Yeah, I’ve run the numbers on the tax bomb, it still seems to make sense to pay less now, have more forgiven later. Also my health insurance is way lower. I’m eligible for a marketplace plan with HSA too, my current option is $40/mo, but could be less if I put more towards retirement, which is the plan now my biz expenses are paid off.
I don’t have any reason to expect to be making significantly more money, there’s a much greater chance I’ll be making less at some point. I don’t see how the Roth is better.
In your situation, I would absolutely do a Roth IRA to save for retirement. You are in a low income tax bracket and there’s basically nothing but upside. Makes no sense to think you can’t and won’t make more money.
But of course, it also depends on your student loan interest rate. I would pay off your student loans more aggressively if it is 5% or higher.
See: FS-DAIR: The Debit And Investment Strategy
I don’t see any reason to expect I would make much more. In my 20 years in the work force the only reason I’ve ever made significantly (difference between $10-15k/yr, and now $30-40k) more is because I switched careers. My work was fairly static for the most point (still have a foot in my old career, but $ has only kept pace with inflation. Fewer opportunities overall and a lot of them pay the same or less than 10-20 yrs ago). My job I have now they put me at the max salary after the initial trial period since I had more experience than their typical person. I could leave, but I’d rather have a low-stress job with supportive boss and a 3 or 4 day weekend, than a 40 hr job where there’s a lot of pressure to network, make sales, etc. Seems to me the best thing is to be the smartest with the money I have, while still living a good life now.
I also forgot to mention that if I invest in trad or SEP IRA or solo 401k now, that can get me lower than ~$25k which lets me do various low income first time homeowner programs. The program I’m on the waitlist for gives me $2 for every $1 I save towards closing/down payment. They said it’s off of AGI not pre-tax income.
I was looking at Dave Ramsey’s blog and it appears that he indicated it’s always more advantageous to contribute to Roth instead of traditional due to growth not being taxed.
But when we assume the tax rate stay constant, the results are the same. Thank you for pointing that out in bullet #4.
With the push for socialism and Medicare for all. Combined with federal debt, social security being underfund….it’s responsible to assume taxes will be higher in the future. Hence, a Roth would make sense. Nobody has a crystal ball, but based on current factors, it seems to sustain a decent standard of living, taxes will need to increase. Why not do some Roth and some pre tax.
haha, according to all the left wingers pushing for socialism and medicare for all, the money is going to come from the uber rich not you and I. According to Bernie, Warren, etc, it won’t cost the middle class person a dime.
So one of three things will happen:
1) You believe them and by some act of God, they are able to follow through with it. In that case your tax situation should be better in the future not worse. Which means the 401k makes even more sense!
2) You recognize what they’re preaching is complete BS and you don’t vote them into office. Thus those things never come to frustration and the taxes stay relatively the same. 401k wins again.
3) You believe their lies, and then they sock it to the middle class. Which will happen and I don’t understand how the public is so blind to this. When has a government social program actually worked? Never! In this case though, you can only blame yourself for voting those clowns into office. And in that case, I have some prime swampland real estate to sell you as well! But on the positive your Roth investment turned out to be a better option. lol.
It’s actually not the same Sheryl. If the tax rate was constant as you say, then we’d be in a flat tax rate system. In that case you would be right, the results would be the same.
However we don’t live under a flat tax system. Our U.S. tax system is tier’d. This is what people aren’t understanding. Any dollar you invest in a Roth you’re paying taxes at your highest marginal rate (highest tier) now. However if you invest in a 401k, later when you retire and withdraw the money, you’d be taxed in tiers plus you get to take a standard deduction. This is called your effective tax rate. If you don’t believe me look at your tax return from last year. Your effective tax rate is always lower than your marginal tax rate! Always!
Everyone’s tax situation is different. For me, I’m at my peak earning years where my salary is likely the highest it’s going to get (adjusted for modest raises and inflation), it makes absolutely no sense to invest in a Roth for me! My effective tax rate in retirement will absolutely be lower than my marginal tax rate now! That’s guaranteed! So the Roth is stupid for me to invest in. But everyone is different. If you get a pension, if you’re currently a student but expect to be a doctor later, etc, etc. All I know is that for my personal situation a regular 401k is the best option!
Also, Dave Ramsey is awesome for the average Joe that needs help with basic things like budgeting, which, lets be honest, the vast majority of America is under this umbrella which is why he’s so famous. However, for those that take control of their life, have discipline, and know how to make money work for you, then Dave Ramsey is not the person for you. Dave believes in absolutely no debt and to pay off your house as soon as possible. I, along with so many other people, believe in the power of leveraged money at low borrowing rates. I will never pay off my house early. Why would I pay it off early when I can use that money to invest instead. I’ll gladly borrow money at 3.5% (and is tax deductible) so that I can instead make 12%+ investing! That’s how your grow an empire! It all comes down to risk and warm fuzzies. If you want the warm fuzzy of paying off your house, go for it. No one will judge you. But financially, that isn’t the best option if you want to grow your net worth! if you pay it off as slow as possible and invest instead your net worth will be significantly higher in 30 years than it would be by paying it off early and then investing! That’s what all businesses do, they leverage low interest debt in order to make higher returns elsewhere. So again, do you want an emotional warm fuzzy or do you want a higher net worth in the future?
Taxing growth or avoiding that is not the issue. The math is multiplying by (1- tax rate) before or after the growth and it works out the same. This assumes the applicable tax rate is the same which is what everyone else here is debating. Here is a link to an article (I wrote) laying out the math as clearly as I could. Note: The other moving part related to Roths is avoiding RMDs and thus allowing the money to stay in the IRA longer and thus benefit from no taxation of dividends, interest, or rebalancing.
Aaron, you need to re-read my post because you didn’t understand it or our tax code. 1-tax rate works if we lived in a flat tax world. Meaning 22% taxed on the front (Roth) or 22% on the backend Trad 401k wouldn’t make a difference. But we don’t live in a flat tax world. Trad 401k withdraws are treated as normal income. You get to take a standard deduction, then the money is filtered through the tax tiers. The final tax is called your effective tax rate. Look at your tax returns last year if you don’t believe me. Front end tax (Roth) is not the same as back end tax (401k).
Here’s food for thought, if your 401k withdraw is less than $12,000 for the year your tax bill is absolutely $0 because you get to take a standard deduction. Why would I pay a high tax rate on a Roth right now when I could pay a significantly lower (or none in this situation) later in retirement on a traditional 401k?
As for RMD’s. Most people will retire on less money per year than they did when they were working. RMD’s won’t even matter in most peoples situations because their 4% yearly withdraw depletes the account faster than the RMD’s. RMD’s only come into play if you have a very significant amount of money that you intend to pass down to someone.
In response to your question posed in the article, YES, I expect to be in a higher tax bracket later, so am converting part of my IRA to a Roth. I retired at 57, and began collecting a small pension at 60. I will begin collecting another pension at 65, and SS at 66.5. It makes sense to convert now while my income and tax bracket are low, and before tax rates revert back to higher levels in 2025.
It is great that you feel you’ll make more money in retirement then during your highest working years. This is why the American con of me is so strong. Everybody is rich and optimistic about the future.
ROTH IRA QUAGMIRE
I have read all of the FS articles on the down falls of the ROTH IRA as well as the recent article walking back some of the previous content. I have also done research on my own, as well as reading every comment from readers on the ROTH content.
The mathematics of the ROTH IRA versus pretax accounts are not equal. While the end dollar figure is close if the other variables are equal, the tax efficiency/tax cost is in favor of the ROTH. Total cost is in favor of the ROTH. Simplicity is in favor of the ROTH. Human behavior is in favor of the ROTH.
Suffice to say, I have evaluated ROTHS as the most efficient way for low income, middle income, and upper middle income, or hell – high income with ROTH backdoor, to invest long term and to control the taxes later on. I think my math is correct.
One of the big factors in my adherence to the ROTH is human behavior and simplicity. The other is cutting the government out of your life on the front end. The analogy is like an actor and movie company. The actor represents the government, we as the individual investor represent the movie company. If I want to be able to control cost and get bang for my buck, I want to hire the actor on the front end and pay them a known amount. The actor wants to get paid on the back end, like Robert Downey JR and the Marvel series. I think the following examples illustrate this.
ROTH EXAMPLE
22 year old person contributing the limit of 6,000 yearly into a ROTH in 24% tax bracket until age 60 when they plan to retire a little early. 38 years of work.
6000 x 38 years = $228,000 in total contributions
9% yearly compounded over time = $1,695,778 total account value
6000 x .24% = $1,440 yearly taxes for 38 years = $54,720 in total taxes paid
60th year total account value = $1,695,778
60th year total capital outlay = $228,000.
60th year total taxes paid = $54,720.
60th year total cost = $282,720
PRE TAX EXAMPLE
22 year old person contributing the limit of 6,000 yearly into a pretax IRA in 24% tax bracket until age 60 when they plan to retire a little early. 38 years of work. They avoid taxes until they take money out post 59.5. They reinvest the tax savings of $1,440 yearly in a post tax account that will require payroll taxes at 24% and long term capital gains tax at 15%. Compound interest at 9% yearly.
6000 x 38 years = $228,000 in total contributions
$1,440 in yearly tax savings invested in post tax account = $54,720
Payroll pax on the money to used invest in a post tax account $1,440 @ .24 = $345 yearly
60th year total payroll taxes on principal for post tax investment account = $13,132
60th year pretax account value at 9% compounded = $1,695,778
60th year post tax investment account value at 9% compounded = $406,986
60th year total account value = $2,102,764
60th year total tax bill on pretax amount @ .24 = $406,986
60th year total tax bill on post tax amount @ .15 = 61,048
60th year total payroll taxes on principal for post tax investment account = $13,132
60th year total account value = $1,634,730
60th year total capital outlay = $282,720
60th year total taxes paid $481,166
60th year total cost = $763,886
FINANCIAL SAMURAI RETIREMENT TAX LIABILITY AND RISK METHOD
Hypothetically, taxes in retirement could go down. FS is betting they will. I am betting that no one knows until you reach retirement age. Unknowns are risk. Let’s drop all tax liability on the pretax accounts to long term capital gains. I’ll speculate this is an overly generous best case scenario.
60th year total account value = $2,102,764
60th year total tax bill on pretax amount @ .15 = $254,366
60th year total payroll taxes on principal for post tax investment account @ 24% = $13,132
60th year total tax bill on post tax amount @ .15 = 61,048
60th year total account value = $1,774,218
60th year total capital outlay = $282,720
60th year total taxes paid $328,546
60th year total cost = $611,266
SUMMARY
ROTH – DEFINITIVE
Total account value at age 60
$1,695,778
Total cost to achieve
$282,720
PRETAX ALL THINGS EQUAL
Total account value at age 60
$1,634,730
Total cost to achieve
$763,886
FINANCIAL SAMURAI WITH LONG TERM CAPITAL GAINS IN RETIREMENT – SPECULATIVE
Total account value age 60
$1,774,218
Total cost to achieve
$611,266
For both pretax scenarios I did not calculate the yearly taxes on low turn over index mutual funds invested in the post tax account. It is another tax bill to account for.
A pretax cost difference of $328,546 and a greater value of $78,440 is a bet. Is it worth it? Add the fact you have to take RMDs and any inherited IRA is likely going to have a 10 year window for distribution once SECURE its passed. Any pretax account ends up paying the government way more on the back end than a ROTH does on the front end.
Lastly, most people, including me, are not disciplined enough to fully fund a pretax account then re-invest the tax savings in a post tax account. It’s a pain to do it. If you don’t fully invest the tax savings then there is no argument. If you do re-invest diligently you have a tad more if taxes break your way in retirement, but you still end up paying a kings ransom to achieve it compared to the ROTH.
If I am the government, the taxes pulled backend from pretax are 6 to 8 times higher than the ROTH. The government will get its money. It’s a question of how much do you want to pay.
OMG I just want to kiss you. This^ says it all.
Perhaps this needs to be revisited with a focus on converting a 401k to a Roth for folks nearing retirement. Given the increasing national debt and the potential for increased government spending on debt servicing, healthcare, defense, immigration, and so called entitlements, it seems likely that the current income tax rates may be the lowest we’ll ever see. Could a couple in their fifties with two or three million in 401k accounts be making a good decision to convert to a Roth now? Does this mean they would have to come up with hundreds of thousands from other sources now to pay the tax bill? Might it help avoid a future reduction in Social Security benefits if those are means tested?
Running numbers for a 22 year old in the 28% bracket working 38 years and investing the max at $19,000 yearly @ 9 % compounding:
ROTH 401K
60th year total account value (38 x $19,000 @ 9%) = $5,368,835
60th year total principal invested (38 x $19,000) = $722,000
60th year total taxes paid (38 x $19,000(.28) = $202,160
60th year total cost ($722,000 + $202,160) = $924,160
No RMD’s
No tax bill for heirs
TRADITIONAL 401K AT 15% CAPITAL GAINS IN RETIREMENT WITH TAX SAVINGS RE-INVESTED
60th year pretax account value (38 x $19,000 @ 9%) = $5,368,835
60th year post tax investment account (38 x $5,320 @ 9%) = $1,502,459
*does not include the yearly tax bill for a low turnover index fund post tax account*
60th year account value before taxes = $6,871,294
60th year pretax account bill @ 15% = $805,325
60th year post tax account bill @ 15% = $225,368
60th year total payroll tax bill (38 x $5,320 x .28) = $56,604
60th year total tax bill = $1,087,298
60th year account value ($6,871,294 – $1,087,298) = $5,783,996
60th year total capital outlay ($722,000 + $202,160) = $924,160
60th year total cost ($1,087,298 + $924,160) = $2,011,458
RMDs currently at 70.5
SECURE legislation is pending that would move RMDs to 72
Inherited IRAs currently have mandatory RMDs but no time limit
SECURE legislation is pending that would set a ten (10) year window for the total draw down of an inherited IRA
Heirs have a tax bill either way
SUMMARY
ROTH 401K
60th year total account value
$5,368,835
60th year total taxes paid
$202,160 = 4%
($202,160 / $5,368,835)
60th year capital outlay
$722,000
TRADITIONAL 401K PLUS POST TAX INVESTMENT ACCOUNT
60th year total account value after tax
$5,783,996
60th year total taxes paid
$1,087,298 = 16%
($1,087,298 / $6,871,294)
60th year total capital outlay
$924,160
In conclusion:
Do you want to pay the government $202,000 to get to 5.4 million with no government interference for your heirs?
or
Do you want to pay the government 1.1 million and invest an extra $202,000 to get to 5.8 million with strings attached for your heirs?
I am sure I have mistakes in calculations, but it is going to be very close unless I am a lot dumber than I already know I am.
Unfortunately you’re focusing on the wrong thing. You’re focusing on the dollar amount you pay in taxes (now versus later). Of course the monetary tax amount will be higher, but your 401k balance will be significantly higher than a Roth as well. You should be focusing on what percentage of your income are you paying in taxes. That’s the real question……
For example. Would you rather make $50,000 and pay $5,000 (10% in taxes) or would you rather make $100,000 and pay $7,500 (7,5%) in taxes? Not sure about you, but I’d rather much rather make $100k and pay $7,500. Yes I’m paying more in taxes, but it’s a lower percentage of my income and that’s what I’m concerned about!
If you invest in a ROTH you’re paying taxes at your highest tax bracket right now, in your case 28%. So for every dollar you put into the ROTH you’re paying 28% in taxes. However if you invest in a 401k the money is taxed in tiers AND you get to take a standard deduction on the back end. This is your Effective tax rate. Your effective tax rate will absolutely 100% be lower than your marginal tax rate (ie 28%). If you don’t believe me, look at your past tax returns. You’re in the 28% tax bracket, but you definitely didn’t pay 28% of your income in taxes!
For me, I’m in the 22% tax bracket, but I only paid 10.9% in taxes. When you withdraw from a 401k, your money is taxed in tiers and you get the standard deduction. I’d much rather pay 10.9% on my money later in life than 22% right now. It’s a no brainier!
The only way a ROTH makes sense is if you plan on making significantly more money in your future. In that case invest in a Roth now, but switch to the 401k later when your income rises. If your income has stabilized (adjusting for raises and inflation), then the 401k is hands down a better investment because you pay a lower tax percentage later in life than you do right now with a Roth!
The real question is how to most effectively invest money for the long term paying the smallest amount of tax. Then, I want to pass it to my heirs tax free. If you have no kids or others to pass it to then it is a moot point. For me it is a big factor.
First, the balances in the 401Ks, whether ROTH or traditional, will be exactly the same. The ROTH will have no tax lien, the traditional a hypothetical lien at 15%. It could be higher, and your heirs will have to continue to pay RMDs. Regardless, it is an unknown what your tax rate will be when you are eligible to start taking distributions from your traditional account. It’s fun to gamble. You had better hope your tax rate is substantially lower in retirement, like at a minimum 12%-15% lower. Hope is generally not a great plan.
Second, you have to re-invest yearly tax savings from the traditional in a post tax brokerage account. Then you pay the payroll tax to do so. Then you pay the on-going taxes on your index funds with low turnover. Then you pay LTCG on the account when you liquidate. Taxation 3 ways. Awesome! Super simple! If you do not re-invest the tax savings yearly then there is no debate. ROTH is the choice hands down.
Third, well aware of effective tax rates. The example of 28% is just that, an example. It too is taxed in tiers, meaning the effective tax rate is lower. I also get to take a standard deduction on the front end, so that is moot. It illustrates the total cost over time in this hypothetical situation.
Fourth, if you are paying a 10.9 effective tax now in the 22% bracket and not shoving money into a ROTH then you are absolutely making a mistake. Pay 10.9% now then 0% later on compounding growth. The ROTH vs traditional argument only gathers traction the higher up the income/tax ladder you go.
The numbers demonstrate that you will end up paying roughly 5 times more in taxes and double your total cost at a 28% rate today, while the government still has a lien on your account. I know the government will appreciate the extra income. In this example, you are proposing the $1,087,298 in extra taxes and capital is worth the the extra 7% you achieve in lump sum. I disagree. While I am dumb, I cannot make those numbers work in any way shape or form.
As for me, I know our household tax rate will remain the same as it is currently. ROTH is a no brainer for us. I will be able to pass it to my kids. I don’t have to pull any money out at anytime if I don’t want to. No RMD’s and no government interference.
Let’s hope taxes don’t up in the future.
@macarthur it’s definitely possible to make a case for why the Roth might be better; however, your reasoning fails quite badly at doing so. I’d recommend finding someone you trust with a better grasp of mathematics. A few basic points:
1) Marginal tax rates matter, not effective tax rates. If you receive an additional deduction for $10k, for example, that prevents you from needing to pay taxes on the last 10k made. To illustrate, your taxable income could go from $150k to $140k in which case the $140,001 to $150,000 dollars are no longer taxed.
2) There is a commutative property of multiplication. So, for example, if you have $5,000 today, it doesn’t matter if your money grows by a factor of 10 over time and then you pay 25% tax, or if you alternatively pay 25% tax now and then your money grows by a factor of 10.
$5,000 * 10 = $50,000 * (1 – 0.25) = $37,500
$5,000 & (1 – 0.25) = $3,750 * 10 = $37,500
In the first case you pay $12,500 in taxes in the future, whereas in the second case you pay $1,250 today. You can’t say the first case is a bad deal due to paying 10x more in taxes, because you end up with the same amount. The accounts do offer varying degrees of flexibility, but the one big unknown in the equation is what your future tax rate will be.
If I had a firm grasp of mathematics my name wouldn’t be macarthur wheeler.
And you certainly hit on one of the big reasons the ROTH makes sense, you know your tax rate.
I don’t like the unknown.
And I want to keep things simple.
I am dunning-Kruger hear me roar.
@macarthur I too favor ROTH, but your heirs will have to deal with RMD with inherited ROTH as well. In fact, if Congress passed the SECURE ACT it will reduce the “stretch IRA” time down to 10 years. Even if it doesn’t, there’s always been an age adjusted RMD schedule for inherited ROTHs.
You just ruined my day.
However, if I interpreted IRS.gov correctly, as long as the inherited ROTH IRA is over 5 years old then the RMDs are still tax free. Still a win.
If the ROTH is under 5 years old then any growth is subject to tax when the RMD occurs.
Yes SECURE if passed as is would reduce the stretch only. Still ROTH non-taxable and no RMDs for owners, just inheritors but still tax-free. Still a huge advantage for those who live a long time. Still no RMD for owner allows them to pass it on.
The fact that this still comes up as a top article on this subject probably means it’s time for it to be seriously overhauled in light of Section 199A. For those with pass-through income who are eligible for the new qualified business income deduction, the entire landscape has just changed with respect to retirement planning. Pre-tax contributions are actually now potentially disadvantaged. For those whose retirement assets are primarily pre-tax dollars, there may be a very significant opportunity to diversify retirement savings by contributing to roth 401ks with after tax dollars or to convert to roth if your plan allows it (or you have an IRA).
199A is counterintuitive and complicated. But anyone with pass through income needs to really re-assess everything they think they know right now, including all this conventional wisdom about the downsides of using post-tax dollars for roth contributions.
If you have a retirement plan through your employer, you are married filing jointly, and your modified adjusted gross income is over $123,000 ($74,000 if filing single or HOH) you get no deductions for traditional IRA contributions. If you are getting no tax breaks regardless of which one (Roth or Traditional) you contribute to and the Roth earnings and withdrawals are generally tax-free (assuming you don’t withdraw early) then doesn’t it make perfect sense to max out Roth contributions while you can?
In my position at 25 my calculus is that my income will increase before retirement and that the government will impose higher tax rates. So, that means a Roth is a way that I can minimize my overall tax burden in the long run. Plus since you can withdraw contributions at any time without tax or penalty it is a great way for it to also serve as my emergency fund. I’d be greatly interested if I am missing anything with regards to my plans as a miscalculation this early on in my career will cost me tens of thousands of dollars.
Hello Sam, longtime follower here. I think that when you are doing the math you make an assumption regarding the ground rules, ie that tax rates remain the same. That’s an unfounded assumption as illustrated by the TCJA enacted in 2017. TCJA dramatically reduced top tax rates, particularly for a single payer vs a couple. It is unlikely those rates will be in force in 2026 and beyond, if they make it that far. For the right individual at the right stage of life, a Backdoor conversion under the TCJA rates could result in what amounts to a tax discount even after taking into account future value of the taxes paid.
In certain states that presently exempt retirement income from taxation, that effective discount on taxation grows, as the Roth is portable between states and once the contribution is made it is beyond the reach of any of the Revenue Services.
Understood that this is a special situation, for a small number of readers in a few states, but there are cases to be made for shifting your balances from an IRA to a Roth.
My Thrift Savings Plan (essentially my 401K) allows me to pick between Traditional and Roth contributions. The limit for 2019 is $19,000. My wife and I each max out our Roth IRAs, and I max out my TSP with Roth contributions. Should I switch to Traditional for both my TSP and our IRAs?
Will – More details are needed to answer that properly. For example, the rate of income tax is a big piece of the puzzle. Many people will slide into lower tax brackets upon retiring. When they are working, they are earning what they need to live on AND what they need to save for retirement (=> higher bracket). This argues for traditional (non-Roth) accounts to pay (income) tax later when rate is lower. Other folks are ‘stuck’ in high brackets before and after retirement. At the same time, they will likely leave significant $ to heirs. In this case, Roth can help extend tax benefits. That is, there are no RMDs on the Roth account. So more $ stay in the IRA and enjoy those benefits (these benefits can be extended further when bequeathing $ in form of inherited IRA to children or grandchildren).
Hope that helps,
Aaron
Since you have a TSP, you are most likely in the military. You will never be in a lower tax bracket in your life. There is no reason you should ever contribute to a traditional IRA while you are still serving in the military. One of the points the author really didn’t point out is, all things are equal as long as your in the same tax bracket. If you’re in a higher tax bracket when you retire, then the Roth IRA is a better deal. If you’re in the military, at worst you will be in the same tax bracket, but most likely be in a higher tax bracket when you retire.
I disagree as I love the Roth :)
I think the Roth is awesome as you can withdraw the money whenever you want while protecting future appreciation. Key is to max out the 401K first and all the other upfront deductible contribution retirement options, then anything going to a Roth is just like holding money in your regular non qualified bank account except the earnings are tax free and you can withdraw the contribution whenever you want. And you can put in $20k-$30K per year to a Roth on top of the $18.5K 401K contributions as the total annual cap across all retirement accounts is $55K per year currently.
The different tax rates for Roth (current tax) versus traditional IRA (unknown tax) are not the only factors. It is entirely possible to end up with more money despite a higher tax for a Roth. The key here is the avoidance of RMDs. In particular, those who might not need all of their RMDs to support their own retirement can extend the tax benefits (no tax on div, int, acp gain from rebalancing, etc.) by avoiding RMDs – longer or altogether. This approach can be amplified by possibly passing an IRA on to their heirs (RMDs on their presumably longer schedule). I quantified these benefits within a couple articles I wrote recently and they can result in significantly more wealth.
I maxed out my 401k and roth ira from 2002 to 2012.
I tried to convince a friend to fund a roth and got the answer that you cant do anything with 5000 a year and tax rates were to low at present to defer taxes to the future.
Since retiring in 2012 I have been converting regular ira funds to roth ira as fast as i can while paying 0 in taxes.
Now my roth is a 350000 tax free investment acct. My friend still has no roth and no 401k
with the decrease in tax rates this year i am considering paying some tax to convert more ….
Roth IRA/ Roth 401K contribution limits are effectively much higher than traditional accounts. Consider a Roth 401K vs a traditional 401k. Assume that taxes are the same now and in your retiement years. Say you put 18,500 into a traditional account, it grows to 100k, and you withdraw it at retirement. Assume you pay a 20% total income tax rate. After tax, your contribution was effectively 14,800 (80% of 18,500), and your withdrawl will be $80,000. Now consider if the contribution had been a Roth – your effective after-tax contribution would be 25% higher (18,500 instead of 14,800), and your withdrawl will also effectively be 20% higher (100k after tax vs 80k after tax).
And that, friend, is why I use a Roth 401(k). Same logic applies to backdoor Roths IRAs, since income limits don’t apply and they still yield a much higher effective contribution limit. My logic is that I want to shove as much money into a tax advantage account as I can, and Roths are the way to maximize the effective amount that I can contribute.
In addition to all the strengths of the Roth outlined above in the comments, ROTH distributions don’t add to your taxable income, which has tons of effect at retirement tax time, including impacting the amount of taxable social security income you have and your Medicaid premiums. Plus Roth passes to your heirs tax free (subject to estate tax limits). This guy, from the article, should absolutely Roth 401(k) his money, even with only a few years left to retirement. For so many reasons, in retirement, lower taxable income offers advantages that are not easily calculated but must be considered.
I’m posting again regarding the ROTH. It’s anecdotal, but, I have spoken with a handful of people in retirement. The consensus follows.
Those that don’t have a ROTH wish they had opened one for contributions and conversions. RMD’s have been a pain in their butt and negatively impacted their taxes and medicaid.
Those that have them are happy with them.
These are people in retirement that are having to take RMD’s. Again, their accounts are owned by three parties:
1. The person who funded the ROTH to begin with ( you, me, and FS).
2. The US government.
3. The state government.
The RMD’s are increasing their tax burden. Has anyone else spoken with people in retirement with ROTH and without ROTH? What are their experiences?
There is no age limitation on Roth conversions. You can do it every year until the year you die, even in your hundreds. If you retire at 50 and do Roth conversions until drawing deferred Social Security at age 70, you can potentially do Roth conversions at a lower tax bracket for twenty straight years.
Hello Sam,
I really like your blog but had to respond to respond to this one. I don’t believe that Roth IRA is always the way to do, nor do I believe that a traditional IRA is hands down the best. Lest you think me egregious, please allow me to explain.
I am an American who lives and works abroad. I make under the equivalent for $100k a year, so I fall under the Foreign Earned Income Exclusion. As such, I get no tax advantage putting money into a Traditional IRA, as my taxes do not decrease. I do however get the tax advantage from withdrawing tax free under the Roth IRA at some point in the future. As such, for myself and other Expats, the Roth IRA is often the better choice.
What do you think about Roth Conversions at 63 years old, while staying in the 12% tax Bracket?
At 70-1/2 I expect my investments to produce $40,000 of dividends and capital gains that I can’t escape, plus $30,000 of SS income. Then in a few more years, my wife will get SS and that will put us up near $90,000 of income. It could be a lot worse, the above is just what the mutual fund distibutes each year, I also need to with add 3.6% RMD the first year, that will add over $50,000 to the above.
I think by starting Roth Conversions now, we can stay in a lower tax bracket when I/we must make RMDs.
We earn about $70,000 but can easily live on $50,000 or less, so if I can get the money into a Roth, we could live on SS plus some tax free money out of the ROTHs and pay very little taxes.
Plus I see these additional reasons to opt for Roth Conversions
1.You think tax rates will increase for your bracket at RMD time.
2. A Roth is easier for your heirs to inherit.
3. The extra income from a traditional IRA will push you into higher tax Brackets.
4. If one spouse dies, that could push the remaining spouse to a higher bracket.
5. Phaseouts and benefits based on AGI and MAGI, for example, more money in a Roth lowers your AGI which may make less of your social security taxable.
I maxed out my Roth IRA for 2017, and I was planning on maxing it again this year. My gross salary is only $42,000 and I live in a state without income tax. After all of my research, it made the most sense to stick with Roth due to my low income. Could I get your thoughts on this?
Also, it seems you keep reiterating to max out one’s 401k before contributing to an IRA? Why is that? My IRA is with Wealthfront and my 401k is with Voya. Voya doesn’t give me many investment options, which I don’t like. This is why I am only contributing the bare minimum 4% my company is matching, and why I’m focusing more on the IRA. I am dumping the remainder of the unspent post tax money into online savings @1.6% and into a personal investment account with WF as well.
Also, keep in mind that my 401k contributions are Roth as well.
Dude, you are killing it. Well done!
Gabriel,
The general investing rule of thumb:
1. 401k up to the company match
2. Max out Roth IRA
3. Max out 401k
4. Taxable Investing (Stocks, Index Funds, etc…)
You are on the right track.
Max out your 401(k) and then max out your IRA if you can. Your 10 year older self will thank you for it.
The whole premise of this article is that it’s better to pay taxes later. (Is that always true? I think it depends on your situation.) So, I believe he’s saying max out a *Traditional* 401k first because it’s tax deferred and this aligns with the aforementioned premise. Of course, you should at least contribute enough to get the max employer match if you get one — that is free money. Given your circumstances, I think a Roth makes sense and I think your plan is a good one. You likely have more options with a personal Roth than with an employer plan. Also, this article was written before recent tax law changes. If you believe taxes are more likely to go up than down from here, a Roth starts to make even more sense. While you would want to avoid tapping it, a Roth can also be used as an emergency fund since contributions (but not gains!) can be taken out tax and penalty free — just make sure you keep track of your contributions.
The wife and I have invested in pretax 457 plans our entire careers. Most of this time our income exceeded ROTH limits and we were not diligent enough to do a back door ROTH.
Our employers have established ROTH 457 plans now. Our new money is going in. We are also going to start converting pretax money in while staying in the same tax bracket.
Why make such a dumb decision?
Welp, being of low intellect and even lower affinity for the unknown, I don’t like to speculate or keep the tax man on the books from now until I die.
FS opines that taxes will probably be lower in retirement, so paying the government up front is like giving Congress extra money to blow like a bachelor party in Vegas. This might be true. But it is not fact. For us, our tax bracket will probably stay the same.
I know for a fact that investing in a ROTH now means I have secured my cost to invest from here to eternity, or Thanos strikes, whichever comes first. It also means that decades of compounding interest will grow without mandatory distributions or taxes.
That’s right, I paid the government off on the front end and kicked them to the curb. That in and of itself is called peace of mind. I also took “might be” and “probably” out of the equation.
If a person keeps their money in pretax accounts betting that taxes will go down, they are also ensuring that there will be three people owning your account:
1. You
2. the US government
3. The state government
That is a certainty, not speculation.
My mindset is also why we are paying our mortgage off in a few years and not investing that money in paper assets or rental real estate. Getting rid of the mortgage is peace of mind. So is getting rid of decades of tax bills on money that we invested and are watching compound.
So if you want the tax
Man owning a percentage of your investment account for the rest of your life, good for you. You’re betting a lot on speculation.
There are several flaws in your argument that should be pointed out.
I’m 58 and in the 22% tax bracket. My retirement planning is currently based on replacing 85% of my income when I retire between retirement accounts and social security (and more if we can). Since I currently do have 15% coming out due to pre-tax retirement savings, that means I’ll be in the same tax bracket when I retire. I’m not maxing out my 403(b), but I am maxing out my Roth IRA and close to maxing out my wife’s. Your argument is that in my case the math is the same so I should just put all of that into my 403(b). Here is where you are wrong:
1. You are absolutely certain that taxes will never increase. The is a mighty big assumption. For quite a lot of people they just did. We personally got a tax cut this time, but a few years ago this change would have increased our taxes. Taxes have increased on the middle class in the past (FICA increases being a big example), but imagine if they just decided to reshuffle things so I’m the loser this time, but lots of others get another cut? And, this time the cut is going to push deficits over $1T a year during good times (as opposed to temporarily during a recession) with no end in sight. That’s not sustainable. Something is going to have to give. Remember, this round of tax cutting has an expiration date.
2. Only about 11% of our retirement funds will be in a Roth account at retirement. I’m sure you are saying “that’s nothing, why did you bother”. Will, that 11% makes it easier to spend a larger amount in one year without taking a larger amount from our 403(b), which might push us into a higher tax bracket. Maybe we do a really big trip? Or maybe we want to buy a retirement property? Home renovation? Those funds can be taken out at any time without pushing us to a higher bracket. Maybe we’ll just use them before RMD kicks in to avoid that 85% of social security being taxed and allow us to be in a very low tax bracket. That 11% gives us flexibility.
3. One of us will die first. When that happens, the survivor will no longer be filing jointly. But, the required minimum distribution will not go down. In the current tax system, the survivor jumps into the 24% bracket. Then the math favors the Roth.
The formula above claiming “equivalency” between a Roth and a traditional IRA is overly simplified. It cleverly hides a number of key details that are critical to the actual amounts an average person would amass at retirement. It does so by modifying the starting investment amounts for both IRA types to account for taxation, to put them both on “equal footing”, yet ignores the realities of typical investor behavior.
Here’s why.
Assuming a person qualifies for the traditional IRA’s tax deduction, they would only need $5,500 of pay before taxes to make the maximum contribution. With the Roth, contributions are made in after-tax dollars. Which means you have to part with more than $5,500 in pretax dollars to make a $5,500 Roth contribution. So for a person in a 25% bracket, the pretax equivalent of a $5,500 Roth contribution is $7,333, or $1,833 above the $5,500 maximum. So far so good. Factually, this is accurate.
But this is where the cleverness occurs. Because if you’re investing the maximum $5,500 in a Roth IRA, it is impossible to invest the pretax equivalent of that amount in a traditional IRA, as you would exceed the IRA annual contribution limit. So to make this “equivalency” math work, one must assume this person will not only invest the pre-tax $5,500 into a traditional IRA, but then also diligently invest the “extra” after-tax $1,375 into a taxable side account. (That $1,375 represents the after-tax amount of the $1,833 overage, reduced by $458 in taxes at the 25% rate.)
Additionally, while investment gains inside an IRA compound without the drag of taxes, you must pay taxes on any gains in your “side” investment account. Which means the money invested there—the $1,375—will grow at a lower after-tax rate than money in the Roth IRA (assuming the same rate of return before taxes). And right there, that difference in returns—the “tax drag”—gives the Roth IRA an edge over the combination of a traditional IRA and a taxable account. So already we have dashed any hope of an “equivalency” in tabulating the final retirement balance. Also, the present capital gains rate isn’t fixed. Its whatever it happens to be many years down the road retirement age, based on the current political climate at the time. So, this is yet another variable that breaks equivalency, because its a factor in one IRA type but not the other.
So quite honestly, that overly simplified equivalency formula is really just a math-nerd “fantasy”. Generally, most people don’t think this way. Most people will typically invest the same dollar amount into either a traditional IRA or a Roth IRA by asking themselves “How much can I afford to contribute to my IRA”? And for those with the means, they’ll try to max it out-$5500 or $6500 over age 50. The “real-world” bonus here is that those who invest the “same dollar amount” into a Roth IRA vs traditional will in fact be investing at a higher level, due to the higher amount needed to overcome the after-tax hit. Thus, they will reap a higher benefit with their tax-free distributions at retirement.
So people think: “Okay, I can do $5550 in my IRA”. They DON’T think: “Okay, I can put in $5500 in this traditional IRA, then I can invest the difference of what I would have invested in an after-tax Roth into this taxable side account so I can earn the same amount that I would have earned… yadda yadda yadda.” No. It’s just not a normal persons thinking.
And that’s why most retirement analysts start from the premise of a person wanting to “max out” their IRA contribution-because that is the typical retirement investment behavior of the average Joe.
And for anyone who’s not already in the final stages of their career (perhaps late 50’s or after), setting up and contributing to a Roth IRA in all practicality will net them more than a traditional IRA would. Most will pay a lower tax rate earlier in their careers as they put their money into the account, and since qualified Roth withdrawals aren’t taxed, they will avoid paying a higher tax rate at withdrawal (for those who choose to actually spend their amassed wealth during retirement, thus putting them in a higher tax bracket).
Lastly, the number of compounded investment years used in the simplified formula (10) is rather small. And this actually matters. Because now that it’s clear that this “equivalency” formula is mostly a fantasy, whatever deviation that favors investing in a Roth IRA or a traditional becomes exponentially magnified as the compounded years accumulate. The different after 10 years is vastly different than for 20 or 30 (sort of like the butterfly effect).
So I just wanted to give others that may be reading this thread years on a bit of a reality check. Because constantly hammering phrases like “the math is exactly equivalent” and “just look at the formula” is not really a representation of the whole story. In the end, its your money. Do your own digging.
Mark, you sir are a gentlemen and a scholar.
I’d love to hear your take on opening a Traditional IRA and doing a backdoor Roth in my situation…I file taxes as HOH and make $202k as a W-2 slave, with $60k in supplemental rental property income. So I can’t do a Roth anyway, and I’m in the 28% bracket after maxing out all my tax advantaged accounts including my 401k, and have about $400k saved for retirement. I’m 38 and am starting to really get serious about retiring “early” (like early 50s since I’m wising up late)…so, do I just sock away more in a post-tax 401k contribution with my employer, do a Traditional IRA with $5,500 every year and leave it, or roll it over right away/later to a Roth? Thanks – I’m having trouble finding articles that address my type of situation where I’m earning and contributing more than the tax advantaged opportunities allow.
No one has mentioned that 401k’s have investments that give kickbacks to the employers who offer them in the portfolios as well as the operating fees that vary between investment choices.
Yeeesh …. I’ve been reading your blog for about 3 months. I’ve never commented, and generally agree with all you have to say. I followed a link here on one your recent posts.
I have been contributing to a Roth IRA, and now I feel bad that I’ve made a mistake by doing so. But you read and learn and make mistakes and learn more hopefully. I guess my thinking had always been that I want a tax-free source of retirement monies in my golden years to strategically supplement the taxed income streams SSN, 401k & Trad. IRA, and income generated from a brokerage account.
As someone else mentioned above in the comments, I wanted to diversify the tax treatment of accounts as well as the asset classes within those accounts. Now I have to consider how to proceed.
You just exploded my head …. sincere and friendly thanks.
@Schnack,
I am an avid seeker of tax free income for retirement as well as all the ways in which one can save and minimize on taxes. Hence, my attraction to the samurai today. I really like what I’ve seen so far and have signed up, but I am still sorting through the Roth opposition. I am with you, so let me validate your way of thinking as to why a Roth IRA, versus a traditional IRA. To be honest, I certainly don’t expect most people to have made this correlation, however, here are my two sense.
Despite the dollar amount being the same whether or not one pays taxes now or later, there are three critical benefits that tend to be prematurely overlooked simultaneously. First, do we really know what our tax bracket will be in the future? Yes, per Sam, it could be argued that current middle class bracket might be the same, but no one can predict the tax rate. Death and taxes might be the two surest things in life and just based on the increasing deficit, which some believe is significantly higher than what is actually mediated, taxes must be paid. Most likely it will have to come from increased taxes in one form or another. I certainly don’t want one more thing to have to worry about, especially during my retirement. Secondly,there is no RMD, so your money can accrue for a longer time, generating more gains of which you have more control instead of having, not Sam, but Uncle Sam () tell you when and how much of your money to take. Lastly, and my favorite, is the fact that you will not have to pay taxes on your Social Security benefit. Gains from a Roth is not considered earned income, unlike unearned income from a traditional IRA. So in looking at the bigger picture, I am still for the Roth versus the Traditional.
I welcome any comments, corrections, criticism or any other input in case have misunderstood our current laws. Sam please share your thoughts on my findings. This is how we learn. all the best Schnack
Here is my situation. Newly married (NYE Wedding!) at 25, and estimate to make a combined $75k in 2018, putting us in the 12% tax bracket. I plan to max out my 401k and 2 Roth IRA’s, and am having a difficult time understanding why we shouldn’t max Roth IRA’s vs Trad IRA?
I understand the risk of passing on the tax benefit now, but if we will need withdraw from investments during early retirement, would it not make sense to first withdraw from the Roth IRA contributions instead of requiring us to invest/withdraw more from taxable accounts? I’m trying to keep income potential in scope, so if we never reach a point where we are able to max 401k + 2 IRA’s, AND have taxable investment accounts, I don’t want all of my assets to be “trapped.”
Any advice or inputs would be much appreciated!
At only a 12% tax bracket, I would contribute to a Roth IRA and max out your 401k if possible.
Hopefully you’ll one day earn more that you won’t be able to contribute to a Roth IRA anymore.
I hope that is an honest opinion, and not just what I want to hear…. :)
I believe our income will increase over the next few years, but with my wife being an actor it is very unpredictable. I guess my next step is to research at what point it would make sense for her to begin operating as a “business” instead of as an individual. Will make for an interesting case study.
Thanks Sam!
I should clarify, you still need to be over 59 1/2 and have the account open for at least five years to be able withdraw the gains tax free, but I still think this is amazing!
I plan to use it for sure.
Hi Sam,
I think I will read the other two articles on the Roth, but I am not sure if you touched upon the fact that one can also take up to $10K in gains for a first-time home (no tax penalty) and there is also no tax penalty for withdrawals so long as the account is 5 years old.
I think this is huge! My Roth is a brokerage account and it is amazing that I do not have to worry about tax consequences! My income is enough to qualify for a regular Roth as a single filer and though I haven’t taken money out, I think it is awesome that I could sell some ETFs – and pay no taxes on the gains – and use the funds!
We do not know what the future holds, but I think people should take advantage while they can. Perhaps some of us will be grandfathered in. Also, at the time I opened, I was really early on in my career and certainly expect to earn more and hopefully be married upon retirement. Anyway, thanks for the insight but I think not paying taxes on capital gains and dividends is amazing. It could also be a plus that there are no mandatory withdrawals.