If you contribute to a Roth IRA
For years I’ve been an opponent of the Roth IRA after the government came out with its tricky dick way to let us all do a “one-time” conversion from our traditional IRAs. The government was so successful in getting people to pay huge sums of taxes on their IRAs up front during the financial crisis that I just shook my head in disbelief.
As a personal finance blogger who wants to help you achieve financial freedom sooner, rather than later, it’s my duty to write this post to help you see the error in contributing or converting to a Roth IRA if you have not maxed out your 401(k).
Of course if the choice is between NOT SAVING and saving via a Roth IRA for your future, then the answer is that one should open up a Roth IRA rather than piss their money away on stupid stuff that depreciates in value. However, do know that you are still pissing money away by giving 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 the reasons why a Roth IRA is not a good idea for most of you. I really hope this article will wake you up to the tremendous government brainwashing that is being conducted to get you to part more with your hard earned money. If you’re still in favor, at least you know the other side of the story and Uncle Sam thanks you!
DISADVANTAGES OF A ROTH IRA – NOT ALL MILK AND COOKIES
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? Would you give a drug addict some meth? Would you eat a double cheeseburger in front of an obese person who is trying to lose weight? No, no, no! There is a reason why there are $2,000 staplers and $10 staples in the government 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 so underfunded? The government wastes your money, so don’t give it more.
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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 $116,000 a year as an individual or less than $183,000 for married couples can contribute as of 2016. After making more than $131,000 a year for singles, you are shit out of luck! No soup for you. Sorry, but the government doesn’t believe you have the right to save in this way. Discrimination is not OK, just because you aren’t being discriminated against. We need to fight for equality for everybody! The income cap for contribution is too low. The irony is, the government is actually saving people who make more than $116,000-$131,000 a year from paying more taxes and getting tricked into entering the Borg. Unfortunately, there are income limits for contribution on an IRA as well, which are even more egregious at $61,000 – $70,000 for single filers.
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 $500 million dollars! Trust me, I was a rock math star in the 2nd grade!
5) What will $5,500 do for your retirement? A max contribution of $5,500 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 $18,000 for 2016), and you are eligible for a Roth IRA maximum contribution for a single filer ($131,000 income or less), you probably will get more out of spending your $5,500 on life now. I am a big proponent of aggressive savings, however, if you are only earning up to $88,000 a year in gross income after maxing out the 401K, I’d rather you not tie up that $5,500 in a government savings vehicle until 59.5. Invest your money in a low cost investment account like Wealthfront, or keep it liquid.
6) You may never reap the fake rewards. Let’s say the math wasn’t the same, and you continue to contribute to your Roth IRA because you believe in the tax benefits. Unfortunately, you die at age 59. You’re screwed! All those taxes you paid upfront to the cunning government, and you’ll never once get to utilize the returns on your Roth IRA. What a shame. Guess what? Over those 37 years, the government has happily spent your tens of thousands of dollars on themselves. That makes me sick, and it should make you sick as well. But maybe not, since you are a patriot.
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.
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 8-10.4% and we’ve got a huge budget deficit! There’s no way I’m giving 10% of my hard-earned retirement income to the politicians up in Sacramento to waste. Instead, once I retire, I plan to move to one of the 7 no income-tax states (Nevada, Washington, Wyoming, Florida sound reasonable), and avoid paying 10% state taxes altogether. You have the power to save on taxes just by moving.
CHOOSE THE TRADITIONAL IRA OVER THE ROTH IRA WHILE MAXING OUT THE 401K
If you are a recent college graduate who is at the beginning of their earnings power, then choosing to participate in a Roth IRA is less egregious than someone who is older and makes more money (up to ~$122,000). Your tax rate is low, so 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 pre-tax traditional IRA first.
Do the math. Let’s say you make $50,000 a year and contribute to a Roth IRA. At $50,000, single, with no deductions, your Federal Tax bill is estimated at around $6,250, equaling an effective tax rate of 12.5%. However, you are squarely in the 25% Federal Tax bracket. Let’s say you are hot stuff now and make $100,000, the very income edge of where you can still contribute to a ROTH IRA. Your Federal Tax bill is now around $18,900, or an effective tax rate of 18.9%. You are in the marginal tax bracket of 28% now. What’s your saving?
Your savings really is nothing, because it’s not about moving up and down the Federal Tax Brackets. It’s about what you think future tax rates will be at for income levels below $105,000, since any more and you get phased out and can’t contribute completely after $122,000! The $122,000 and below income level for single filers is the protected middle class where no politician dare assaults. The middle class is what puts politicians in office and therefore, taxes will unlikely ever go up for this income group!
To humor you, let’s do the math anyway. $5,000 X (18.9%-12.5%) = $320 “savings” or $5,000 X (28% – 25%) = $150 “savings” per year. If these savings were real, they would be somewhat meaningful, but not really. This math is absolutely wrong and therefore, the “savings” is irrelevant.
Final Important Point: If you are a middle income person who generates $131,000 a year or less for your entire life, and is therefore able to contribute to a Roth IRA, do you really think when you retire, your income will now be more than $131,000 a year, putting you in a higher income tax bracket during withdrawal ceteris paribus? Be realistic. At today’s 10-year risk free rate of ~2% (as of 2016), you need $6.3 million dollars to generate $131,000 a year in income!
You will likely NOT make more in retirement than during your working years. Stop being delusional!
2017 Vs. 2018 INCOME TAX BRACKETS
Surprise! Income taxes are going down in 2018. The government thanks you for paying more taxes up front out of the belief you will earn more money and be an higher tax bracket in retirement than while working.
2017 Tax Brackets
2018 Tax Brackets
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.
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Updated for 2018 and beyond. Under the new tax plan, the vast majority of Americans will now be paying LOWER income taxes.
I think Govt wants to collect money from people with help from Roth IRA. That is a way to curb inflation.
but your views are backed by some credible reason which has confused me about my likeness of Roth IRA
Not sure how you got the argument of collecting more taxes to curb inflation, but maybe! If the middle class citizens have less money to spend since they gave more to the government, demand for goods and services will go down at the margin, thereby curbing inflation!
Nice! Another great government manipulation tool.
I agree that you should first max out your 401K.
However, if you max out your 401K and still fall under the income limits for the Roth IRA – then I think it makes sense to do BOTH.
“What are your thoughts about the intentions of the government?”
The intentions of the government is to get re-elected, nothing more nothing less. Well for the most part anyways.
Regarding conversion for a regular IRA to a Roth IRA – I did not take “advantage of this opportunity” for the reasons you list above. I could not convince myself that it definately made sense and thus I did not want to pay the government money now with the HOPE that it would save me money later.
Sure, if you’ve maxed out the 401K, then max out the traditional IRA, not do a ROTH IRA and pay more taxes to the government. That’s just nuts!
Not sure if I understand your comment correctly.
However, if you are saying that maxing out a 401K and a Roth IRA is nuts because a traditional IRA should be used instead – I do not think its nuts. The reason is the $ limits for the traditional IRA are much lower than for a ROTH IRA. Thus many people will that have the $ to max out a 401K will be over the traditioanl IRA limits but under the Roth IRA limits – thus not qualify for the tradtional IRA but still qualify for the Roth IRA. Thus, for these people the ROTH IRA seems like a good idea with little to no drawbacks.
If you are stuck in the $67,000-$105,000 gap = still qualify for ROTH IRA but not traditional IRA, then yes, it’s not that bad to contribute to ROTH. Better than spending the $5,000 on something that depreciates.
Thanks for the reply Sam!
Not at all. Thanks for your continued thoughts. You should really consider starting your own blog or writing a guest post here. You have a lot of great ideas.
Actually, I think Uncle Sam hits you harder with 401Ks. First, 401Ks are not tax-free in any sense, while Roths clearly have the benefit (on gains). Moreover, since the IRS taxes every $1 of distribution as ordinary income, you do not get a cap gain deduction on any of your earnings. Yup, if you can buy “tax-free muni bonds” in your 401, they will be taxed. Taking a loan from a 401K (which I have) means you pay it back into the 401 plus 6% interest. Yes, you are paying yourself that interest but since you pay it with after-tax money, you will get hit with Fed/State tax when you withdraw it. Double taxation.
I like your attitude and your financial prowess. Keep it up.
I think it’s hilarious that you are posting this up while every other PF Blog out there is on the Roth IRA movement right now. I have a Roth but its such a small amount of money that I’m not too concerned about paying taxes on it.
And when you make more than $105,000, you are going to look at your ROTH IRA amount, with absolutely not that much to help in your retirement and wonder, “why the hell did I lock that money up and waste my time!”
It’s nuts.
Wait… I’m not understanding something. I thought Roth IRA grows tax free so when you retire you don’t pay taxes at all? So comparing Roth and 401k assuming both are contributing equally and growing equally you end up with $1 million but because you have to pay say 25% taxes for 401k you end up with $750k vs the roth’s $1 mil still. With 401k you end up paying taxes on your contributions+growth+employer contribution, this can end up giving way more money to the government than you would with a Roth. That’s assuming you don’t ditch your family and roots by moving to another state. And I don’t understand how contributing to Roth is giving money to the government, isnt Roth being invested to the same funds available in 401k or Traditional?
Im not disagreeing with this post but I don’t have Roth yet but have been considering it and this post contradicts what I thought I knew. And maybe I’m plain naive :)
You are right on the money.
Also, tax rates WILL be higher in the future. I would stake everything I own on it.
If you would rather pay a higher rate later, please be my guest.
Sure, happy to bet you whatever you want that middle class income, currently defined as $122,000 or below since that’s the cut off limit for where one can contribute to a ROTH IRA doesn’t go up.
Let me know why you think the government would dare assault the middle class, when politicians need the middle class, the biggest class for their votes to remain in power.
I don’t think you’re looking at the macro trends in demographics.
The younger generation that will be compose the middle class in the future is open to the idea of higher taxes in exchange for increased governmental benefits (think Europe).
I am personally not, but that it was the polling shows.
I guess we won’t know until that time gets here.
Umm, no. What does “the younger generation will be compose the middle class in the future” mean?
Demographics are getting OLDER in American, not younger.
Let’s set a timeline… how about 4.5 years, until the end of Obama’s second term. If taxes don’t go up by for those making less than $122,000 a year, I win $200. Sound good?
hehehe…it’s the end of 2017. funny to read this 2012 conversation about whether taxes will grow or not. under the current gop proposal for tax “reform”, we are looking at an increase in taxes for a great number of poor and middle class people.
https://www.nytimes.com/interactive/2017/11/28/upshot/what-the-tax-bill-would-look-like-for-25000-middle-class-families.html
ny times too liberal for you? check out forbes. they’re not a fan either.
i’ve told my dad earlier that there’s really no reason for me to use a Roth for anything else except a rainy day fund. i know i’m pretty much stuck under 110k in my career…so no upgrade in tax bracket.
Looks like you won $200
Right on! Thanks for the reminder. Did you just randomly scan this thread? Or did you subscribe? Amazed you highlighted this.
Very fun to look back at old threads and see what people were thinking. At least anybody who invested via a Roth IRA has done very well over the past five years!
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I normally agree with you, but on this post I cannot help but just shake my head and say what the hell are you talking about? You seem to be missing the most important reason for investing in a Roth IRA, which is that you do not have to take out the money! The best investment is the one you never withdraw. People in their forties who start contributing have the option of letting their money compound for forty or fifty years while they draw down on their other retirement savings (e.g., 401k)…and maybe the last thing they do is take from the Roth tax free when everything else is gone, or maybe they pass that money on to their children. What am I missing here?
So cool to read this thread now. The vast majority of people are getting a tax cut in 2018. Feel bad for folks who locked in higher tax rates in 2012. But, it’s just money at the end of the day, and supporting our country is a good thing.
Hope everybody at least maxed out their 401k and rode this bull market to mega wealth!
Sam
I was reading through some most commented posts (this one is #2 or #3 all-time). Imagine how much money was spent on taxes converting over the last few years at higher rates! I know people that intentionally fill through the 25% bracket (or higher) with Roth conversions, which is silly because majority of retirees aren’t in that bracket because of additional standard deduction and favorable taxation on social security income. I suppose their children will appreciate inheriting tax-free dollars.
As an advisor, I see people so thirsty for Roth IRA’s and conversions because everyone believes they will pay higher rates in the future and they will be in a higher bracket. In reality, this is rarely the case. Roth is great for income of a minor and professionals under 30. Need to keep an eye on minor income now though, as it will be taxed at trust rates.
Yeah, but now that the lower tax rates are set to expire for the individual, couldn’t you make the argument that it’s smart to invest in a Roth IRA until the tax rates expire?
“Also, tax rates WILL be higher in the future. I would stake everything I own on it.”
Oops, maybe you should stick to your day job! Under the 2017 Tax Reform, tax rates went down across the board. Also, the standard deduction doubled. The middle class will end up paying less taxes in 2018 than when you wrote this in 2012.
Only because cheeto is a fucking idiot. I think we’re going to have far bigger fish to fry in the coming years…
@Lance…You have already paid the taxes on the money you contributed into the Roth IRA. That is why you really are not saving much on taxes compared to your 401k or Traditional IRA.
The earnings and reinvested dividends in a roth aren’t ever going to be taxed, which is a benefit. Also there are no required distributions. You can pass it on to your children.
unless the government decides they want to tax it again. although i think the chance of taxes going up several times is a lot greater than the chance of the government taxing already contributed roth money in the next 40-50 years. i have doubts about the us being around that long period. i expect the government to be bought by amazon.
Sometimes I think you post stuff like this just to entice contradictory comments. I suppose your line of thinking might make sense if you don’t understand compound interest and if you are expecting crappy investment returns. Also, last time I checked, you still pay taxes up front on traditional IRA’s. Tax free contributions are only within things like 401k’s or 403b’s.
You did make a good point though about possible death before retirement. I would add that tax laws could change in the future, such as a consumption tax replacing the income tax. That would really screw all the future tax savings in a Roth.
For folks like me though, the Roth absolutely makes sense. Assuming tax laws stay the same and I live well into my golden years, the tax free growth on all of the compound interest over that time period will be worth it. This also assumes I will earn a good rate of return on my investments over the years, and I will.
Pls check again on traditional IRA. And please re-read or read this:
* 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.
And after reading, if you still are for a ROTH IRA, then I and the government thank you for your contribution.
So the math is not the same. You can contribute $5,000 after tax to Roth and $5,000 before tax to the Traditional. You might have to earn about $6,500 to $7,000 to contribute the after tax amount, but if you can contribute the $5,000 after tax you are effectively saving more than the $5,000 before tax. However, tax diversification is important because there is a minimal amount of income that is not taxed in our current rate (and probably future rate) scenarios. You want to max out that first part of the effective rate calculation with taxable income at those lower brackets.
Kyle, please do the exact math to prove your point. Thanks
Kyle,
Let’s say you’re in the 25% tax bracket. If you contribute 5,000 to a Roth IRA that is the same as contributing $6,666,67(not $5k) to a 401k. So after 10 years, both get a 5% return.
Roth: 5000*(1+.05)^10 = 8,144.47
401k: 6,666.67(1+.05)^10 = $10,859.30*(1-.25) = 8,144.47
The amounts are exactly the same after the 401k is taxed 25%. Now where I argue for a Roth is that how do you know what this 25% will go up or down. There are two factors that affect this: gov. tax rates and your future income. Both of which I guarantee you cannot predict with 100% certainty. And when you can’t predict something with certainty, I like to diversify. Which is what a Roth IRA does.
What if Sam has 3 kids and they each have 3 kids and now he has 9 grandchildren living in CA? Would he trade being away from his family for saving 10% on taxes? Hard to say :)
Btw, I gladly pay 10% to live in Cali, it’s awesome!
Your discussion of Roths is focusing on spiting the government as the main goal when it should probably be maximizing the amount of $ you get out of the $ you put in. You keep repeating that people will get the same amount out, but that’s assuming their tax rate stays the same. You mention it in passing, but that really is the crux of determining how much $ you will be able to withdraw. Additionally, you gloss over the fact that you are eliminating uncertainty when you choose a Roth. You have locked in your tax rate, an no longer need to worry about whether taxes will go up. You have a lot of good points, but it seems you are focused on spiting the government, not helping people have the most available for retirement.
Tax rates will almost certainly be lower in retirement. Calculate how much capital you need to generate your current income. You think you’ll get there?
it is only the same if you assume that tax rates will be the same, your income will be in the same bracket, and the government doesn’t change the rules regarding both types of ira. honestly you’ll probably be in a lower tax bracket. the government won’t likely start taxing roth ira money already in one. the biggest risk is taxes increase dramatically. the younger generation will be older but i don’t expect their politics to change dramatically as they do. i easily see us getting an average tax rate higher than the current highest bracket of 37%.
Matt,
“Also, last time I checked, you still pay taxes up front on traditional IRA’s. Tax free contributions are only within things like 401k’s or 403b’s.”
You are wrong.
The only difference is that 401(k) contributions are seen in your paycheck but since your IRA is held outside HR can’t possibly know what to do with your paycheck. But it 100% reduces your Gross Income.
As far as the rest please re-read Sam’s post. To put 5k into a Traditional IRA and 5K into a Roth IRA you will need to make more money now to put the same into the Roth IRA. Once that point is understood the rest of his post (whether you agree or not) starts to make sense.
I believe you can withdraw you contribution to Roth IRA penalty free, so it does make sense to invest in Roth if you earning above the traditional IRA limits since you do have access to the money before turning 59 1/2.
You sure about that? Google “ROTH IRA early withdrawal penalties”. Here are the stipulations one must meet in order to not be slapped with a 10% early withdrawal penalty:
Reached age 59 ½ or older
The distribution is made after your death (to a beneficiary)
You become disabled
You’re using the money for a first time home purchase (up to $10,000)
The distributions are part of a series of substantially equal payments
You have significant unreimbursed medical expenses
You are paying medical insurance premiums after losing your job
The distributions are not more than your qualified higher education expenses
The distribution is due to an IRS levy of the qualified plan
The distribution is a qualified reservist distribution.
Yes, you can withdraw your contributions from your Roth any time you wish. There is no penalties for doing this. Key word is Contributions though. You would be penalized on money that you take out that isn’t your contributions. Say you maxed your Roth out every year for 30 years (assuming max is $5k/year) You could then take out $150k penalty and tax free even if you are not 59.5 years old. You were already taxed on the money prior to contributing to your Roth, so you cannot be taxed on withdrawing your contributions.
you can always withdraw your contributions at any time. however any contribution to “repay” that withdraw is a new contribution. the limitations of withdrawals is for the earned income.
Yes, you can take out contributions tax and penalty free. Key word is Contributions. That money has already been taxed and cannot be taxed again. You cannot be penalized for taking out your contributions. Say you maxed out your Roth (assuming $5k/year) for 30 years. You could take out $150k penalty and tax free if you are under 59.5 years old. That $150k is money that was already taxed prior to being put into the Roth, and can’t be taxed again. If you withdrawed any more than the $150k of contributions then you would be penalized on the extra that you withdrawed, not the $150k. All of those non-penalized things in your list only deal with the non-contribution money in the Roth.
BTW, this is a good example you’ve written. Thanks. I’ve highlighted this in the post.
Not all of the unqualified distributions are taxable, as long as you withdrawal below the basis, which your total Roth IRA contribution, your withdrawal is tax and penalty free(at least it worked out that way few years back when I actually went through the IRS worksheets). However, once you start to dip into the earnings it is a whole different story. I also cannot vouch for the non-qualified distributions on the converted Roth accounts since the tax treatment on these might be different.
Yikes, that’s a long list of hurdles to jump over to avoid that 10% penalty!
There are 0 hurdles to withdraw your contributions, only money that wasn’t contributed.
To clarify, what’s the definition of money that wasn’t contributed? How does one can non contributed money into a ROTH IRA?
Do you mind sharing with us whether you contribute to an ROTH IRA, and what your stance is on the government’s efficiency with your money and the viability of full Social Security benefits?
thx
Money that wasn’t contributed= Your invested earnings/interest from contributed money. Assuming you made money from the investments.
I am just starting to contribute to a Roth, But my main retirement is my 401k. Everybody knows that the government sucks at efficiency of money, any person with a little common sense could spend the taxpayers money more efficiently. I am not counting on SS benefits being there when I retire, that’s just another government program that is crap. Like you I am a fan of smaller government.
I contribute to both my 401 and a Roth because I want a little diversification in my retirement. That and I hate my 401k broker, its pretty limited on what I can trade. No options or anything like I can trade in my Roth.
OK. So you think the government sucks, and you don’t count on SS benefits, yet you are willing to pay more taxes up front? I don’t understand the inconsistency.
Are you maxing out your 401K yet? If not, why would you want to open a ROTH IRA if you haven’t maxed out the $17,000 in pre-tax money in the 401K?
I would love to understand more about what younger people who make under $105,000 a year think nowadays. tx
“So you think the government sucks, and you don’t count on SS benefits, yet you are willing to pay more taxes up front? I don’t understand the inconsistency.”
There is no inconsistency.
I don’t understand why you think Roth IRAs are a scheme to take your money. This simply gives you the option to pay taxes now vs. pay them later. Let me spell it out:
-You think the gov. is awful with money? [It is.] -> The gov. is going to have to pay the piper eventually. Since the gov. gets its money from taxes, that means that tax rates will be raised on everyone, across the board. I’m not talking 2019, or 2022, or 2025. I’m talking 2040 or 2050.
-If, like some people, you plan to “work”–generate income–for as long as possible, you might well be in a higher income bracket AFTER “retirement” than you were at the beginning of your career.
-Financial Advice for Young Professionals, above, illustrates the mathematical equivalence between a Roth IRA and a Traditional IRA.
-So, bottom line:
1) You pay the taxes now, and let that money grow. Once you’re 59 and 1/2 years old, you can take the money out tax-free.
OR
2) You invest now, pre-tax, and pray that the gov. doesn’t raise taxes on withdrawals 30 years in the future, or that your tax bracket in retirement is lower than your tax bracket is right now.
Either way, you’re still paying taxes on the investments in your IRA! Choosing option 1) amounts to a bet that you’ll live to at least 60 years old, you won’t need the money before then, and that the government will eventually have to raise taxes to bail it out of its own foolhardiness.
Option 1) gives you certainty–you KNOW how much tax you’ll pay. In 2060, I have no idea how much tax I’ll pay on my forced distributions from a Traditional IRA, 401(k), etc! So Option 2) is less desirable from that standpoint.
If you pay 25% in taxes now, and you think you’ll have to pay MORE than 25% in taxes in 2060, then choose a Roth IRA.
If you pay 25% in taxes now, and think you’ll have to pay LESS than 25% in taxes in 2060, choose a traditional IRA.
If you are indeed a student, then just give it time. The more you make, and the longer you are in the working world, the more you will realize how inefficient the government is. When you pay little to no taxes, of course the government is great.
Sam,
I never said the government was great. In fact, I said the gov. was awful with money! The question is whether they waste your money now, or waste it later.
I’m currently in my 20s. Since I expect the gov. to raise taxes on EVERYONE by the time I’m 65-70, I choose the certainty of paying taxes at the current rate, so that I don’t have to pay *even more* in taxes in 2060.
Nope, not maxing out my 401k yet. I am just putting in enough to get the full match from my employer because I’m not going pass up the free money. I told you why I opened my Roth, I want more investment options than my 401k can provide. My 401 broker sucks. I understand that I could invest in a traditional IRA and get the tax benefits now. But I would rather pay the taxes now, and yes that means giving more money to the government now, than get taxed on it later in life. I don’t want all my eggs in one basket. Taxes could be way higher when I retire, or they could be way lower. Nobody knows. Thats why I both my 401 and a Roth so I’m safe either way.
America thanks you for the contribution.
It is good to hear you and others are so willing to contribute for the betterment of us all. Also, it is good you want more investment options. Whether you are market savvy or not, more options are generally better than less.
Deferring taxes is just as good as not paying taxes until you have to pay them! Do you feel the goverment will spend your money more efficiently when you take it out of your 401k and have to pay taxes?
No. But I will be able to leave California and avoid the 10% state tax by setting up residency in Nevada. Practically all state’s income taxes are cheaper than California.
Is that a joke? That’s not a “long list of hurdles to jump over to avoid the
10 that 10% penalty”. It’s a list of ten different conditions, EACH of which
would entitle you to withdraw your contributions early without any penalty.
I’d have figured you would have gotten the point from the first condition:
“Reached age 59 ½ or older”
If you reached age 59 ½ and didn’t meet any of the other conditions, WHY
in the world would you think that withdrawing your contribution would still
count as “early”?
Matt, thank you for making me believe in Social Security again!
Just to word the 10% penalties for withdraw from Roth a different way in case other folks didn’t catch it.
If you’ve contributed $5,000 for 2 years and it’s grown to $20,000, and in year 3, you take out $5,000. That amount is BOTH penalty and tax free, because you’ve put in $10,000 ($5,000 + %5,000).
Where the penalties come in are if you take out MORE than $10,000. Which is what debtntaxes was saying. Contributions are the money that you took out of your paycheck and already paid taxes on (and also didn’t claim as a Traditional IRA).
“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!”
Not at all. They actually used to collect taxes that way.
But as taxes went up they realized that if most people had to write a check for hundreds if not thousands of dollars at the end of the year there would be a tax revolt. So they “bleed you slow” because it doesn’t hurt you so much.
There was a great npr planet money podcast on when the government started taxing citizens on income. You guys should check it out.
Or at least look at this funny propaganda video the US government paid Disney to create!
https://www.youtube.com/watch?v=00u6qUelp6c
Your points are absolutely spot on.
I like a Roth as a part of a mix of Roth IRA, Traditional IRA and non qualified investments. My thought is that by creating a mix, when I begin relying on this money after retirement I can orchestrate my tax liability at that time. And perhaps it also helps me hedge my bets a bit in reference to moves the government may or may not make in the future.
Sure, a mix is good, and better than NOT saving. But voluntarily giving the government more money just doesn’t make sense. The gov’t has proven their mismanagement and ineptitude over and over again.
I completely get where you’re coming from, Sam. I agree – giving any money to the government before you absolutely have to is ludicrous. I am torn though between that and giving the government control of my money (savings) overall. I have to choose between rolling my 401k over to a traditional or Roth IRA (or hell, biting the bullet, paying 33% -bracket – in taxes and throwing it in my private savings).
The thing that bothers me about the traditional IRA is that the government is forcing me to wait until I am 59.5 before I can withdraw money unpenalized. At least with the Roth, I can withdraw the principal anytime I want and wait to play with the gains/interest when I’m 60. I don’t like the government telling me when I can and can’t spend my money.
Besides, they’re already going to tax the hell out of capital gains. That’s why no one wants to invest, the arse holes.
Thoughts?
Glad to hear someone agree!
Well, since you couldn’t withdraw your 401k before 59.5 anyway,
then it shouldn’t be too big of an issue to roll over to an IRA.
I really think we need to keep our money away from ourselves. It’s not like we don’t have other money in which to live.
Good luck!
I agree with your first point.
I’m partially with you on your second point. However, if you can max out your 401K and are still under the ROTH IRA income limits – I think it is a great place to put your money.
Stick it to the government then by maxing out your 401k, retire 5 years early and rollover 20-30k a year when you are at a low tax rate! Or rollover when your spouse takes time off for a baby, or any numerous other situations when your income is reduced. Great opportunities to rollover!
What would I be rolling over when a retire to save tax?
I would love to be able to “stick it to the government” I just do not know how to.
David
Not paying your taxes isn’t “sticking it to the government”. Apparently you haven’t noticed, but “not having enough funds” has never stopped the government from spending. If it doesn’t have a budget surplus (and it never does), it will merely print more money (which devalues the wealth you own), or borrow money from other countries, which ultimately YOU or future generations of taxpayers will have to pay for.
I’m going to laugh at the people with Roth’s when the government decides they need the cash in the future and implements a tax on gains.
I can easily see the gov’t change and start taxing your money, which is in NOT in your possession when they need more money.
The one major point in favor of your argument that you didn’t highlight is that most people using a Roth IRA assume that they’ll make more money in the future than they do today, thus realizing a lower tax rate by paying taxes now than they would have in the future (even assuming tax rates stay constant). The fallacy here, for many, is that most people will NOT make more in retirement than they do while they are working. In fact most people will make less, and therefore the tax bite would work the other way.
No arguments here:
“Final Important Point: If you are a middle income person who generates $122,000 a year or less for your entire life, and is therefore able to contribute to a ROTH IRA, do you really think when you retire, your income will now be more than $122,000 a year, putting you in a higher income tax bracket during withdrawal ceteris paribus? Be realistic. At today’s 10-year risk free rate of 2.2%, you need $5.45 million dollars to generate $122,000 a year in income!”
“Be realistic. At today’s 10-year risk free rate of 2.2%, you need $5.45 million dollars to generate $122,000 a year in income!”
Thanks for making me smile and laugh!
People do not like to be realistic – its human nature!
I want as many different kinds of retirement savings as I can have. So I have an IRA, Roth IRA, Brokerage account, pension and 401K. When I had income property, it was another one. I do not think you can ignore a choice.
Is this a case of Roth IRA envy? Come on Sam, tell the truth. If you were not ineleigible, you would take advantage of it.
Yes, I hate discrimination and these arbitrary income limits the government imposes on who can and cannot contribute to their retirement. It’s crap.
I don’t have ROTH IRA envy at all. I feel bad for the thousands of people who are giving the government more of their hard earned money. I only wish more people could read this article with an open mind before contributing.
I wrote a post on #RothIraMovement that says a lot of the same things. It’s ridiculous that bloggers make a case that you need a special account or program to save money, or that you will be eating dog food if you don’t contribute to a ROTH. You don’t.
Whatever happened to people just saving their money. Why are special government accounts required for every need? Due to the income limits, contribution limits plus all the rules and interactions with other accounts, it hardly seems worth the trouble.
Donno why the government has to try and get into everybody’s business. Oh yeah, b/c they want people’s money. More taxes up front thank you very much!
I’m happy with my 401k and have no interest in opening a Roth IRA. My employer has a good matching plan which has really helped my total balance add up nicely. If they didn’t offer a 401k plan then I’d probably consider an IRA though or open a single K for my own company.
Good. Don’t do it! :)
Putting the Roth vs Traditional IRA argument aside for a moment, I have heard a couple people here say it’s better to max out your 401(k) first, THEN think about an IRA (if you meet income requirements).
Can someone explain why maxing out my 401k (or in my case, a 403b) would be better than only contributing some money to my 403b, but putting the rest in an IRA?
If you haven’t maxed out your 401K(403b) yet to $17,000, why bother opening up another account instrument for the government to potentially siphon away? Why risk more of your money in the government’s hands? The rules are ALWAYS changing, simplify and minimize.
The only reason why you would want to complicate your life and open a traditional IRA without maxing out your 401k is b/c you might feel a traditional IRA has better investment options. However, even then, you have no idea. The big risk is Big Government and ever changing tax laws.
Because you can typically get better returns in an IRA that you manage vs the limited options available in the company 401k.
You lost me at: “Only those fortunate enough to make less than $105,000 a year/$165,000 for married couples (it’s always changing)” because I wonder what it would be like to make that amount of money.
Just plug those incomes into a calculator, and see all the taxes you’ll have to pay the government. That’s how it feels.
If my choices are either:
1 Not paying taxes
2 Making some Money
I guess I’d like to be an “unfortunate” one making more than $105k. Sure I’d have to pay up to $18k of that to the fed, $8K to SSI/Medi and $4k or so to my state, but that would mean I get to keep $75000! You may think that would be unfortunate, but I think there’s a reason ‘fortunate’ has ‘fortune’ as it’s root!
My observation about your statements You get WAY too tied up in how much you’re paying the government. The gov’t isn’t limited by how much you (or any/all of us) pay them in taxes as Matt pointed out. You’ll pay then now or pay them later as you pointed out, and they aren’t going to suddenly become enlightened, efficient, and thrifty before you start to pay your taxes in retirement. I’m concerned that your concern about putting off paying them could potential to affect your decisions on this diversification issue discussed by several of your responders.
Sounds good. Have you made more than $105K? Or is this conjecture on your part?
It’s easy to say i’m way tied up on how much I pay the government if you don’t have to pay as much to the government, don’t you think?
I like the Roth! A few comments from your statements:
“* The math is the same whether you pay now or later.” –> my thinking is my tax rates will be MUCH higher 20-30 years from now than they are now.
“* What will $5,000 do for your retirement?” –> putting away $5K/year for 20-30 years with compound returns and low fees (surely, a Vanguard IRA offers much lower than the fees anyone’s 401(k) offers), that’s a few hundred grand in retirement. Maybe not enough to retire on alone, but nothing to sneeze at!
You highlighted the contribution limit for single filers only several times but not couples. The couples income limit phase-out begins at $169,000. That’s not chump change. Most American families as you can imagine, are eligible to contribute.
“At today’s 10-year risk free rate of 2.2%, you need $5.45 million dollars to generate $122,000 a year in income!” –> You’re citing today’s 10 year rate for a retirement question that wouldn’t be contemplated for decades for most of your audience. It’s not today’s rate that matters, but the rate in 30 years for me. Do you honestly believe the 10 year treasury will be at 2% indefinitely?
* I’ll take the other side that tax rates will be “much higher” 20-30 years from now for singles making $122,000 or less, and couples making $169,000 or less. Please explain to me why you think the government will assault the middle class at their own detriment to stay in power?
* I highlight single filers b/c everybody reading is at LEAST single by definition. I don’t want to presume that everybody reading is married. Furthermore, it’s stupid that the government doesn’t double $105,000 for couples to $210,000. Where the hell did they get $169,000? I hate sexual discrimination.
* Yes I use 2.2%, b/c that is what I know! The 10 year yield has gone down for 40 years in a row, and anybody who can claim with interest rates will be in 20-30 years is fooling themselves.
I’m surprised you and your wife can contribute to ROTH IRAs. I thank you for your extra taxes to our country! It’s why I’m so bullish about Obama and big government. People loooove big government and are easily swayed.
S
“Please explain to me why you think the government will assault the middle class at their own detriment to stay in power?” – someday we’re going to have to start paying for our entitlement systems and deficits. Seen the austerity measures in Europe lately?
“I don’t want to presume that everybody reading is married.” – Why not just highlight both in the article?
“The 10 year yield has gone down for 40 years in a row, and anybody who can claim with interest rates will be in 20-30 years is fooling themselves.” – Would you like to wager that in a year the 10 year treasury yield will be below 2%. I say it will not. I’d gladly put money aside in an escrow account and take that bet if you like.
“I’m surprised you and your wife can contribute to ROTH IRAs. I thank you for your extra taxes to our country! It’s why I’m so bullish about Obama and big government. People loooove big government and are easily swayed.” – I can’t really follow what you’re saying. First off, why would you be surprised that I, as a single earner filing jointly makes $179,000 or less. Are people that make $179,000 or less poor by your standards? I know you live in big bad silicon valley and all that, but in most of the country I make a pretty good living. I don’t understand the bullish, Obama, big government connection and what that has to do with contributing to a Roth IRA for my retirement. Please enlighten me.
I really don’t think the middle class will ever be touched. In this case, $122K for singles, $169K for couples and below. They are too important for politicians to meddle with.
The 10-year yield is at 2.22%. Why am I spotting you 0.22%? I’m happy to bet you the 10-year yield does drop below 2.22% at some point this year, or during the next 4 years of the Presidential term. We can do a friendly $100. I’m happy to also take the other side about your belief a Republican will win the Presidency for $100.
I honestly thought you and your wife made more than the ROTH IRA income limit of ~$170,000 based on your posts, tweets, and being so against Obama’s policies. Income of ~$170,000 for a married couple is definitely good income, and it’s below the government’s target of $250K for couples to raise their taxes. Not rich, but not bad at all.
Here’s my post on what what I think of the various incomes: https://www.financialsamurai.com/2012/01/27/how-much-income-do-you-consider-to-be-rich/ The income scale is definitely a little warped here in the Bay Area b/c two 29 year old MBA grads out of Stanford and Berkeley or each making about $115,000-$150,000 on average. Hence, that’s $230,000-$300,000 for the couple at 29 years old. By the time they are 35, they are likely making $400,000-$500,000.
I’m bullish on Obama b/c people are so willing to pay more taxes to support our government.
I’m bullish on Obama b/c people are so willing to pay more taxes to support our gover”nment.
The real problem with American people it that they want big government BUT they do not want to pay for big government. That is why we are running a HUGE current deficit and have HUGE unrecorded future liabilities related to Social Security and health care costs.
Someone/Anyone needs to sit us all down and make us face reality!!!!
Just my rambling opinion for a Saturday morning.
Well… we’ve shown right here with this post many many people are willing to pay more taxes up front than they need to with a ROTH IRA. That’s bullish for big government imo!
As of 8am PST, 4/9/12, the 10-year yield is at 2.03%. You worried yet? What did we decide to bet Darwin?
Darwin, I’m talking to YOU. I suspect that even with the 10-year yield below 2% as of today, you probably still won’t pay up. At least offer something and admit defeat. Be a man. Welchers are the worst.
Sam, is Darwin the one who always talks about how the Republicans will with the presidency because the economy is so bad, and when you asked him to bet, he decided not to? Is that the guy?
If so, good luck collecting money from Darwin, even if the 10-year does break 2% in one year. He’s all talk, and doesn’t back anything up with real money. Besides, he and his wife only make under $169,000, so you don’t want to take his money!!
Darwin is indeed a tough one to get money out of! I’ve been close! When the 10-year yield dips below 2%, I will ping him for sure.
Dude, Jerry Curl, WTF are you talking about? Please provide these purported claims. You’re the one talkin’ trash and you haven no idea who said what when.
You make some great points. What if the government decides to tax the Roth in the future? There is nothing stopping them from doing so.
There really is nothing stopping them, just like there’s nothing stopping the government from raising the Social Security benefits age to minimum 67 or slashing distribution by 30%.
The thing that would stop them is that it would hurt the middle class, the ones that are able to contribute to a ROTH. You have made the argument several times on this page that the future tax rates on middle class income will most likely not increase because that is the class that has the strongest voting power.
Exactly. Which is why anybody who contributes to a Roth in fear of higher taxes is seriously misinformed.
Financial Samurai,
You misunderstood his comment. His point was that the government would never tax the Roth because it would hurt the middle class. Does this not follow the logic of your assumptions?
Thank you, Matt. That was exactly what I was getting at. It seems he is trying to take both side’s positions on this issue.
@Anna
If you contribute $5,000 a year in an IRA (traditional, non-deductible, or Roth) for 10 years and you have 10% returns and you would end up with $87,655.84 (assuming full contribution on 1/1 of each year). The Roth would have an after tax value of that amount, but the others would be worth (1-T) with T being your tax rate. However, the gross income it takes to contribute $5,000 in each scenario is different. It takes $5,000 to contribute $5,000 to a traditional IRA, but it takes $5,000/(1-Tax rate) to contribute the $5,000 to a ROTH or non-deductible IRA. This is why people make the claim that if tax rates are the same, and you have $5,000 in income it does not matter which one you choose (because you would contribute (1-Tax rate) to the ROTH not a full $5,000). If you can afford the extra money it takes to make a full $5,000 contribution to a ROTH, that is better than a full $5,000 contribution to a tradition IRA. (I hope that is coherent enough to get the idea across.)
I can’t disagree with a lot of your other thoughts. the biggest fallacy with ROTH’s is that if you are in a higher tax bracket later they are better. While that is true, what are the odds you will have higher income in retirement than your highest earning years? probably pretty small for most people. So if you take that away, then rates have to be increased across the board, rather than you jumping up a rate. As long as we get to vote, we will never vote for someone to increase our tax rates.
The odds are low that one will make more in retirement than while working b/c for goodness sakes, one is retired.
The average American saves less than 20% of their after tax savings for retirement. Good luck generating capital 50X your average annual lifetime income at that rate!
You didn’t admit that the $5,000 in the ROTH is worth more then $5,000 in a traditional IRA. i will take your silence to the debate as you giving up.
Here u go. From the post:
* The math is the same whether you pay now or later. Whether you pay taxes now and let your investment grow tax free, or you let your pre-tax investments grow, and then tax it upon retirement results is more or less the same! Don’t believe me? Do a calculation yourself. Here’s an equation: Y = A * B. Re-arrange to A = Y / B. Or Y = A * B is equal to Y = B * A. Trust me, I was a rock math star in the 2nd grade!
Maybe I’m not understanding something.
As far as I understand, Roth IRA will tax your contributions when you deposit $5500 max per year. If you don’t touch that until you’re 59.5 you can withdraw your contributions AND all the interest they produced tax free.
Traditional IRA will allow you to write-off your $5500 contribution but will tax your contributions AND all the interest they produced at your marginal tax rate.
The point of investing is to have a majority of your money come from the interest not your contributions. So the traditional IRA taxes that too, the majority of the money you made for retirement??? That’s the part that matters!
Am I wrong?
First off, a Roth is fine for someone in the lower tax brackets. Once you are in 25% or higher brackets, then the benefits of pre-tax money make much sense!
Main argument against investing in a Roth instead of traditional IRA is:
You are not getting any immediate tax benefit w/a Roth. If you are in the 28% tax bracket and contribute $5000 to a traditional, deductible IRA, you get to subtract that $5000 from your taxable income (so a $1400 savings). Also, people forget that you also avoid paying state taxes on that $5000 as well (which are at 7% where I am, so another $350 savings).
If you invest in the Roth, you are paying a lot of extra $ up front in order to invest that $5000. Plus, in retirement, you can move to a state that will not tax your retirement benefits. So you could be getting the same tax-free treatment by the state for your trad. IRA as you could had you contributed to a Roth.
Also, your income will most likely be much less in retirement, so you will very likely be at a lower tax bracket.
Holly, I think you just reiterated everything I just wrote in my post! Thanks for your thoughts though!
Yes, I did…! Just felt like siding w/you on the topic. And someone in the comments sounded like he wasn’t sure how you get the tax benefit with a trad’l IRA, so I was hoping to clarify that. Enjoyed this post, FS!
Gotcha. Thanks for getting my back! :)
I contributed to my ROTH IRA for 4 years until I wasn’t able to any more due to my income. Ihave about $23,000 in it. It’s going to do nothing for me.
I should just pull out my $20,000 and keep it liquid.
The ROTH is a waste of time for higher income earners.
It is a curious thing to just have some money tied up in an account that is going to do very little for one’s future. Best to spend it on something you need/enjoy now imo.
“It’s going to do nothing for [you]??” Your Roth account is now growing tax free. Why would you say that it is doing nothing for you? The wisdom of whether or not to invest in a Roth is now in your rear view mirror. I would suggest that pulling your money out would be a major error. Why not invest wisely and let it grow tax free?
I don’t understand the argument where each of you conclude that this money is “going to do very little for [your] future.” If you are young this money could very well be a portion of the foundation for a comfortable retirement.
I think that once the regulations change and 401(k) fees are disclosed PROPERLY you may have to change up the post a bit. Maybe focus on maximizing the Traditional IRA then then the 401(k) then finally the Roth lol
I want to pay the least amount of taxes TODAY.
Disclosure: Between The Wife and I we have one of each, but the Roth IRA is no where near my main priority (I really think it just gets a paltry $100 a month or something stupid).
You might be right Evan! Managing 401Ks and IRAs are big business! Fidelity and Vanguard are cleaning up. I’d love to know in one clean line item what my annual 401K fee is.
Never pay more to the gov’t than one has to!
Evan, bad idea on maximizing the Traditional and then the 401k. Because you can only put in $5,000 (not counting catch-up contributions), to either Traditional or Roth, or a combinations of the 2.
So, if you put $5k in the Traditional, you can no longer contribute to the Roth because it receives penalties I believe, because you are over the maximum amount of $5,000 for IRAs in any given year.
Well it is even more complicated than that. If you are a covered employee things even get a bit more complicated on deductible IRA Contributions, I was just making an abstract point on the 401(k) fee issues while agreeing with Sam about the Roth
Agreed! :-)
I wonder if by throwing social security into the mix, your conclusions would be different. I am referring to the issue of additional income causing up to 85% of social security to be taxable. It would seem that if one had a large traditional IRA and was taking distributions, those distributions would be taxable, and if the amount was sufficient enough, it would make at least a portion of the social security taxable as well. That would not be the case if one had instead, that same amount in a Roth IRA.
That’s a good point. I’ve never collected SS, hence, I’m not in a position to say.
Thank you for bringing up the disadvantages of a Roth IRA.
I have to agree with you that if the tax rates are the same for now & retirement, the math is actually the same. However, the federal tax rates are at their lowest level in more than 50 years. I think the tax rates may go up in the future when US economy is getting better. According to this article, “Analysis finds U.S. tax burden lowest since 1958”
, “USA Today calculated that a person making $100,000 per year pays $23,600 in taxes today, compared to $28,700 in the year 2000 and $27,300 in 1990.”
I think contributing to Roth IRAs make more sense to young people. We don’t have much money setting aside. Roth IRAs can be served as a buffer.
I always want to save more for retirement besides 401(k), but I afraid that I may need that money later on. Indeed, I have an emergency fund that covers 6 months living expenses, and regular online broker account with few thousands dollar in it. If, a big IF, I am experienced long time unemployment and/or I decide to open my own business, I know I can tap into my Roth IRA without worrying about the penalty and tax. It should be better than cashing out from 401(k) or traditional IRA.
You bring a good viewpoint on your fear of your money being locked up in your 401K. You can borrow from your 401K at an interest rate you pay yourself back at. If you have a 6 month EF, you should be fine. Unemployment benefits in America are pretty good!
Of course, if he decided to quit his job to open up that new business, the ability
borrow via the 401(k) is gone. Also, if he borrowed from the 401(k) while working
at that job to start up a side gig, and then later decided to quit his job to pursue
his dream and still had an outstanding 401(k) loan balance, and was unable to
repay that loan, then that entire loan amount would immediately be classified
as a distribution and taxes and (assuming he is under 59.5) early distribution
penalties would apply as well. And those numbers can be a bit brutal.
Sam, I agree with you that Uncle Sam knows how to get your money now or later. Having said that, I still believe that Roth has one major catalyst for very young people that you’ve missed. And, it is called the “Rule of 72”.
If you are young — in your 20s — and if you are savvy to open a Roth IRA and keep putting 5K per year, you can grow your money at 8-10% rate by investing in the best of the fortune 100 companies like Google, Apple etc.
If you do math, you will see that the compounding power of after tax money can make you rich in 30-40 years. Remember, you squirrel away only 5K and assume as if it never existed.
I don’t want to go there but — out tax code is designed to create class war — we need to have a simpler tax code rather than offering Roth IRA to make people feel as if they are getting a huge favor from our government.
You make a compelling argument, Sam. But I still think the Roth IRA is a good vehicle for saving. IF you choose a Roth IRA at a brokerage firm, you can purchase individual socks. Will help a young person to learn how to invest their money. An employee sponsored 401k usually only lets you choose a hand full of mutual funds from their plan, which doesn’t allow for stock analysis and deep investing theory. However, it is good for someone who wants a simple index fund and doesn’t want to pick individual stocks.
Also, the 401k plans charge a management fee, usually around 1%, while a brokerage account usually only charges a flat fee per trade. The Roth IRA has its downfalls, but I still think it is a good tool for you to use in your retirement toolbox.
Yes, good point about the 401K management fee, which is not clearly delineated how much. I’d still do the traditional IRA over the ROTH IRA. But, these are both not bad choices. I just don’t like giving more of my money to the government than I have to.
You can pay them now, or pay them later. Either way, they will be wasting our tax dollars. Even if you move from California to avoid the 10% state income tax when you retire, you still have to pay federal taxes in retirement. Your argument about WHEN one will pay taxes to the government isn’t a good enough argument against the Roth, since your math states it’s all the same anyway. You’d probably do yourself a bigger favor now by moving from California to a state with no income tax and saving yourself the indignation of paying extra 10% tax for the priviledge of living there. I’m surprised someone so concerned with how government spends one’s money would live in California.
I think this an excellent/informative post. Many thanks. You are certainly in the minority – everyone out there is touting the benefits of a the Roth.
But in a similar vein, could weigh in on the ROTH401K. My company has begun offering the ROTH401K option in 2012. I’ve read the same concepts – advantages/disadvantages – could also be appleid to this option. Thanks so much.
No problem. So long as you have more investment choices you like, and you can contribute pret-tax money, it’s all good. Don’t give the government more than you have to!
The Roth 401k is NOT pretax $, thus I will not be putting any $ into a Roth 401k.
The problem with the Roth IRA is that it gives the most benefit to lower income earners who would find it hard to save $5,000 after tax. IMO, if you’re under 25% Roth is a yes, over 25% Roth is a no. So the debate should really only apply to those in the 25% tax bracket, like me!
I look at both arguments for/against but haven’t seen any that are based on fact. Everything is just an opinion, ie you think taxes will not go up. I have no idea where taxes will go, so I use the Roth to diversify against this. With that being said, I think a 401k is often under utilized. Once you pay taxes to the government, you can never get them back! At least with 401k contributions you are deferring your taxes until a later time.
I read through all the comments and it seems like you really hate how the government wastes your money! I agree, but do you think this will get better over time? You will have to pay taxes eventually right? I like your argument, but not sure it can be used in this case, or am I missing something?
Sorry site wasn’t working for a while there, just saw your reply :)
One last point concerns Required Minimum Distributions (RMDs). I have dealt with a number of people who, upon reaching 70.5 years old, must begin taking RMDs from their traditional IRA accounts. They do not want nor need the money but must in order to avoid a penalty. A Roth IRA avoids this issue because Roth IRAs do not require RMDs. Because of the lack of a RMD requirement for Roth IRAs, this also makes a Roth IRA a great tool for passing on to the next generation for continued tax free growth over a long, long time.
If I am 70.5 years old, I am NOT hoarding my cash anymore. I am spending it freely and often b/c stats show I will die in 10 years. And will die within 30 years w/ a 95% chance.
Wow, someone not drinking the Roth IRA kool-aid? Imagine that in this blug-o-sphere. Usually, a PF blogger and Roth IRA are like a dog and its owner’s leg, they just sit there and hump wildly hoping for the best.
While I wouldn’t put Roth’s down completely, they aren’t for everyone. And I think having some diversification is nice. I laugh at those in the 28%+ (even 25%) marginal tax bracket who think they are being all sneaky doing conversions.
One point you missed about them being the same (if tax brackets are the same at contribution and distribution) is you have more money to invest if you go the traditional route. We did a whole post on this, and even have a spreadsheet you can see all the different options of where to put your money. wp.me/p2h40p-1c
Also, I agree with the tax rates on the middle class. We also did a whole post on how the tax system works and tax rates (marginal and effective, before deductions) back to 1913. I personally think it will go unchanged for the middle class. But, we all get to decide for ourselves. wp.me/p2h40p-R
I think Roth IRAs still make sense for high income earners since the income limit for conversion was removed in 2010.
If you make more than $68K MAGI then your contributions to Traditional IRAs are not tax deductible so you might as well convert it to a Roth IRA so the proceeds are never taxable since you are forced to contribute after tax funds. While $5K isn’t a whole lot it does add up and compound over time.
Conversion and contribution are different. High income earner is $105,000 in this case. Someone making $105,000 isn’t going to see their taxes go up.
Not sure I understand your comment. My understanding is that if you for already have a 401k then your contributions to a traditional IRA are not tax-deductible once your MAGI is greater than $68K. I
f you make over $125K then you cannot directly contribute to Roth so what I do is contribute $5K after tax into a Traditional IRA and then convert it to Roth. Doing this means that I don’t have to pay taxes in the future when and if I decide to take distributions. Whereas $5K in a standard investment account would be with after-tax funds and subject to tax on any gains.
High earners are the only group that does well on Roth IRAs. First max out your 401k, including over 50 extra amount. Then contribute to your traditional IRA full amount + over 50 kicker. You will not get any deductions. Stuff it into a money market for a week. Then convert to your Roth IRA. You evade the income limits and get free in the future. The financial recession even helped out on my conversion of my legacy IRA. I converted at the valley in stock values, moving all the appreciation that subsequently occurred into the tax free side and paid very little tax at conversion. One advice note is high income earners need to avoid natural tendency to roll 401k to IRA after leaving firm. That action limits benefits of conversion because you have to do a pro rata of all IRAs. My firm allows me to leave money in a non-IRA 401k type account, still invested. Once I stop earning, then I will roll it to IRA.
To my knowledge, this process is independent of Bush tax cuts and goes on unless changed by law.
Backdoor Roth allows high earners who have to pay tax anyways to shift $5K a year to the Roth without paying any tax. Still get to enjoy the tax advantages. Also it’s supposed to be easier to transfer Roth assets to heirs. So Sam, wouldn’t you at least provide an exception to high earners?
I currently live in Texas where there is no state income tax, and it is very possible that I would move to a state with income tax after retiring (all of my family is in PA). Though ofcourse by then I may be really settled here. Anyway, my situation could be the opposite of Sam’s where he could move out of a state with income tax to a state with no income tax.
I have a Roth IRA and pension (I work for our state government). My husband has a 401(K) which is no longer in use after his company was bought out, and a Roth IRA.
Since we are in a state with no income tax and are contributing to Roth IRAs, aren’t we essentially saving money by paying taxes now in the event that we move to a taxed state when we retire? (Still thinking through the post and comments).
That is a good point. If you have maxed out your own 401k, then by all means contribute to a ROTH if your income is about the traditional IRA cut off.
I would never give up Texas residency if I have established it. I’d just wander elsewhere for half the year.
FS,
I assume you fully realize that by no standard definition could $169k for a married couple be considered “middle class.” (table A-3 pg 41) of the 2010 census data shows that $138.9k of household income puts that household at the 90th percentile, $180.8k puts that household at the 95th percentile. These are hardly middle class numbers. $150k per year is achieved by only 8.4% of the households in the united states (pg 34, table A-2). The median household income (half make more, half make less) is only $67.5k ($72.7k for married couples, Table A-1, pg 33). Congratulations to all of those who make too much to contribute to a Roth IRA, you are far away above the “middle class” and can enjoy a great deal of things that the actual middle class does not. https://www.census.gov/prod/2011pubs/p60-239.pdf. For the record I have both a 401k and a Roth. I will have two pensions upon retirement and it is quite possible that my AGI at that time will exceed my current AGI. The Roth will allow me flexibility in how I take distributions and enhance my ability to control my overall tax burden.
John, do you think therefore that couples making up to $169,000 are at risk of having their income taxes raised by politicians?
If “only 8.4%” of households make more than 150K a year, does that make discrimination right? And if so, at what percentage does it make discrimination wrong?
thanks!
You are SO right. This would open the can of worms called “class warfare”.
Sam, this is a complete fool’s bet, surely you realize that right? “I’m happy to bet you the 10-year yield does drop below 2.22% at some point this year, or during the next 4 years of the Presidential term.” So, the 10 year ended up closing today at 2.06%. Your proposal as written would be as foolish as me now saying, “I’ll be you at SOME POINT in the next year, or (even more laughable), during the NEXT 4 YEARS, the 10 year tips 2.06% once”. That’s lunacy. What I proposed, and stand by, is that a year out – say, April 9, 2012, the 10 year will not be below 2.00%. I stated a year out because you said nobody can predict the future. Personally, I don’t see Treasuries moving lower long-term. Day to day perturbations are anyone’s guess and I don’t care to wager on daily swings. If you want to pick a line in the sand a year out, I’m game!
So you want me to spot you 22 basis points? Very well then. At some point by April 9, 2013 (not 2012), the 10-year yield will breach 2%. It doesn’t have to be under 2% by then, or that day, it just has to breach 2%. A friendly $100 bucks?
Sam, either you’re completely messin’ with me or you have some serious comprehension issues. Here is my initiat statement verbatim: “Would you like to wager that in a year the 10 year treasury yield will be below 2%. I say it will not. I’d gladly put money aside in an escrow account and take that bet if you like.”
[IN A YEAR]. Does that register? My comment was March 30, so this would mean on March 30, 2013, the rate is either over or under 2.00%. Very simple. Nowhere did I say “any time in between”. Obviously the odds are much changed in that scenario.
Surely you can see the difference, no? Are you seriously still not understanding the difference?
Let me put this in perspective of something you should understand. Last year, you predicted what the S&P or Dow or whatever would do in 2011. You cited the performance at the end of the year as evidence that your prediction was accurate, right? Now, if I went around and cherry-picked a March or Jun data point where it WASN’T up that amount, claiming you were wrong, that would be silly, right? You made a 1 YEAR OUT PREDICATION. Same here.
Jerry Curl – you’re a troll. a clueless online anonymous coward. Go away.
It makes no sense to me that I would spot you 30+ basis points and bet out a year.
Why dont i just bet you over under on 2.75% then?
If you said over under on 2.35% in one year at the rate at the time of discussion, I would take you up on the offer.
I make tons of prop bets all the time, and you can ask anybody who prop bets frequently that asking for 30bps + a line to close under at an exact future date is unreasonable.
Can we at least bet on the Presidential race since you’ve been so anti Obama? $100?
Thx!
just figured id say, with respect to betting on the presidential race…obama is drawing a -185 line on sportsbook on today 5/3/12…so asking for an even line just seems unreasonable every time i read this.
Then the line has moved a lot! It was -105 when I first threw it out.
I would still bet -185. Interested?
All valid points. If I were you, I’d probably reach the same conclusion. At this point in my life, I use a Roth as a forced savings plan that I can’t be tempted to touch in case of emergency. With three kids in the mix, there are always reasons we need cash ASAP, and we’ve raided our traditional brokerage account (non-retirement) more than once for random reasons. I also like having mini-goals like putting $5,000 away per year here and there.
Disclaimer: I participated in the Roth IRA Movement just last night! LOL Kept it simpler though. My tax site is more for beginners, so I wrote about contribution limits and deadlines.
Sounds good Lena. Saving $5,000 in a ROTH is better than saving nothing!
A Roth will be good for me. I max out my contributions yearly by saving half of my gross income and putting that in a 401K Roth and a Roth. I have done the math. The illogic fail of why Roth’s are bad rests on the differences between present tax rates and future tax rates. Tax rates are unknowable, but if either possibilities of 1: near lowest historical tax rates coupled with historical high deficits being addressed by raising broad tax rates or 2: personal wealth putting me into a higher tax rate, I will do better with my Roth. Scenario 3 of both 1+2 is what I expect.
I have control of my personal savings and am already to the point to have been advised by my CPA tax man to buy Roths. RMDs are killers. I don’t subscribe to anti-tax rants. I am proud to contribute to my country, I just believe in not over-contributing.
The country thanks you for your extra tax contributions. I thank you too!
I think a Roth is good in certain situations. When I was living in an income tax free state, but didn’t anticipate always living there, I was maxing out my 401k and earning too much for a deductible IRA so I contributed to a Roth. When I quit my full-time job and traveled around the country for a few years, working here and there in multiple income tax free states, I contributed to a Roth and I ended up with a $1000 tax credit to do so. I rolled over my 401k and converted as much of it to a Roth as I could without using any of my own money, using up $1000 tax credit because I had no other tax liability. I managed to get quite a sum into my Roth without ever having to pay tax on the money because of the small amount of money I made during that time. When I went back to work full-time, I stopped converting because it no longer made sense because of the reasons you listed above. I still contribute to my Roth currently, I make too much to get a tax deduction for a traditional. I’m also saving/investing a lot outside of retirement accounts because I have nothing better to do with my money at the moment and it’s fun. I will be using some of my extra income to go on some awesome trips in the near future though.
Robyn, that is an excellent example of one of the many good uses for a Roth. You did the right thing.
I find that the Roth is an excellent retirement plan account to supplement the 3 pillars of retirement income- 401K ( or other retirement plan), social security, and investment income.
Most of the 3 above spit out taxable income and can cause your social security to be taxed (big bummer). By being able to withdraw tax free income and balance the other two, you can get more net income and pay less tax.
Obviously, this scheme doesn’t work for everyone but it’s great when you can work it.
Fern LaRocca CFP® WholeHeartedWay.com
To be fair to Obama, he had nothing to do with the lifting of the IRA conversion limit; that was done back in 2005, by a Republican Congress under a Republican President. It was part of the Tax Increase Prevention and Reconciliation Act of 2005 (aka, TIPRA): https://www.gpo.gov/fdsys/pkg/PLAW-109publ222/html/PLAW-109publ222.htm (section 512). That’s not to say Obama didn’t benefit from the law, but it wasn’t his idea.
Hunh, not sure why this didn’t appear as a reply to The Genius’s comment above, but there you go.
While I’ve got a new comment open, though, here’s my thoughts on the Roth debate: It’s generally good to diversify your funds as much as possible, tax-wise; nobody can say with absolute certainty what the tax system will look like numerous years from now (although the smart money says that it’ll probably be even more complex than our current system). Having taxable accounts, traditional IRAs/401(k)s, and Roth IRAs to your name provides you with flexibility to withdraw in a manner that minimizes the amount that goes to Uncle Sam. As I’ve mentioned myself (https://www.theamateurfinancier.com/blog/great-debates-retirement-account-redux/), I definitely am leaning more towards traditional-style accounts, as I know what I’m saving now but have no idea what our tax system will look like in three decades or so when I retire.
I have a question about this article. So many websites I read address the Roth IRA or the IRA or the 401K but very few address the Roth 401K. How does the Roth 401K fit into this article, and what are your feelings about it for different ages and income levels? Thanks for taking my question.
Haven’t explored it, sorry. Just more investment options I guess.
Hi Sam, i think i have an example as to where a roth contribution might be beneficial:
james has recently been accepted into medical school after graduating valedictorian in undergrad. he comes from an upper class family, and has no immediate need for money (his parents will pay for his medical school bills). eventually, there is a very very good possibility that he will be a very high income earner.
but for this summer, james is working a part time job at the local hospital, and will earn ~$10,000. should he not eat the tax bite now (and only for this year) as he will pay so close to nothing in taxes?
No job, no money. Unless Bank of Mom and Dad will give him an allowance, I’d say keep that $10K liquid to live life!
I’ve been reading up on quite a few articles, trying to see where I should be putting away for retirement, saving etc. You provided me with some great perspectives and I wanted to get your input, if possible…
Current Situation:
30 year fixed mortgage
4% toward 401(k) 50% employer match
$5k per year in Roth
Possible Changes:
Refinance to ARM
Max (if possible) employer 401(k)
Also start contributing to wife’s 403(b)
Only contribute to Roth if maxed on 401(k) and 403(b) ($34k total, right?)
Thanks for the great articles and good perspectives to make me think a little differently.
I agree with many of your statements, to the extent that they are intended for your target audience, which tends to earn well into the six figure arena as I understand it. In the current horrible economy, however, there are a large number of investment savvy, educated, hard working, low income individuals. I for example, am an attorney who makes only around $35k per year. After my various deductions, with the tax credit available due to my qualifying Roth contributions, my effective tax rate is in the low single digits.
It is reasonable to assume that in the future, my income will be many times greater than my current income. In the mean time, it makes sense to pay my near zero tax level on savings. Because I understand the glory of appreciation/compound interest, and because my terrible job has no 401k plan, I scrimp and save, and manage to put my maximum annual IRA contribution together.
I agree that my tax rate upon retirement is likely to be much lower than my tax rate at the peak of my career. It is unlikely, however, that my tax rate upon retirement will be as low as my rate now. For me, the use of a Roth IRA is very much about keeping my money out of the hands of the government. I make the bet that giving the government a a few points on the front end will save me from giving them many more on the back end. In thirty years or so, I guess I will find out.
Dan, thanks for your balanced response. If you have such a low effective tax rate ten by ALL means max out that ROTH!
I wish you great fortune in the future!
Just a thought about what may be a significant difference between a Roth and Traditional.
If both accounts are equal, you may be better off with a Roth if you don’t want to withdraw money from the account at age 70 1/2.
A traditional IRA and a 401k (and a lot of annuities) require you begin withdrawing at least a certain amount based off of your life expectancy. I can’t find the article right now so I’ll go hunting for it in a little while, which stated that the Federal guidelines require you to withdraw a certain minimum amount every year based off of your predicted longevity.
I found the article Sam: https://news.fidelity.com/news/article.jhtml?guid=/FidelityFeeds/pages/ira-crackdown-coming&topic=living-in-retirement
Scroll down to the section labelled “Failing to Withdraw”, in which is says:
I don’t believe that the Roth IRA has to follow that same rule, so that it could (if you so desired), let it grow more before withdrawing.
Some of your points are valid. Most are not, Roth 401k and 401k are not going to be the same. You are going to be taxed at different rates throughout your entire career. So if my tax rate is 25% while I contribute to a Roth and when I retire my tax rate is 30%, I have already made out on the deal (as long as the gov’ doesn’t change any rules). It does not take a genius to figure this out.
Great article from Forbes that all should read:
https://www.forbes.com/sites/ashleaebeling/2012/02/08/how-a-high-earning-couple-got-roth-iras-and-you-can-too/2/
Re: * The math is the same whether you pay now or later.
True, assuming that tax rates remain the same, and that is very, very unlikely. Taxes are historically low right now, very much unlike the 60%+ rates of the 1970’s.
The odds of taxes going DOWN by the time you retire? Not good, so better to pay the tax now, at a known rate, than risk paying rates 2x or 3x higher.
Taxes aren’t going up, and also, the chances of you making mega millions by the time you retire is small to generate an income in the highest tax bracket.
Consult a professional. They will advise a Roth if it is an option. The author rails against the government but doesn’t grasp that the Roth tax structure is not in the government’s best interest. This ‘article’ is a jumbled mess of misinformation and juvenile idiocy. Locking in your tax-rate in retirement is an incredible option. The tax-free growth can be argued against with a time-value of money stance and the liklihood of a much weaker dollar, but the author does not even scratch the surface of the other benefits of a Roth (incredible flexibility). Also, what if the dividend tax is 25% in 25 years and you have a nice income portfolio? What would you prefer, a tax-free Roth or a taxable Traditional? The dollars will count a lot more in retirement when income is lower, and there is no guarantee you will be paying less taxes during retirement despite what the ‘Financial Samurai’ says.
The government and I want to thank you again for paying taxes up front to help our country. With such a big budget deficit, we need all the willing tax payers as we can!
I’m retired now, and truly am thankful for everybody paying taxes up front.
Cheers
Spoken like a true Libertarian gold bug! Go Ron Paul! See you in 4 years! Your anti-government brain is, to the detriment of your readers, drowning out your pro-investor brain! In all but the most unrealistic scenarios, 5k that grows to 100k in a Roth in 25 years is worth a lot more than if it grows in a Traditional IRA.
Go Obama!
So many people don’t know how to do math. Try it sometime.
Hello,
I have a question. I am 32 years old and putting in 6% to my 401k and employer is matching 100% with 3%. I am making a decent salary and have 75k+ in assets right now. I am wondering if i should max out my 401k or start an additional ira. I currently live in texas and salary is just above 50k/year. In a few years I plan to make 80k+ with the certs that am pursuing. Any help would be greatly appreciated as I am stuck on what I should do.
thanks
Hello, I am 32 years old and in the 25% tax bracket. I have a 401k now and dump 9% into it. I am wondering if its worth it to start a ira on the side from my 401k and max it out per year. thanks
If you’ve maxed out your 401K, then yes. If not, then no.
Calculate whether you can amass a $4 million portfolio yielding a 2.5% risk free return by the time you retire to be in the 25% tax bracket.
but paying the tax now than later may be better since it will probably be much
more in 30 years. My 401k is not maxed out as i stated i put in 6% and my
company puts 3 to equal 9%. My 401k is invested all in stocks.
Calculate how much of a Nut you need to amass to generate your current tax rate in income.
The math for much of the pro/cons of ROTH vs. Non-Roth treats these items as the only tools in the retirement toolbox. Your arguments make sense for those who are under the cut-off limits but what if you can max out all of your tax-advantaged options? Roth conversions then provide you with some options:
I am still trying to grasp the complexities of having multiple retirement accounts but what about:
1) Cherry Picking Investments with Losses for Conversions
Consider a Traditional IRA with a $10K mutual fund that has decreased to $5K. When you roll this into a ROTH, you pay taxes on the $5K amount. If this asset recovers its value, wouldn’t you rather have it in a ROTH than in a Traditional IRA? If your tax rate is the same, then the ROTH provides a 50% tax savings.
2) Asset Allocation
ROTH – Aggressive Investments (Emerging markets, developing markets)
Traditional: Standard Investments (Standard Large, Small, Value Caps)
Non-Tax: Tax Free Bonds 4% returns
Under this distribution, wouldn’t having your higher risk/return investments in a ROTH make more sense?
3) AGI Impacts in Retirement
I understand that ROTH distributions do not impact your AGI while Traditional distributions do. This could impact the taxes on your social security and medicare premiums.
Perhaps I am missing something, but I think there are opportunities to use the ROTH wisely when and only when your pre-tax plans have been maxed out.
I agree. If after you max out pre tax, you can start considering the ROTH.
I personally am against the income cut off limit, and also would rather use the small sum of money to invest in something other than stocks and bonds, but myself and my life.
This is more more unfairness creeps in. With a SEP-IRA, I can contribute far more to a ROTH than a person can typically contribute. One advisor suggested I cherry pick items that have declined and I expect to return. When those assets are sold move those funds into higher risk/yield investment options.
OK, so here’s a thought that Ethan kind of posed on your other thread (https://www.financialsamurai.com/2010/01/11/be-a-sloth-and-dont-roth/#comment-4278).
I thought I’d pose an alternative POV (point-of-view) with an almost perfect anti-tax situation that makes the ROTH IRA a better alternative over Traditional if one has the cash flow to facilitate the extra savings.
One of the big problems I see is how OFTEN people raide their ROTH’s for emergencies. I think that’s self defeating, b/c if you want, you can make everything an emergency and screw yourself in the process.
I couldn’t agree more about raiding one’s ROTH for an “emergency” being self-defeating.
However when used along with saving in a 401k and traditional savings, it can be most advantageous once you hit that age of 59 1/2, since you can then utilize both the contributions AND the earnings, to extend the length of time until one draws (or has to draw) on Social Security.
Always a pleasure to have discussions with you sir!
Just to clarify, the bolded text above is referring to “using a Roth IRA along with saving”.
Under current tax law, Roth 401k does not have any contribution restrictions. Since 2010 contributions can be made to traditional IRA’s and immediately converted to Roth IRA’s if desired. Effectively there is currently no income restriction.
It depends on what you think all future tax rates are going to be. If you retire in a lower income tax state and you have modest retirement savings and all other things are equal, then don’t do Roth.
If you think income tax rates go up in the future (e.g. the Bush tax cuts expire and are not fully replaced) then a Roth may have been better. Obviously if you think a lot of waste, fraud, tax expenditures will be removed and the tax rates go down, then a Roth would be worse off.
Withdrawls from tax deferred accounts will generally make your Social Security taxable at your nominal rate, say 25% Federal. If Roth income also makes you SSA subject to taxation, the SSA tax starts at 0% (until you fill the standard deduction and exemptions).
You are ignoring the effect of the business cycle on account balances. It is tough to predict a recession before it happens, but the result is always the same – a drop in 401k balances. It is easy to know when you are in the middle of a recession. 2009 was a great year to convert balances to a Roth if possible. You don’t need to be near the bottom either. You could have been off by a month and still pay a much lower overall lower rate. Of course the caveat here is that you have to be employed and pay the conversion taxes as a lump sum.
Also you are ignoring the estate tax. Paying taxes on income now will reduce the amount in the taxable estate. Obviously, this is only needed for accounts with balances that are much higher than average accounts.
Of course for those who tend to like Roth’s, the idea of a capital gains and dividends taxed at 0% is appealing if it happens.
There is a contribution restriction for Roth 401(k)s: $17000/year total for Roth 401(k), Traditional or a mix of both. The catch-up contribution is the same as the Traditional. The advantage is that $17000 (or $22500) is bigger than $5000. I played with mine this past year. After contributing a percentage to the Roth and recently concluding that it was not a good idea for me. I shifted 1% extra from my Roth 401(k) to the Traditional side and took home an extra $100 a month. As has been endlessly repeated in this thread, the math is the same assuming equal tax rates now and in retirement. The people that deny that are at best being obstinate. Since my home will be paid off, that’s ~$1500/month I won’t need, so I don’t expect my top marginal rate to be 25%. Of course, that needs to be shifted down due amortization, I am just using that as an illustration. In states like California, they capture more of our money in fees, fines, state and local taxes anyway. Even in this economy, there are multiple state and local sales tax, and also property tax increases on the ballot.
What I have not seen anyone comment yet is that IRA/401(k) Traditional or Roth contributions come off your top marginal income rate, while the distributions *fill in the bottom*. What this means is that $5000 in the future *won’t* be taxed at the same high rate it might be now. It will be taxed at the lowest marginal rate (currently 10%, set to go to 15% if DC doesn’t get its act together soon). I think one big mistake I see people doing is confusing effective tax rates with marginal ones.
I work overseas and and pay no Federal income tax. Since I pay no tax up front . . . and Roths are not taxed on the other end, would a Roth IRA be right for me or should I increase my contributions to my 401-K?
Sam, the thing you are missing with your Y=A*B formula is that income tax rates are probably going to rise.
It might be worth it to pay 25% tax on a contribution now, to avoid getting hit with a 50% tax on a withdrawal later.
I’m pretty sure Romney said he’s lowering taxes and Obama is only raising taxes on households earning $250k if Congress approves.
Hence, I would say for 90%+ of Americans, taxes aren’t going up for a long time.
Hey. Nothing like a prompt reply!
As IFA Abroad mentioned below, I am thinking 10-30 years out. The next 3-4 years may well continue stupid political bickering. But, just like 4% mortgage rates won’t last forever, eventually the income tax pendulum will swing back. Roth IRAs should remain one of the last vehicles that are grandfathered.
Also, Roth’s have no minimum deduction requirement, they don’t count toward estate taxes and principle can be withdrawn early in case of an emergency–without penalty.
My current strategy is to have both tax-deferred as well as tax-free retirement accounts, so I can draw up to the first say 15-25% from tax-deferred sources (keeping the low interest rate), and top off my standard of living with the tax-free Roth. Right now my ratio is about 1.5 tax-deferred : 1.0 tax-free, and the ratio will only increase as my income is currently over the Roth IRA contribution limit…..unless I want to go with a Roth 401(k).
“Also, Roth’s have no minimum WITHDRAWAL requirement [at age 70]”…sometimes wish I had an edit link.
Here’s my reason for contributing to a Roth – After maxing out my 401K, I am still over the limit to make a deductible Traditional IRA contribution. So, instead of making a non-dedustible Traditional IRA contribution, it makes a lot more sense to make a non-deductible Roth contribution – at least my earnings grow tax-free! I have to pay the taxes upfront either way- why not reap the benefit of tax-free earnings and avoid paying Uncle Sam some more of my money? Actually last year, my earnings phased me out of making a Roth contribution too. But I was not about to be cheated out of my tax-free earnings, so I made a non-deductible Traditional IRA contribution and then turned around and converted it to a Roth! As long as that loophole is available, I will be using it! (The government recently removed the income limits for Roth conversions)
I agree with Jason, tax rates are going higher. Have you ever looked at historical tax rates? Current rates are amazingly low. Rates may not be headed much higher within the next two administrations, but I expect some reversion to the mean over the next 10-30 years, and for people that are retiring in 30 years – you still have another 30 year time horizon.
50% tax is a distinct possibility, in which case you’ll be murmuring about the ‘good ‘ol days’ when rates were 25%. Roth is an excellent hedge.
25% is unsustainable – they will have to either raise rates a lot or cut spending. And we all know politicians at the federal level will never cut spending!!
For me, a 401K to Roth IRA conversion made sense. I went back to school full time and got to wipe out any federal income taxes on the conversion while in the 10% bracket by using the lifetime learning credit (which would have been otherwise useless to me). Although it is true I had to pay a whopping 6% in GA state income taxes, that is all that I will ever pay on this formerly pre-tax asset provided I wait out the five year period which I fully intend to do. Plus, I expect to have a six figure income within ten years of coming back out of grad school, so this is most likely the lowest tax bracket I will ever be in again.
I believe a Roth is a good option for me. I am a 30 year old, highly educated low income earner. I fully expect that, with more experience, I will see my income grow by at least one order of magnitude through my career. I work with a small company at the moment, which has no 401k plan. Due to the current state of my income, my taxes are negligible, and I can still take a tax credit for my roth contributions, which exceeds the benefits of deducting the money, and provides the added bonus of tax savings later.
Sounds good Dan. If you are in the lowest tax brackets and expect a decent increase in income, then go for it! Keep on saving and never deviate from the plan!
I invested $125,000 in a penny stock and have 200,000 shares.
The stock took a dump and my $125,000 Rollover IRA became $70,000.
In December, 2011, I converted $35,000 into a ROTH IRA and had to pay $6000 because of the conversion.
In January 2012 I converted the other $35,000 and had another tax liability of $6000.
So now I have $64,000 in my Roth IRA.
The stock has gone up and now my ROTH IRA has $117,000 in it.
So if I cash out now, I end up with $117,000 in my pocket and owe no taxes.
I am a glass half-full optomist and will not do that. I am hoping for another 500% increase
so I end up with $10 million in my ROTH IRA and no tax liability.
Wish me luck – GO UCORE
Hey Sam,
While I agree in principle with some of your arguments for sure…I am already in a Roth. At a time when my wife and I were in the 60-100K range, we were putting in allotments every year. We have about $80K total with investment and ‘earnings…’ I’ve not even looked at how small the earnings amount is, but alas.
Now I’m there and I have an idea to make it WELL worth my while:
I do some real estate flipping/wholesaling, depending on what comes our way. I was obviously getting chewed up on taxes at a 30% clip, this year being rather painful. But I’ve learned that I can push my Roth over to a self-directed IRA (pondering Pensco) and invest in these flips that way. Under a Roth, I will NEVER (never say never with the govt.) have to pay taxes on my profits again. I see no flaw other than my money being trapped til retirement. I’ll continue doing some live deals where I pay the 30% just to have some bonus cash, some under a C Corp I started and now some under the Roth. The Fed will get some obviously, but far less at least.
As a CPA I am asked this question a lot. If you are going to be in a similar tax bracket after retirment than while working, then the Roth is the better deal. Why, because for most people,
the required distribution from a retirement plan is going to make 85% of you social security taxable. Say you live 25 years after you start drawing Social Security of say $20k a year.
You are going to pay tax on $425,000 over tht period. Remember, IRA distributions are taxed as ordinary income, not capital gains. And to add to that misery, if you die, there is no step up in basis. You would have been better over never opening that IRA.
Thanks for your thoughts David.
And I like your ending about never opening that IRA. The government is smart!
Sam,
You seem to be missing the point of your own article:
” * The math is the same whether you pay now or later. ”
You seem to be making all kinds of projections based on facts of the future which are unknown.
HOWEVER, in the end it is still 2nd grade math – pay me now or pay me later.
The only way to lower your taxes in retirement (where I am now) is to have both types of savings (Roth and non-Roth). That way you can lower your tax base in retirement and enjoy a lower tax rate. If you don’t have any Roth (or tax-free income) because you thought the 401k or traditional IRA was the way to go, you are just wasting money — remember the 2nd grade Math!
fd
Ok, so I am fairly new at looking into my retirement and trying to figure out if my thinking is in the right direction. That’s how I stumbled on this thread which I read through the entire thing.
At the moment I don’t make a ton of money and will probably not make much more in the future because I work retail and have no degree, just a some basic college, and no traits in any one field at 32 years of age.
I currently contribute to my company’s 401k at 6% which is the max they match. Now I only make in the mid 40k a year, I believe the 25% take bracket. If I raise my % and contribute approx 15k into my 401k through out the year, I would fall into 15% tax bracket. I’m assuming, just by broad thinking, that the government would overal tax me less on AGI and I can utilize more of my own money into my retirement and less to them. Given my current paycecks will be less by 100-200 dollars per check it seems like it could be worth it.
Also If that is true and I could also afford putting whatever dollar amount 100/month-5k per year to a Roth IRA. Would that mean by the time I retire in 30yrs, that If my tax bracket stays at 25% or grows to 30% that I would overall be making the most of my money.
Tho I would be tax on my 401k at 25-30% the capital gains should only be tax at approx 15%, I believe as long as things don’t change with that. So I will be tryiing to maximize my pretax dollars, more for me less for them, and maximizing my company match. Plus with dropping down a tax bracket to 15% before contributing to a ROTH then I’m already saving the difference in the tax when I retire because it will probably be in the current 25-30% bracket.
Is my thinking way off or is this something I should consider. Again this is all somewhat new to me even tho I be my 401k for about 10 yrs now
Good information, but I don’t get your “retire to a state without state income taxes” comment…seems pretty simplistic as many of the 7 states have high costs of living, have high unemployment, the housing market has collapsed, and/or make up for a lack of income tax with very high sales, gas, liquor, etc. taxes. Wyoming and South Dakota (or is it North Dakota, but what’s really the difference?) may be exceptions, but those states may not fit all tastes.
I appreciate all articles on IRAs because everyone brings something new and interesting to help demystify all of this. But your article is extremely biased and opinionated, not saying its not true, but if you really want to help people and let them decide for themselves, then the ONLY way to do that is to be neutral and give all the facts, positive ones too.
Anyway, my main question is about the “math” of it all. Paying tax on 5000 now is MUCH better than paying tax on that principal in the future when it will have grown. Say it doubles every 10 years, then in 40 years (I am young and have that long till i retire) you will have tax free 20,000 to withdraw. So, pay taxes on 5000 now for tax free 20,000, or dont get taxed on 5000, and instead get taxed on 20,000. I doubt that explanation was needed, you get the point. Do you agree with this? If not, please explain your side more because I missed something and I really want to understand all this.
Do the math and run scenarios to figure it out for yourself. It’s the most objective way to come to a conclusion.
Feel free to share your investment experience.
Contributing $5000 for 30 years at 7% growth = $472,304
With a 401(k) you will pay tax later on the entire amount – $472,304. Let’s say you are in the 15% income tax bracket every year of your retirement. You will pay $70,845.60 in taxes.
Whereas if you used a Roth IRA, you would pay taxes upfront, but ONLY on your contributions, not on any of the investment growth. So $5000*30 years = $150,000. Say you pay at the 28% income tax rate. You will only pay $42,000.00 in taxes.
So even if you are in a much higher tax bracket now than in retirement, the Roth still makes more sense due to your not having to pay any taxes on any of the capital gains. Also, the money is not even tied up to the extent it is in a 401(k) as you could withdraw $150,000 (the amount you contributed) at any time for any reason, not pay tax or penalties on it, and then do with it as you please.
You pay less taxes with the Roth IRA unless your investments perform very poorly.
(and note my tax calculations are probably not exact as in the progressive income tax system you the entire amount may not be taxed at the level of the bracket you are in, but these are good estimations)
Well for me contributing to a Roth IRA is the next logical step in saving after contributing the max in my 401k and traditional IRA. The advantage of tax free growth in my opinion makes it a higher priority than simply funding a taxable brokerage account…
True. If you are maxing the 401K, and have the privilege to contribute to the IRA (not everybody does due to income), then max it out! I’m disappointed the gov’t has discriminated against people who make more than $100K a year.
One of the most confusing articles recently read. I’m taxed at 20% going in, it grows tax free. I average 10% annually over 40 years I still have all the money I put in and it has grown 400% 10×40=400 I can take out whatever money that I personally put in and paid taxes on at anytime I want (even before 58yr of age). I can pass it on to my heirs tax free. Really! I’m having a very hard time understanding the point of finanical samurai.
Your argument against the roth is so full of holes I don’t know where to begin. First, I do agree that the limit on the Roth is dumb. The limit on the IRA only applies to you if you participant in a 401k- otherwise, there is no income limit. The gov’t will always be inefficient. Now and in 30 years so that’s an irrelevant point. The penalty is far worse on the traditional IRA because the 10% is on the entire withdrawal- not just the earnings. If you die, your screwed anyway- your dead. The family, your heirs, are screwed in a traditional IRA. The have to add the distribution they receive to there income, maybe pushing them into a higher tax bracket. In the Roth, you prepaid those taxes when you can most afford it, went your alive.
The math is not the same for a number of reasons. First, today I have mortgage deduction, children deductions, business deductions- I won’t have any of those when I’m retired. Second, with the current low tax rates and my deductions, I’m most likely to be in a higher tax bracket at retirement- uncle sam will get more of my money.
The traditional IRA gives a false sence of net worth- there is alwaya a tax liability attached to the asset. With a Roth, at least you know want you have and you can access in retirement without any tax liability. My income will be the same if I save properly and have a small pension. Planning to have less is planning to fail.
I’m not saying the IRA is bad. Unfortunately there is an over-reliance on a very inefficient product. Balancing between taxable, tax free and tax deferred is the key. Paying the taxes now gives you a more predictable income in retirement.
I’m glad you started your argument against my reasoning with an agreement.
Whatever floats your boat Mikey. Having a ROTH IRA is better than not saving. But not paying taxes is better than paying taxes. Go Obama!
While you made a number of valid points, what about the factor that you do not pay taxes on the growth of your Roth IRA? If I contributed $100K to my Roth IRA over the years and the stocks/investments doubled that to $200K. In a Roth I do not pay taxes on the additional $100K when I start taking it out at retirement.
Les, the math is quite similar. Run the numbers and let me know. Thx.
I get that the math is the same. But, if you are so keen on not giving the government your hard earned money, why are you so willing to pay them taxes after you spent so much time growing your tax liability to them?
If you contribute 100K in a Roth and you pay taxes up front you only gave the government the smallest possible amount you would owe (putting aside all other pre/post tax bracket arguments).
However, if you contribute that 100K in a traditional IRA and wait to pay taxes until you take distribution, sure, the net take home to you is arguably a wash. But, your payment to the government in taxes has grown at the same rate as your investment.
If you are truly someone who doesn’t like to give the government money, contributing to a traditional IRA and growing your tax payout to the government is an odd way of making your point.
I think that both investment vehicles have uses and should be well understood in order to use as effective tools when planning for ones own retirement. I just think your argument about not giving the government money seemed silly.
I’ve come to realize I cannot convince you to stop paying more in taxes to the government than you need to, due to all their waste.
Hence, all I can do is thank you for your patriotism and helping pay for my early retirement. We do need taxpayers to keep on paying to subsidize the rest of use who worked hard all our lives and paid taxes.
You may enjoy this article as well, Going John Galt And Protesting Government Waste, I wrote.
In 2012 if I max out my SIMPLE contribution at $11,500 may I still contribute up to $5000 in my personal ROTH account? If I am married and max out my SIMPLE may I and my wife each contribute $5000 to our separate personal ROTHs if we are within the income guidelines?
Thanks
Yes and yes; you and your wife can open Roths, but have to be under different account. You can open additional Roths for your kids (if you have any). Actually, you can open up 100 Roths, but cannot exceed the $5K yearly limit when totalled. However, you can convert a pile of funds from your other IRA, but each starts a new 5-year waiting cycle.
In my limited understanding of Roth vs Trad; many here are missing on the following:
1). There is nothing “tax-free” with a 401k. In a Roth, all the gains are tax-free.
2). Your 401K distributions (contrib + gain) will be taxed as ordinary income. You do not get a ST or LT cap gains deduction, so you essentially are taxed twice. I don’t think you are allowed to buy tax-free muni bonds for this reason. In great contrast, your Roth earnings are not taxed at all.
3). New Math: Initially, a single $5,000 contribution to a 401k will cost you $5,000 up front, while a $5,000 contribution (i.e., buying power) will cost you $6,250 assuming 25% tax rate. At the end of 5 years, assuming a 10% increase in value per year, both your 401K and Roth will have and equal amount of $8,053. Your net gain for the 401K, once taxed and subtracting the $5K contribution, will be $1,040. Your net for the tax-free Roth will be $1,803. Imagine what an even greater benefit the Roth will be if you compound over 10, 20, 30 years!!! Company matching, if any, is as variable if not more than tax rates.
4). The max contrib for a Roth is not $5K (or $6K if aged like me) per year. You can convert a much larger amount from your 401K or other IRA. You can even “recharacterize” if you think the Roth isn’t working for you, and you re-convert the money back into the trad IRA.
Disclaimer: I have not read the entire thread up to this point, so forgive me if I repeat others’ comments.
Your gains are taxed, just not the initial contributions.
So your middle class makes 122k a year, what would you call someone who makes 30k a year? Poverty level I suppose. I am with a previous poster who says that they’d feel fortunate to keep 75k a year.
Oh, and I should mention that I don’t use any government benefits, own a home, have no credit card debt, contribute to a matched 401k and just made the transition from a Traditional IRA to a Roth and am looking forward to withdrawing my contributions tax free when I decide to withdraw before the age of 59.5, I just wish I had made the transition sooner.
Then America thanks you for feeding the wasteful beast we call government.
I don’t mind you paying taxes in order to make my life better. I already paid well over a million in federal income taxes already. Your turn to take care of me and others.
I think America will be a better place without people like you. No tax….no tax….no tax. Typical greedy republican bullshit. When you’re in danger, you’ll be the first one to ask Uncle Sam’s help.
Don’t get me wrong, I am very pro you paying taxes. I’ve paid more than a million in federal income taxes alone. How about you, my comrade?
I’m retired now and have sheltered my income.
Btw, who said I’m a Republican?
Roth big gamble at best not just for the tax reasons sighted but bk earning potential so low with govt. death grip on interest rates etc. If earnings are tax free but there are none compared to cost of living increase then where is the value in investing in a Roth. Granted the govt. claims low inflation (keeps soc sec cola increases unrealistically low saving the govt millions) but we know they have modified inflation reporting stats so as not to include gas and groceries and that’s where we are all seeing the real hike in costs. Also Roth earnings are “currently” tax-free but what happens if there is a policy change?? Only time conversion might make sense is if you become unemployed for a year and return to high pay guaranteed in future. But longevity still makes it a gamble.
Hey Irene-
Stop with the you owe me attitude. No one is against helping those who truly need it. Ask and show gratitude. Others give out of concern and brotherhood, not just bk you demand and demean. Poor judgement on your part to say America will be better off without earning taxpayers. That is like you killing the goose that lays your golden egg. Think Girl and while your asking how about asking for a job…like the Chinese proverb, you know, learn to fish and feed yourself instead of asking to be handed one meal at a time. Then you can practice what you preach by giving it away freely to someone who doesn’t have foresight or any appreciation. Come on now and do the right thing ’cause thats what you want others doing for you.
I just turned 25, make 100k a year, will max my 401k for 2012 with my next paycheck, opened up a brokerage account to pick up some stock in a few of my favorite companies this year, and also opened up a ROTH IRA at the same time. I made a 5k contribution to the ROTH account in April and felt I was doing the right thing until I stumbled across this article and began to doubt my decision. Since then, I’ve been hooked on financial samurai articles and have read through far too many comments. In regards to my situation, I think it makes sense for me to contribute to the ROTH IRA. Unless I am mistaken, a traditional tax-deferred IRA is not an option for me as I am making 100k a year and contributing to a 401k. In my case, the only options are an after-tax IRA or ROTH IRA. The ROTH IRA makes the most sense in this case as the earnings would grow tax-free. Am I missing something, or is this correct? I was confused from the example in your article of the ‘hot stuff’ making 100k, or the ‘Final Important Point’ of people on the income edge because wouldn’t someone in that situation typically be unable to contribute to a traditional IRA? In those scenarios, contributing to a ROTH IRA makes sense but the article seems to casts a negative light on it.
Hi Shawn,
Thanks for stopping by. You are doing GREAT and if you keep it up for the next 10-15 years, you are going to have tremendous optionality to do whatever the hell you want in life! Trust me when I tell you that even the most exciting thing gets boring after a while, so you want to have the financial freedom to do something new. I know I did after 13 years working in finance.
You are correct regarding a ROTH IRA given your income is over 100K/year. Darn the gov’t for discriminating against those making six figures! So definitely feel free to max out your ROTH IRA and 401K. Contributing to a ROTH is better than not contributing.
Finally, I strongly suggest you sign up for Personal Capital, an online wealth management company that is free for users. You can track all your accounts in one place so you can have a better handle of your finances. It comes in handy the more accounts you have, and the more your wealth grows! Before PC, I had to log onto 7-8 different institutions to track 25+ different money accounts.
Best,
Sam
Wow, I wasn’t expecting a reply so fast. Thanks for your comment Sam.
I’m currently using mint.com to track my various financial accounts at a high level, but I will give Personal Capital a look. Mint is not that great at tracking investments so I’m open to other options.
No problem. I’m pretty responsive to questions and comments here. Mint is OK, but it’s not as good for tracking investments I’ve found, as have others.
Shawn,
You are obviously very gullible. This article is a waste of the bytes it is taking up on this site. Unless of course it was meant to lend a bit of comedy. I’m sure the “samurai” will delete this post. But realistically, the reasons he poses for not doing a roth are laughable at best. Case in point, “After making more than $122,000 a year for singles, you are shit out of luck!. . . Discrimination is not OK, just because you aren’t being discriminated against. We need to fight for equality for everybody! “. What does that even have to do with investing. Investing is not about equality. Unfortunately it is not going to be equal. Someone always has to lose for someone else to profit, otherwise everything would essentially be free.
If you don’t think effective tax rates will be higher when you retire (which is the point of doing a Roth) you are kidding yourself. They are already on the rise, and will continue.
Tax rates increased for individuals making more than $400,000 and stayed the same for everyone else. Folks making over $122,000 can contribute to a ROTH, so contributors haven’t seen any tax rate increase. Please use your head.
I’m impressed you think you will make more money in retirement than while you are working. I wish you good luck and the country appreciates you paying more taxes to support the system so we don’t have to.
Ignoring the questionable math on individual tax rates, this article ignores the single biggest financial benefit of the Roth. Specifically, there are no capital gains taxes paid. Period.
I’ve paid 50k into a Roth. My tax rates on that 50k have never been higher than 20%.
Thanks to some good investments, my Roth’s balance is almost 3x those contributions. I’ll never pay tax on that 50k with a Roth. Nor will I pay capital gains on the hundreds of additional thousands to millions in gains I make before turning 60.
To say I am paying more to the gov’t by having a Roth is patently absurd.
Ravi:
you are absolutely correct…this article misses the single largest postive of ROTH’s. I started my Roth at the age of 22 and am now 31. I originally put $10,000 in that account and has now grown to about $44,000. I will never be taxed on that $34,000 increase plus any future increases.
This article doesnt address any of the positives/negatives of the ROTH vs. Traditional debate but instead focuses on the stupidity of paying tax upfront to pay for a growing government. This debate is different for each person and you really need to evaluate your personal situation before you can say what is best for you. Things such as age, current income, current tax rates, future rates, anticipated retirement income, etc all have an impact on this decision.
I am a CPA who does tax prep and planning so this is something I do almost daily. Articles like this do nothing but harm people as it mucks up the facts and makes it more difficult for someone to make an educated decision.
Austin – How much do you have in your 401k and what is your overall net worth beyond the $44,000 in your IRA? It’s about the bigger picture here.
Being a CPA is fine, but it’s the end game that’s most important. It’s not bad contributing to a ROTH after you’ve maxed out your 401k while you are young and in a lower tax bracket. And it’s not bad to support the government more, because we need more tax dollars to fund our country.
I hope this article gets people to stop blindly listening to what financial advisors, people in the money industry, and maybe even CPAs tell to their clients. People have got to learn to think for themselves.
Check out: https://www.financialsamurai.com/the-average-net-worth-for-the-above-average-person/
HI Sam, I am in a unique situation…I am 50 and am no longer working due to disability; I receive a small amt of income from a combination of Social Security and private insurance benefits (about $24K a year) plus about $15K in interest and dividends from investments I have. When I stopped working in 2004 I rolled my meager accrued pension of $19K over as a lump sum into a Fidelity IRA and have since transferred it to TD Ameritrade in a standard IRA account. It is now worth about $25K. I am fortunate enough to have come from a saavy investing family and will be receiving about $1 million in a trust this month and eventually when my parents pass away (if the gov’t hasn’t confiscated all their wealth) will inherit about 2 million more (sometime in the next 1-20 years since my parents are both in their mid 70s right now) . My question is whether I should put that $25K into a Roth at this point when I am in the 25% tax bracket, pay the upfront tax on it (yes I do HATE giving the gov’t my money but at least I’m getting some of it back through my disability payments…) and then work to make it grow tax free until the forced withdrawal starts in 20.5 years when I am 70.5. I am almost certain to be in a higher tax bracket down the road because of income from investments so doesn’t it make sense for me to do that ? Thanks for your input…
Julie,
I would say definitely pay that tax upfront then. If you stand to inherit millions of dollars, then worrying about taxation on $25 shouldn’t be a big deal.
I would spend time spending as much time with your parents and frankly helping them spend their money and enjoy life for everybody. If you inherits $2 mil at 70, that’s great but suboptimal.
How’d you find my blog btw? Always happy to have new readers.
Sam
I found it by googling “cons of Roth IRA” and the rest is history! Very helpful because I just couldn’t figure out whether it was a good idea or not to do a Roth. Another question…could the money if just left in the traditional IRA be donated to a not-for-profit charity thus avoiding tax on it altogether? Or would I have to take the money out, pay the tax on it, and then donate it? If a tax free donation is possible, that might be another way to deal with it wisely. I love your advice on spending time with my parents….I am extremely grateful for their lifelong commitment to saving, investing and teaching us kids the importance of remaining debt free, never buying anything we didn’t have the money to pay for, and not becoming materialistic and greedy. We all worked through high school and I worked in college because I simply wasn’t given extra money to just blow on stuff I ‘wanted’. My two siblings and I have never carried any debt other than a mortgage, and all of us have now paid off our homes in full. With the gov’t likely to take more and more of their hard earned money in the future, my mom and dad have just made the decision to start spending more of their own money on themselves which is wonderful! They are planning on going into a really nice retirement center in a year or two and will have great care and amenities as they get older. Thanks for the advice!
With a Roth IRA, there are no required minimum distributions at age 70.5. This only aplies to traditional IRAs.
Thanks Anthony….did not know that….!
Hey, Sam….I did as you suggested….converted to a Roth and will be paying the taxes this April on it. I’ve done a little stock buying in it and am already up about 1500 bucks from when I converted it! Yeah! Now I have another question that I think I know the answer to, but just want to confirm. In the Roth, can I buy and sell stocks freely as often as I want and not have to pay attention to holding a stock for a year as I would in a regular brokerage acct.? i figure since that is a tax issue, it likely doesn’t apply. In other words, are there any restrictions on how frequently you can buy and sell the same stock in the Roth? I’m not a ‘day trader’ by any means, but might want to take profits from stocks that go up and buy different ones with the money as I go along.
I truly believe that Obama WILL go after the middle class’ money eventually….you actually think his goal ISN’T to reduce all of us to a peasant-like existence with a dictatorial super rich political leadership class at the top? He is wooing the lower and middle class now, dividing them against the upper/wealthy class to ensure that they continue to vote future liberal gov’t leaders into office. Once that is locked in place (with Hilary becoming the next President) then taxes will slowly creep downward in exchange for more and more (poorly run) gov’t programs. @Darwin’s Money
Hello,
Great site. I am cashing out my retirement, taking a lump sum I am 55 dec 30. My wife and I want to take 150,000.00 and put down on a first time home purchase. I will need to use some of it for living exs. And I am just learning about ira s cd ect never had much to put away. Oh homes in our area are 550,000.00 and up what would you sugest to make the rest grow? Also I heard if purchase property within 90 days its tax free is this correct? One more thing when I take the lump sum do I have to roll it over to an ira? And to quilifie for no penities on early retirement must I end employment Dec 31 2012? If we rollover to an ira and want to withdraw? Thanks for your help this is all new to use.
Hi Rick,
Best to speak to a tax account for these questions. The one thing I’m worried about for you is why buy a first time house now at age 55 unless it is for 100% cash? You don’t want to take on huge debt now, unless you plan to work for a lot longer. Sam
Thanks sam,
We took the cash out to buy a home that we in the past, wasnt able to come up with the cash for the down payment. We are looking to buy a home that our mortgage will be less them we pay for renting
We pay over 1800.00 a month for a small 2/2 apt.
Hoping this will cut down on our budget to afford to work less. But I am learning its mot as simple as it sounds jusy to tale the cash. Thanks for you info rick.
Sorry for that type o (just to take the cash)
New follower here so i am sorry if this is redundant or if you answered this somewhere else. From this article I understand the disadvantages of the Roth IRA for the middle class. I know you are in favor of maxing out your 401k every year to maximum contribution limits. My question is on Roth 401K options for middle class and what your thoughts on this option. My company like i think a lot of companies offer employees the option in 401k to contribute to a roth 401k or traditional 401k. Thanks and have a great day!
Just say no to ROTH, IRA or 401K if you don’t have to pay taxes up front. Thx
If you are not very old a roth is a great option to save on taxes. I don’t make a lot a money from my employer (also don’t work a whole bunch!). Taxable income from W2’s after maxing out 401k is approx 30K, max out Roth, max out health savings plan. itemize my deductions, take the saver’s credit on my 1040, depreciate my rental properties for a loss = effective tax rate in 2012 of 1.2% If you spend the extra time on your taxes and make small deliberate investment decisions that are tax advantaged early on in life, then you will, over your lifetime, pay as little taxes as possible. I am trying to not pay taxes now AND not pay taxes in the future. When I am older and Financially independent, I will make each rental property my primary residence for a coupla years and travel the world, sell the property as my primary res and repeat. By then most of my liquid assets will be within our Roth IRA’s with the rest in the 401ks. I would have no problem paying extra taxes throughout my life if I saw it as a good investment and the gov’t using my dollars effectively. until then, minimisin’ my taxes baby!!
I feel a bit out of my league here even writing this question.. But here goes. I am 28 and finishing my masters in Norway. I graduated at 22 from my undergrad and took a few years to work and save before pursuing a graduate degree. My tuition is 100 percent free in Norway and I am able to work part time to support myself with a salary of a meager 25,000 a year. While I am grateful for not having to spend the 20,000 i set aside originally for grad school between the ages of 22 and 25, I am plagued with feeling behind in where I’d like to be by 30. I have minimal expenses here, but my earnings as mentioned, are meager. Do I invest My max 5,000 in a roth this year as I don’t presently have the option of contributing to a 401k? Or do I wait for that opportunity and pay off some student loans from my bachelors instead and let bygones be bygones until my life stabilizes post this degree?
Welcome from Norway! You still there? I think you’ll like this post about the happiest people on earth which describes your situation perhaps exactly? https://www.financialsamurai.com/2012/10/04/learning-from-the-worlds-happiest-people/
I would max our your IRA even if it is 20% of your income. Pretend it is debt you would have to pay for your master’s! You have to start somewhere!
Hi! Just found your site and very grateful if you can answer my questions. I basically have lost everything from a divorce, except $15,000 from the equity in my home that I was forced to sell. I am now living with my brother and collecting on my Social Security (not much but every little bit helps). To supplement my SS, I am hoping to locate some part-time work. I am 65 and feel like I am starting over from square one! I am trying to stay positive and not panic. My question is where should I put this $15,000…a CD, an IRA or a sock in my closet? Seriously, it’s kind of scarey and I, also a two time cancer survivor, don’t want to be a burden on my family, should anything happen to me. I am realistic and know that at this point in my life, growing a retirement seems unrealistic, but I don’t want to just keep putting this money in a savings account that gives me nothing in return.
Any help you can give, will be greatly appreciated. Thanks so much!!
Hi Leslie,
Hang in there! I would suggest you NOT lock away your $15K in a CD or anything that takes a penalty before expiration to get out. Keep your $15K in a liquid savings account where you can access ONLY for true emergencies if this is all you have left.
Definitely find some part-time work where you can to supplement SS. I am glad you are getting SS btw! It’s not a guarantee for other generations. Do you have an expertise in writing and such? There are a lot of freelance gigs online. Fiverr.com has all sorts of opportunities, and there might be things like paid surveys, being in a physical survey, etc you can do.
Good luck and hope you stick around and subscribe.
Sam
I would rate my financial competence about a 5 out of 10, and after stumbling on this article I am even less confident about my setup.
I appreciate the information on the site and in this article and I was wondering if you could give me some feedback about my saving strategy?
My current salary is 135k and I have a 25k yearly bonus. I am married (single wage-earner) and 31 years old, rent ~$2000/month, very low debt (Ch 7 BK around 4 years ago) and only debt is intentional to help build credit.
One thing which strikes people as odd is that I currently rent. The reason goes back to my financial competence which in the past was closer to a 2 out of 10. Some bad real estate decisions in the past when I was single/unmarried (5-7 years ago) pretty much wiped me out. I do plan on buying again – maybe in Lafayette ;) .
Setup
I have a savings account with a +1 year emergency fund, 401k being maxed/matched, checking account with Schwab (basically for the ATM reimbursements and to pay CC bill), use a Chase Sapphire Preferred Card for almost all daily/monthly purchases and memberships (goal is to build credit and earn reward points), and a roth ira at Vanguard being maxed with their target 2045.
Questions
1) I’m confused now if I should swap the roth for the traditional ira? other?
2) Should I be doing anything else with Vanguard besides automatic investments into the single target fund via my roth account? I’ve read discussions about investing in ETFs via Vanguard and I’m assuming that is just a different Vanguard account that would need to be opened?
3) Should I have a separate stock brokerage account like Ameritrade/Scottrade (or use my Schwab account) – or should I stay away from buying individual stocks because I honestly don’t know much about them?
4) Other accounts or ways you think I should be saving?
Couple of last details
I have a newborn and set her up with a standard savings account at a credit union w/ automatic deposits from my account. I’ve heard about some people buying their child gold coins regularly from somewhere like apmex.com, but I’m a little hesitant to do that. Thoughts?
I’m 21 and I have 6,000 in a roth ira. 5,000 of it is my money and the rest are earning . I have two question . One should I still keep this account and add money to it or should I close it and use the money for something else. Two will I get penalize for taking out my 5,000 even tho its only been 3 years and not 5 yet ?
I recommend you keep your money in your ROTH IRA for five years and sign up with Personal Capital and track your fund for free. Start early in your life, leverage the internet, and keep up your savings. Personal Capital has this awesome Fee Analyzer which is saving me over $1,000 a year in portfolio fees I had no idea I was paying.
Sam,
Your section on the withdraw penalty is misleading. At 59.5 years of age, you’re allowed to withdraw ALL of your money (even the earned interest) tax/penalty free. Your failure to mention that prompted me to look it up afraid I misunderstood it.
If the math is the same then why does it matter which account you choose to fund? Why argue against the roth if it is the same as the 401? The answer is its not the same.
Few major advantages to the roth. One you can put it in a brokerage account and buy more than just mutual funds. If over 3 year you double your money an extra time or two because youre good at investing then any advantage you had in the 401 disappears. This is also a disadvantage if you see buying stocks as gambling as your more likely to lose than with mutual funds with this approach as well. The other factor is tax rates when you make the money vs when you retire. This one is really tough to know. I dont know what tax rates will be in 30 years its tough to say.
Great article, thanks Sam! I was just doing some research on Roth vs Traditional, and your article was very helpful.
Hah, that picture is great, definitely embodies how I feel about the government.
I’m going to be honest, I only roughly understood the difference between Roth/Traditional IRA’s and what I thought I knew wasn’t entirely right. Thanks for breaking it down Sam. I just rolled over and I was forced to split between Roth/Traditional (no choice), at least now I know where future savings will go.
I’m 27 and just started working July 2012. My AGI was about $36K for 2012. My employer doesn’t match 401K so I have only been contributing to a roth IRA ($3600 so far). Through April 15, 2013, I plan on maxing out the $5K contribution. I will be changing jobs next year where I will hopefully have a 401K match and hope to start contributing to a 401K at that point. What do you think of my situation right now? Should I change my game plan? Any input would be greatly appreciated.
Confused on your equations. Scenario: 32 years old. Has $5,000 invested, and contributes $916 per month into two IRAs at 12% and stops after 7 years. At 62 (30 years):
Roth has $2,063,827.30 , only given the government (say 25% bracket) $19,235 and has full amount of 2 million to spend tax free.
Traditional has same amount, given $0 to government, but now has full taxes coming out of 2 million dollars. I don’t care what tax bracket that is, but I think it will be much more than $20,000 I think.
Even if you pulled out only the interest in the first year (12% of 2 million dollars), you will be giving the government taxes on $240,000 income. So at (just guessing at least) 35% that would be $84,000 in taxes. That is over 4 times more in just the first year of retirement in interest ALONE.
Equation 1 does NOT equal equation 2. It seems that if you want to keep money management from the government, a Roth is better.
I do think it isn’t fair that they limit the access to under a certain income range. That is wrong. I was great at math too, but I guess I did a bit better in Calculus and measuring the total under the curve…
For all the years I’ve done my ex-husband’s and my individual tax returns, I’ve not questioned the contents in Box 5 of the 1099-R until now. I’ve read the comments on your website and want to know if I can get some or all of that money back and how do I go about doing it?
Am I being paranoid when I think that 401Ks Roths, IRAs etc will come back and hunt us? I mean to you really think they will not tap into the last shred of wealth for middle class America some how? Even though I have a 401K I am beginning to view it as I view SS. it will not be there for me when I need it.
Just a thought Sam. I think it would be fairly easy to get 4%/yr on average if you’re in the market. Thus it brings the necessity of $6.5M to have $122,000 income (@ 1.65% safe investments) all the way down to $3.05M to have $122,000 (@ 4% safe withdrawal rate).
Don’t forget that funding the Roth allows you tax free money that can be taken out when you want (as long as you don’t take away earnings). And I think it would be a bit easier to hit $3M than to hit $6.5M. :-)
Ps: Sorry, I keep wrestling with myself over this. Especially since my 401k is limited to mutual funds as opposed to less safe investments such as individual stocks.
No problem rich. Who knows the future right? What I do know is that if I pay taxes upfront to the government, I lose, they win. They’ve got my money to blow on wasteful things and I’ve got 0 chance of ever optimizing my taxes again.
Never give up. Never give up, unless you really think the government is doing a bangup job………
Well, actually you have 0 chance of ever optimizing your taxes for THIS moment in time only.
Likewise, you’ve locked in your ability to NOT have to pay taxes on your money farther down the road.
I just got my first job out of college, I’m in the 15% marginal tax bracket, and will be maxing out my Roth 401k and Roth IRA this year. Although I love your website and agree with you 99% of the time, I think we differ in opinion about the use of Roth accounts. It’s pretty simple to me, if you think there is a >50% chance that the money coming out of your account will be taxed at a lower marginal tax rate than you are paying now, then contributing to a traditional IRA/401k is more beneficial. It’s very very unlikely that I will be paying less than 15% on this money when it comes out.
Also, a couple points you tried to make don’t make much sense to me, such as:
“The government wastes your money, so don’t give it more.”
That’s the whole point of a Roth! (Giving the government a little money now to avoid giving them a lot of money in the future.) You’re not preventing paying taxes by putting money into a traditional IRA/401k, you’re just delaying payment.
also: “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.”
I know what you’re getting at (you might have given up spending power from the tax savings of a traditional IRA/401k during your life), but this is still irrelevant to me. Your wife or kids would get the tax free money and they would reap the benefits.
One other small advantage of Roth accounts that I think is worth mentioning, although the contribution limits for traditional and Roth accounts are the same, if you were to max out a Roth you’re effectively putting more purchasing power into a tax deferred account as compared to maxing out a traditional account because it comes out tax free.
Sam, congrats for getting your first job out of college and maxing out your retirement plans. If you can max out the 401k and then max out the ROTH then great. Better than not saving that’s for sure.
I think it is great you are helping support the country and America needs folks to pay taxes now to fund our burden and our older generations. I do wonder whether blogs such as mine are inadvertently hurting the government by taking away money from them and keeping more for ourselves.
Let me know in 10 years how you feel about the government and taxes. Thanks!
Financial Samurai,
Sam gave some very good points on the pros of the ROTH yet in your response you failed to address any of those points and gave in my opinion a thinly veiled sarcastic response. I and many of your readers would have loved to see your response to the point Sam made that it’s better to pay taxes at 15% now versus a higher rate in the future when taxes are almost sure to go up and a person may be in a higher tax bracket even if the tax rate remains the same.
The fact that anything a person takes out at the appropriate retirement age even the earnings can no longer be taxed is another benefit. I just wish your response to people who challenge your views were as in depth as your articles.
How do you know tax rates for someone on the 15% tax bracket are going up? Not many people can make more in retirement than while they are working.
I’m happy for folks who want to contribute to a ROTH. Just contribute with your eyes wide open and pay attention to things such as $3 million IRA limitation proposals and Cyprus.
I’m back again. Like Chris replied earlier quite clearly, this is pretty inaccurate and financially inefficient advice.
Roth protects your investments from any future taxation. Say I lock in my 6000% return on $10,000 invested in Apple 10 years ago that I’m about to cash out tomorrow on my 60th birthday in my Roth versus my self in an alternate universe that made too much thus forced to use a 401k.
In the Roth, my original after tax money that I used to invest was taxed at say 20% of $10,000 yielding a $2,000 tax bill. My alter ego pays a similar 20% rate on the $600,000 gain yielding a $130,000 tax bill. Unless one assumes their portfolio will yield negative returns at retirement, it is wholly illogical to not maximize one’s Roth opportunities.
The numbers just doesn’t add up. Maximize your Roth to save big bucks on one’s investments. Taking compounding and investments that outperform into account, that can very well mean an order magnitude difference in tax savings that’s locked down in your pocket vs. the (to some, repugnant and vile, others, a liberal democracy) government.
The government is too big and places almost the entire tax burden on the top 10% of earners, that’s why I’m maxing out my Roth accounts this year while I’m paying a relatively low tax rate. I’ll pay about $3,000 in taxes on the $23,000 that I’m allowed to put in(17.5k in Roth 401k / 5.5k in Roth IRA). If it grows at the historical rate of return of the S&P 500 (9.77%) this sum of money will grow to about a $1 million in 40 years. If it were in a traditional 401k/IRA I would pay about $350,000 in taxes when I took it out (probably much more because I would take these distributions over a period of time while the account continued to accumulate capital gains and it’s likely that tax rates will be higher in the future). So my options are:
A.) Pay $3,000 in taxes now <– correct answer
B.) Pay $350,000+ in taxes in the future
C.) Don't pay taxes and go to jail
It's possible that marginal tax rates could be 70% or higher by the time I'm old, and I think there's a very good chance that my effective tax rate will be 50%+, so the benefit of the Roth account could be very substantial in protecting me against future social engineering and redistribution of resources by the government. I'd rather lock in the 15% tax on this money now. There's no way I'd have to pay less than 15% on these distributions; if that were the case I wouldn't have to worry about much anyway because I'd be living in some sort of utopia!
I have a couple questions, Im married and 30yrs old and the total income is about 95k. Im assuming from what I have read the first thing me and my wife need to do is max out our 401k at 17.5 each. Then is a IRA even worth it? 5000 a yr for both of us, assuming it is. What type of IRA would be most benefitial. I would rather not get screwed by the government when it come tax time in the end also. After I do a roth what type of investments should I choose? Sorry if my questions seem odd Im new to the roth idea
Correct. I’d max out $35,000 in 401k combined first, then $10,000 combined in normal IRAs if you can afford to do so.
Id go with a 70/30 mix of equities/bonds. Take a look at this net worth allocation post for more details. https://www.financialsamurai.com/2013/02/11/recommended-net-worth-allocation-mix-by-age-and-work-experience/
I did the math when Roth IRA’s first came out and ultimately came to the conclusion that the answer is most likely this simple. Do you think you will make more annually in retirement than you do when you are working? I think for the vast majority the answer is no. Brokers love Roth’s because most of the time they are trying to get you to move money from an IRA account you already have to a Roth, hence they get fees. The government loves it because they want all they can get as soon as they can get it. For most people Roth’s are a scam. Think about this. For a Roth all taxes are on income you have worked for, for a traditional IRA taxes are on the appreciation on your saving , the money you didn’t work for and you get to pay it later at most likely a lower rate. Why do investment guru’s have trouble understanding this concept?
Thanks Chris.
I couldn’t agree more. Why do people think they will make more in retirement than during the majority of their working years, I have no idea.
I have no idea why you’re conflating making more in terms of salary with investment returns that will certainly stand at double if not triple digits over a person’s decades long retirement journey. If that is the case, Roth protects those double plus digits from any future taxation with the cost of paying taxes on the original much cheaper principal you put in.
Not using a Roth is just bad, horrendous math at work.
How can you be sure that whether Fed Gov’t can’t tax the Roth IRA. After 10 and 20 years they may change the rules that Roth IRA will & need to pay tax again therefore why tax now when we are not sure what Washington will do 10 or 20 years from now. Do not pay taxes now but deferred to gain your balance.
If you really wanted to take a look at savings that the government gets through taxes, all you have to do is look at the contribution limit of the 401k versus Roth:
401k = $17,500
Roth = $5,500
The government knows that a post-tax dollar saved is worth way more than a pre-tax dollar saved, because they are unable to tax you when you withdraw from a Roth IRA. That is why the limit is so much lower.
People enjoy seeing their 401Ks read into the hundred thousands or millions digits when they are saving, but what they don’t realize is once they withdrawal from these accounts, probably 25% of the money belongs to the government.
Personally, I believe mixing a traditional 401K with a Roth IRA is the best option. The flexibility and tax-free withdrawals of a Roth IRA allows a person to have greater optimization of spending their money in retirement.
If you put 5000 in a roth and buy stock and double your money in a few years
you owe no tax on that 10000
Have to agree here. While consistent income may be important for people, it makes no sense to say it is bad because you won’t be able to take in your same income. A quick calculation shows that someone with gross $120,000 pay brings home about $80,000 after federal, state, and payroll taxes. With a Roth IRA, look at what it would take to bring in $80,000/yr since taxes have already been paid.
It doesn’t make sense for everyone, but if you are young, have a low tax rate, and still have the ability to stash away some money, it is totally worth it. Say it takes 6-8 years for a person to advance to the point that they can’t invest in the Roth IRA. If they’ve been investing the max, they will have a $30-40k emergency budget set up that is always tap-able, and that earns interest tax free.
And if you want to talk about how inefficient the government is with our money, I think it is silly not to at least mention that their mishandling of money could very well lead to future tax hikes as well. If you think you will make more money in the future than you do now, you can pay a lower tax, invest the money tax-free, and then withdraw it at retirement when you might be in the top tax bracket.
If you are a young person, you can take most advantage of tax-free interest and should really look into a Roth IRA.
Maybe cause it’s not always so simple Chris.
a true investment guru should make more in retirement than they do in their 20’s and 30’s. I am currently in the 15% tax bracket because of the loopholes in taxes in this country while I made 110k last year. I expect to be in a higher tax bracket when I am in my 40’s and letting my money work for me instead of being employed for my money. My dividends alone should be about 100k when i retire at 45 or so.
Having a $3 million plus dividend portfolio is great. How did you save so much? What were things like during the downturn?
I said projected:) my REIT funds alone netted me over 10k in dividends last year. The argument is my future pension which is about 70% of my income + dividends + SS = higher tax bracket when I’m retired then the one I am currently in while working. While I do agree most people will never make more while retired I certainty plan to. I still don’t contribute to a ROTH I.R.A. though because they just don’t seem attractive to me. I invest more money monthly usually than the limit for the whole year on a Roth. Doesn’t seem like a good program to serious investor me but maybe i’m just missing something. My 2 cents.
This article is terrible advice and stems from a paranoia in government. While I am no fan of big government and agree with the sentiment that “they’ll take all you have if you let them”, that is NOT a suitable financial argument for not using a ROTH IRA. The tax free advantages on dividends and capital gains in a ROTH IRA, especially by those who have expertise in investing in individual common stocks is great, and I fear people are being terribly mislead from this particular blog posting.
Share with us your financial position, experience and age so why have perspective of where you are coming from.
If you think you can make more in retirement than while working, then good luck to you. If you think Obama’s $3 million IRA limit and Cyprus’ 30% taxing of savers with over 100k Euro won’t ever happen, then great.
If you are young fella who makes an average wage and plans to make more, a ROTH is probably OK. If not, max out the 401k and IRA first.
I don’t mind you paying more taxes to feed the government upfront. I just don’t want to and have a very chunky financial but to protect.
This is what I was going to ask you. Thanks for mentioning it. I always figured if you’re really young, like only 4 or 5 years into your career, then a Roth makes sense.
But is there any advantage to a traditional IRA if you are over the deduction limit? I file jointly, and our adjusted gross income was $118,000, so we’d not be eligible to deduct contributions to a traditional IRA. So wouldn’t a ROTH be better (for us) since at least we’d be saving on taxes on withdrawals in the future? (Assuming the government doesn’t change the rules. But if they do change and ROTH withdrawals are taxed, then wouldn’t both types essentially be the same in my case?)
I’m far from samurai level and am a little oversaturated with IRA research right now, so forgive me if the answer to this is obvious and I’m just missing it.
Hi Annie,
Sure, if you’ve maxed out your 401k and would like to contribute to a ROTH to have earnings grow tax free, go for it. It’s better than nothing and will also add up over the long run.
Best,
Sam
Telling people not to fund a Roth because they have to pay taxes upfront is terrible advice, especially for younger people. If you contribute $5K/yr for 40 years, you are missing out on tax savings of $30k – $70K (15 – 35% bracket) on those contributions. If you only average 8% growth during that time (and btw, the S&P 500 has averaged ~12% returns since inception), you would have approximately $1.3M tax free at the time of retirement, which saves you $195k – $455k. You don’t have to “make more in retirement than you do working” for a Roth to benefit you. The blogger has forgotten the beauty of compound interest.
However I do agree that funding any type of retirement is better than not funding any retirement at all, so whatever you do, don’t do nothing!
Don’t read this post in a vacuum. I recommend maxing out the 401k first for $17,500, then max out the IRA for $5,000 and then max out the ROTH. But don’t people dare contribute to a ROTH before maxing out the other two first. Not sure why you think compound interest and returns don’t apply to $22,500 worth of pre-tax savings first, but it does to a ROTH?
I managed to accumulate over $400,000 in my 401k ALONE by the time I was 34. And my 401k is a small portion of my net worth. Please share your story and how you’ve done?
If you max out a traditional IRA, you cannot contribute to a Roth IRA. $5K (in 2012) is the max you can contribute to any mix of IRAs total. I do know that compound interest and returns apply to pre-tax contributions, but you will pay ordinary income tax rates on those gains, which if you are starting young will exceed contributions by far. It’s wonderful that you’ve done well for yourself, but doing well for yourself does not automatically make you correct when making a blanket statement about not funding a Roth in favor of a pre-tax IRA.
Do you think you will make more in retirement than you will make by working? If so, please demonstrate some simple math on returns and how much you think you will amass.
Also, please give me an idea of how old you are and how much you’ve accumulated in this time so I know whether I’m talking to someone with experience or not.
Thanks
I thought you could only choose a ROTH IRA, once you have maxed out your 401K. Can you clarify?
I have the same question as AP and I do not understand your reply. Compunding would equally apply to a traditional or ROTH IRA but when it is time for the money to come out the traditional IRA it will be taxed at ordinary income rates and the ROTH monies would all be tax free. So if there are a lot of years to take advantage of time and growth through compounding the extra tax up front on the contribution amount of a ROTH would be less than having the entire amount of a Tradidional IRA taxed (albeit at a lower tax rate). Also if one already has a max contribution to a 401K and can only make an after tax contribution to an IRA then it is better to have a ROTH IRA (likely have to contribute to a traditional then immediately convert since there is no income restriction on conversions). I am 45 and and have 900K in 401K/ROTH IRA. I converted a traditional IRA in 2007-2009 (paid the tax with money outside the IRA) and since then that account has grown from 120K to 200K. I shouldn’t need to touch that account for another 20 years if ever.
How does the minimum required distribution factor into this? Say you reach age 70 1/2 and are required to take RMD? How about passing down to children as inheritance? I used to think mathematically it made no difference, should tax rates remain the same, then I realized that I currently have children, which reduce my tax because of exemptions I can claim. Won’t be the case in retirement. That + RMD made me think Roth is the better option. Am I missing something?
I want to add to your article!!!
This is great. I wish I had read it when I had just started out of college and into my first job.
Instead I did open up a ROTH IRA. But I put a little money in there just the first year $5000. Fast forward, like 6 years later. With all the fees and taxing up front, the money I put in has still yet to recover!!! (It’s still only like worth $4,500).
How sad.
This is not being inflation even. Most people I know are also in the same boat.
—
Anyways, the point I wanted to make was that I agree. If you save a lot of money in your 401K to be taxed later, it is better. The simple reason is that EVEN if you are taxed at a higher rate in your 401k because you make more, YOU ARE MAKING MORE MONEY. It’s not like you are going to be starving for cash. You can probably AFFORD the tax later if you are MAKING more money then.
Right now, you need more money because you are making less.
I agree that ROTH is definitly oversold and is not the best for most people!! You sort of touched on it, but i think you could expand your calculations to cover the fact that if you put into a 401k or regular IRA you save money at your marginal rate, but only pay out taxes at your average tax rate when you withdraw (assuming most of your income is from tax defered retirement accounts). This is a huge factor for my calculations becuase while my marginal rate is 25% (federal) right now, I expect my average rate to be <10% as I plan on keeping my income needs very small. Even if you keep income needs the same i only pay an average federal rate of 14% right now which is much less then my margin. So 401k or regular IRA makes a lot of sence in that case.
You should probably max your HSA as well in advance of your ROTH or even possibly 401k/IRA as it is one of the only ways to get tax defered and tax free money!
Couple reasons/situations why I think ROTH is still a good idea:
1) if you don't quality for regular IRA based on income
2) if your marginal tax rate is very low and you are maxing employer match in 401k I think it makes sense. Backburner plan I have is that if i retire early with low income needs (and hense low margin rate), then i would consider setting up SEP withdraws from my IRAs to move into a ROTH little by little rather than paying a huge conversion tax bill based on my inflated margin rate.
3) For your kids! If you have a business and can employ your kids they have earned income and can contribute to an IRA (or you can transfer money to them via gifts that they can contribute). And since their marginal rate would be so low it would make sence to do a ROTH
4) If you have a lot of money to save you are technically saving more in a ROTH then an IRA becuase 5k tax defered is less then 5k tax free. So if you are maxing 401k and HSA and could easily max an IRA with a lot of money left over then you might consider ROTH. Glad I have that problem :-)
5) College Fund for kids – I personally like the ROTH setup as better than any of the 529 plans for saving for college for my kids as the money is more flexible on use (rather than just education). It helps if you have family members who are gifting you money towards your kids as well.
6) Tax diversification is a good thing.
7) Estate planning – ROTH is better for giving as an inheritance
8) No RMD – you don't have to take money out of a ROTH no matter how old you are, but the gov will force you to from an IRA as they want their taxes ;-)
Sam, you have great points, I never saw this and most people don’t. When you think about it, most people are sheep. When we hear something on TV, read it online on top online websites, top books, we take it for what it is without doing our own homework.
After reading your blog on this topic, I did not believe how it made sense until I did my own research outside of this blog.
Also I see why people are so brainwashed on why the Roth is better if you qualify for it due to income restrictions. If you go google Roth IRA vs Traditional, you will come up on 1000s of articles on why the roth is the way to go.
I have to say, even though I may not totally agree with some of your topics here. At least it has me thinking and forcing me to do my own research outside of here, to make a better informed decision.
Hello, I need some clarification. Sam, in your comments you said you can max out your 401K, then max out IRA, then max out ROTH IRA. My understanding is if you have a 401K, you cannot fund a Traditional IRA. Please explain. Thanks
If you contribute to your 401(k) account, you may still contribute to a Roth IRA and/or a Traditional IRA; however, your participation in the 401(k) plan may affect your ability to take a tax deduction for any Traditional IRA contributions. It will not affect the amount you are able to contribute. (To learn more, see Are You an Active Participant? and Traditional IRA Deductibility Limits.)
Your 401(k) contribution has no effect on your Roth IRA contributions. You only need to ensure you meet the eligibility requirements for funding a Roth IRA.
Your eligibility to claim a deduction for your Traditional IRA contribution on your federal tax return depends on whether you are an active participant of an employer-sponsored plan in the year to which your deduction applies. If neither you nor your spouse is an active participant, you may deduct your full contribution for the year, to which a limit applies. If, however, you are an active participant, your tax-filing status and modified adjusted gross income (MAGI) determine your eligibility to deduct your IRA contribution. Here we take a look at how to determine your active-participant status, which can be tricky as the rules vary for each type of employer-sponsored retirement plan.
From Investopedia
Good suggestion on maxing the 401k, however one thing I don’t see noted is that once your $ is in the ROTH it grows tax free and after 59.5 the distributions are tax free. That seems like a heck of a good thing. Can you comment on this?
Love the site btw.
Hi Mate,
Here are my very candid thoughts on a ROTH IRA. I’d love to hear A rebuttal!
https://www.financialsamurai.com/2012/03/29/disadvantages-of-the-roth-ira-not-all-is-what-it-seems/
Best,
Sam
I have been on disability retirement for about 1 1/2 years. I converted Traditional IRA into Roth IRA 1 yr ago. I am needing to withdraw most of my money from my $2330.00 Roth IRA because of a recent financial emergency. It is my understanding that I can withdraw under disability. Doing so will decrease early withdrawal penalty significantly. Do you know how much penalty I would pay if I receive distribution under disability?
There is one flaw in Sam’s in Tax planning comments on the ROTH. If you are successful in your investment strategy (and many of you will be) and the government keeps spending like crazy (which it no doubt will) then it is quite possible that your tax bracket or tax rate will go UP when you reach age 59 1/2. That means you’re better off paying the tax now and never having to worry about paying it again. People are living longer and will live even longer yet. Thus you may still be working at age 59 1/2, in a high tax bracket, and yet desire to take distributions from your ROTH Ira. Those distributions, no matter what your tax bracket, will be entirely tax free. That’s a benefit that’s hard to beat!
Hi, I’m curious on your take for someone like me who is in a lower paying profession that is not guaranteed to be significantly high paying in the future (non-profit). Perhaps in 10 years, I may be lucky to be making 6 figures, but inflation is a dirty dog. Would you still recommend to not get a ROTH IRA? I don’t have much investment for my age (I’m 28) due to my lack of financial education until recently. I have a traditional IRA now but I was looking at starting a Roth.
What are your thoughts on a Roth when you intend to use the money to fund the down payment on a first time house? Can’t you withdraw the gains without paying taxes for that purpose?
I strongly suggest people confused about Roth to reconsider the advice of this post – it is horrendously misinformed and just breaks down when you do the math.
Roth prevents future taxation on all future compound returns you will gain by retirement with the expectation that you use after tax money now to invest in the original principal.
20% tax paid on $10,000 principal now that yields $100,000 of compound returns by retirement is far cheaper than getting tax free dollars now to invest only to pay 20% on $100,000 10 years from now.
It’s patently absurd to max out your 401k at expense of one’s Roth.
Financial Sumarai,
I’m a newbie as it relates to the financial planning research arena but I have 2 questions.
1) How can you both accumulate a lot of money in a 401k plan and state that you will be a lower tax bracket when you retire in light of RMDs. First, in a 401k plan, you are not allowed to take out any money (with limited exceptions) without a penalty until you are 59.5. This is not true with Roths that allow you to take out your contributions (not earnings) without penalties (assuming you’ve had it for 5 years). Second, you are required to deplete the 401k by virtue of the RMDs starting at age 70.5. If you have the amount in your 401k plan that you recommend, it will be impossible not to be in a high(er) tax bracket when you have to take out AT LEAST 5% of the value of the account per year once you hit 70. This coupled with SS will necessarily ensure that you are less likely to significantly reduce your tax bracket – and that’s assuming that the tax rates themselves don’t increase.
2) Have you taken into account all of the exemptions from income of distributions from the Roth? Distributions from Roths are not counted as “income” for purposes of calculating eligiblity in a significant number of state and federal programs including the actual tax paid on SS benefits, eligibility for senior property tax exemptions, etc.
Using Roths eliminates the guessing game of future tax rates and provides more flexibility in terms of distributions. It also allows you to pass money to beneficiaries tax free. I don’t think that a person who is willing to gamble that the difference in what he/she receives each month by paying taxes upfront will pale in comparison to the tax savings he/she receives by eliminating all of the future Roth distributions from income, not being required to take RMDs, not being taxed on the distributions themselves and the overall peace of mind of knowing exactly how much money is in the account for plainning purposes should be so easily dismissed.
There’s no problem using a ROTH to diversify our tax liability. However, I think it is suboptimal to contribute to a ROTH before maxing out a 401(k). Please share with us your investing experience if possible so I can understand where you are coming from e.g. 25 year veteran. Thx
I am in my early 30s, single, and in the 28% marginal tax bracket. As a single person, I figure that I will be in at least the 25% tax bracket for any income exceeding 36k. I do not plan on taking SS until I am 70. The SS benefits alone will be approximately $25,000 per year. Let’s assume I have the option of putting money into either a Roth 401k or a standard 401k (for purposes of the argument I plan to do a rollover from my Roth 401k to my Roth IRA upon retirment). Let’s also assume that over the course of working I am able to amass $1M in either a Roth 401k or a standard 401k.
The amount of the RMD I would be required to take from the 401k plan is calculated by dividing the balance of the account by my life expectancy. The single life expectancy chart can be found here ) At the age of 70, my life expectancy would be 17 years. $1M/17 years would be approximately $59k. That means that just between my SS and the RMDs, I would have approximately $84k per year as the very miminum income. Any maneuvers witht the 401k prior to the age of 55 (for certain exceptions) or 59.5 could incur penalties, and with very few exceptions, any withdrawal would be taxed at ordinary income rates.
On the other hand, if I amassed $1M in a Roth 401k that I rolled over to my already existing Roth IRA, I would not have to take RMDs, I could take out any of the contributions at ANY time without incurring penalties (assuming I had the account for 5 years which I already have) and none of the distributions are counted as income for federal taxation purposes or for the state in which I currently live. I do not know how different states treat withdrawals from Roth accounts. Therefore, I could withdraw the same $59k tax free, and my only reportable income would be my SS benefits.
I have nothing against 401k plans and I am a fan of saving for retirement in any vehicle a person sees fit. I just don’t see how you can declare Roths to be the inferior option if the the overall goal is to reduce the total amount of taxes paid. There are legitimate pros and cons to Roth options. But, if you are single, it would be very difficult to max out a 401k and receive SS benefits and still substantially lower your income enough to make Roth options universally “suboptimal.” I haven’t run the numbers, but I suspect it is also true for married couples with combined incomes over $160k.
Please explain to me in numeric terms why you believe a Roth IRA and/or a Roth 401k to be subptimal. Your argument about income discrimination should not be considered because anyone regardless of income can convert a non-deductible traditional IRA to a Roth IRA without any tax consequences (if they do not have other traditional IRAs with pre-tax money).
Like I said, I’m new to this arena and fairly late to the game, but I’m interested in learning as much as I can. Congrats on the blog and thank you for your posts.
I like some of the great comments here that a setting the record straight with The benefits of a Roth IRA. Tax free capital gains is THE primary benefit, which is something the Samurai seems to avoid sharing.
Perhaps you can walk us through your “Y=A*B” equation with some real numbers to prove your point.
On average these are great articles but when it comes to facts and numbers the Samurai’s attention to detail fades quickly (which is surprising for some who claims to be a former I-banker).
Let the buyer, er reader, beware!
Have you run the numbers on tax free capital gains after paying taxes on the initial contribution vs the other way? Go ahead and let me know what you come up with.
You don’t have to justify your choice. In fact, we need people like you to pay taxes up front to help keep our shut down government open. So thanks!
I’m a newbie, and I’ve been thinking about rolling my small pension of 21K into a gold IRA. Is the a bad idea ? With economy being like it is and the dollar shrinking, I don’t have much to rely on for retirement .
I have to disagree with this advice. The Roth IRA or Roth 401k make more sense in the following cases:
1. You are in the middle to upper tax brackets and plan to stay there after retirement due to income investment.
2. You believe the tax rates may be the same or higher in the future due to budget deficits.
3. You are planning to be successful in the future and amass a high net worth that generates income (rentals, dividends, etc.)
4. You already have a big chunk in a traditional IRA or 401k and want the flexibility later to take money out tax free (diversify your withdraw options).
People forget that traditional IRAs and 401k’s are tax “deferred” not tax free. There is no rule on what that tax rate is guaranteed to be in the future. Could it be 50%? Could it be 70%? There are historical rates that support that in the US and other countries at different time periods. I guess it depends on how confident you are in the federal and state politicians are at managing budgets.
May I ask whether you have retired or are a Multi-millionaire earning more now than before? I just want to know your background to understand where you are coming from.
Hi,
first of all, I’ve been reading the site and I like it a lot. Very good advice and exactly the kind of things I’ve been looking for. I’m not retired. middle aged, self employed business owner, saves diligently. My business is growing. I try to save half of what I make. I got lucky in real estate, have a bunch of rentals. Estimated net worth > 2.0M. If I plan for success, I will have rental income, investment income, dividend income, interest income after retirement. If I am successful, I will have an equal or greater income in retirement.
If the government raises tax rates to cover budget deficits, then my retirement tax rate could be higher. So, let’s say I have 500k in a 401k, why not start contributing to a roth 401k instead. I can pay a known tax rate now, or gamble and pay an unknown tax rate in the future. With a roth, when I retire, I can choose which plan to withdraw from given the current tax rates and have the flexibility from year to year depending on the tax codes.
I’ve been reading up on Jeff Brown’s ideas. bawldguy.com/ He’s not very big on retirement plans at all, instead he thinks you should cash it out. I’m not that aggressive, and I’m not affiliated with him. But I do look for the best ideas to fit the needs.
Hi M,
There’s no problem in paying taxes up front to diversify a $2 million net worth. I guess it depends on how much you are making now and what is your tax bracket. $2 million may spit out $60,000 a year in retirement relative risk free, which isn’t putting you in a very high tax bracket at all.
With a $2 million net worth, I highly suggest you sign up for Personal Capital. Personal Capital is a free online management management tool that helps you keep track of all your finances in one place. You can track your budget, monitor your net worth, and run your various portfolios through their Portfolio Fee Analyzer to help save you money. It’s an inevitability you will open up multiple financial accounts if you are serious about diversifying your net worth and achieving financial independence. In my case I’ve got 28 financial accounts which I can keep track of via Personal Capital. I’ve sat down with Bill Harris, the CEO of Personal Capital for a couple hours in their offices in Redwood City and I’m confident their product will help improve your finances for free.
Regards,
Sam
Hi Sam
28 accounts is too many. I began consolidating accounts that had less than x dollars. For example less than 200k or 500k. I now have one brokerage firm and about 5 accounts. Life is much easier and I don’t need software to track things. As mr. Buffett says you don’t get points for level of difficulty.
Regarding the Roth I am on the opposite side from you. I am planning to convert as much as I can to Roth accounts. The reason is fairly simple, I believe the government will raise taxes in the future and I believe I will be in a higher tax bracket during retirement due to rental and investment income.
I’m not willing to delay the pain and rely on an unknown tax rate 20-30 years from now coming from an inefficient government. If you have 1 million in a 401k that comes out to about 500k when you have to spend it at the highest tax bracket. If tax rates are higher you get to spend even less.
Unless the government ever goes after Roth accounts then a roth is far superior for anyone that thinks the future tax rates will be higher.
Thanks for the reply, but that assumes I’m retiring now. I’m planning to work for 20 more years (I like what I do). So it would be the future value of $2M now compounding for 20 years at 7% and also adding 100k each year until retirement. That would be about 11.8M at retirement year 1 generating an annual income of $473,556 at a 4% withdrawl rate (if the stars align). Of course you would have to factor inflation as well which people rarely do.
Thanks for the tip, I used to have lots of accounts and brokerage firms, but now I have just 3. I have found simpler is better. Especially if the numbers in the accounts are bigger.
Long time reader, first time commenter. Had two questions that I wasn’t able to find previous posts on:
1) For military, would Roth IRA and Roth 401K (or TSP) make sense since salary is fairly tax-advantaged in the present (e.g. typically no state income tax, no Federal income tax on a good portion of our salary due to untaxed allowances) assuming work at another non-military salaried career prior to retiring?
2) Wouldn’t Roth 401K’s make sense in general since they effectively allow you to contribute more? For example, wouldn’t the pre-tax contribution of $17.5K for a Traditional 401K would be equivalent to a lesser post-tax contribution for a Roth 401K? So by being able to contribute the same $17.5K post-tax, it seems like you’re able to get more untaxed earnings in the end. Or my math is wrong, which could be entirely possible. Thanks!
Quick question:
For military, does Roth IRA and Roth TSP (401K) make sense since our salary is fairly tax advantaged (typically no state tax, lower Federal tax due to untaxed allowances)?
Thanks!
good evening,
I have no clue which one I have to do, traditional 401k or Roth IRA, i am Making 50k/yr,
another twist to add i just got married and she is making 60k/yr ..
where should i put my money ? i am planning to get a house next year.
by the way i am from NY.
thank you
Max out the 401(k) before anything else. Have a happy marriage!
I’m actually doing the opposite of what the article suggests, and increasing my Roth and reducing traditional pre-tax . I have a traditional pension and between the pension, 401k with match, and SS, and possible future tax increases, I’m pretty confident my retirement tax rate will be higher, all other things being equal, and even if its not the piece of mind you get knowing your balance is compounding tax-free and there will be no RMDs is worth a lot. For the last few years I’ve maxed out my 401k pre-tax contributions and maxed out my Roth IRA and HSA. I’m very active with the Roth IRA and do things like selling covered call options and have it loaded with relatively high paying dividend stocks and etfs to generate income. Next year for the first time I’ll be maxing out the Roth 401k+Roth IRA. For people who want to max their retirement savings, I believe this is a great method. One little talked about aspect of maxing out a Roth 401k account is that, god forbid something bad happens and you lose your job, you can roll it over into your existing Roth IRA, which will give you even more income, flexibility and investment options and that will never be taxed. I like this site but a lot of the articles seem to suggest that the retirement accounts will earn little to no interest every year, but I think if you’re willing to spend a little time and actively manage your investment accounts for income and growth, you can get by with far less than average account balances and just live off the income instead of the principal.
Hi, I am currently on SSDI and private long term disability (43 yrs old) and I will be receiving a settlement in the next few months. As my home is paid for outright I am thinking the majority of these funds need to be invested to assist in my income when I am older and the LTD runs out leaving me one day depending on the SSDI which is unlivable. I was considering a ROTH IRA as the stock market scares the **** out of me. I have NO taxable income as my LTD premiums were paid after taxes.
My questions are – can i open a ROTH IRA with no taxable income? And, can I make only one contribution and leave it there as opposed to monthly or yearly?
There is no way I can continue regular contributions on my limited income. I have considered leaving it in savings but I’m afraid that they interest will make my SSDI partially taxable, and there is always the chance I will see something I ‘need’ and spend it leaving me even more destitute when I am older. My plan is to take care of my long term needs i.e. home repairs then put the rest away and forget its there.
Thank you in advance
I am very new to investing, still trying to research and learn so forgive me if my question seems ignorant, I appreciate any information you have (love your site by the way and have spent half the week reading articles and comments). My husband works (I stay home with our 3 young boys) and grosses around $140,000 with bonuses. We live in central IL with a very modest cost of living. Our net worth is at $219,500, a long way from where I want it to be, but it’s a work in progress. My question is, our financial adviser advised against contributing more than what my husband’s company will match in his 401K because they only match $900/year and the investment options are very basic – Bond (Fixed Income) or Large Cap (equities). I’m still trying to understand all this so again, forgive me.
We have been maxing out roth IRAs for the last 5 years. I know one of the reasons we chose roth over traditional is the ability to withdraw what we put in towards college for our kids, should we need to (we are not planning to, but it provides flexibility). This was a compromise for us, to start investing by allowing us to put it towards retirement with some more options down the road. So, that being said, do you think we should stop maxing out our Roth’s ($10,000/year) and put all of it in his 401k? I hate to do that because as a stay at home parent, not contributing even to social security, investing in my own retirement feels like a better choice then just putting it all in his. I’m really curious on your thoughts here?
I may be completely wrong, but my impression in reading this article is that it is missing a big part of the picture here…
Roth IRAs have no taxes, ever again, on all capital and dividend gains. That is to say that a single $5,500 investment, grows at let’s conservatively say 5% (no inflation involved). That investment after 40 years would be 40kish and kicking off almost $2,000 a year in income. All tax free…
It is my understanding, you would be paying your income tax rate on those distributions, if it were a Traditional IRA or 401k.
Won’t lie I would rather pay 20% on my 5,500 now. Than 25%+ on my 40k, in 40 years.
That said, I am diversified between Roth and Traditional/401k holdings, because I very much believe we have absolutely no idea what the tax situation will be like in 20, 30 or 40 years.
I hope to goodness you don’t have to ever pay taxes again after you pay so much tax up front! But the government can change the rule on you and tax you upon exit too. As soon as you pay taxes, you lose.
But if you believe you’ll pay higher taxes in the future, definitely contribute the max and diversify. I would just much rather you max out the 401(k) or traditional IRA first.
Sam,
I think this is what’s missing from your article. As with everything finance, it all depends on your situation.
You are assuming people will stay in the same income bracket their whole lives and/or go lower in retirement. An upwardly mobile person making $100K today at a young age (in the 25% bracket) will most likely be a higher tax bracket when they retire assuming they max out their retirement savings vehicles. That person would most likely be in a higher bracket when they retire.
You say that the government can just change the laws on a whim, but that law sticking isn’t certain, and frankly, it’s highly unlikely they’d ever pass a law like that. The political blow back would be huge, not to mention that the law would be taken through the courts.
My point is, it all depends. Roth IRAs are a great investment tool if you are increasing your income.
It does all depend on your situation, but people need to do the math.
Do you think you will make MORE in retirement than while you are working? If so, do a ROTH. If not, which is 95%+ of the case then I recommend against giving up and letting the government take your money.
You really believe that 95% of kids 22-28ish with AGIs anywhere from $40-70k, are going to make less money in retirement? I dunno, that doesn’t sound right to me.
I’d start to agree with you more as the incomes get over that threshold and head toward the 6 figures range. But I have a hard time believe that young professional will make more fresh out of school than they will with 40 years of retirement savings.
Do the math. If you are retired you are no longer working. To create $70,000 a year in retirement at a 3% return requires having $2.33 million. Now look at what the average American has saved for retirement. Now calculate how to get to $2.33 million earning $70,000 a year.
But, I’m very happy that so many ROTH believers think they will be sitting pretty in retirement. We’ll have a much stronger economy as a result.
95% isn’t the average…if you said 50%, I may be able to agree more.
What are your thoughts on investing in a Roth 401k for people starting into their jobs? I am currently in the 25% bracket and traditional 401k vs roth 401k doesnt change my tax bracket. Math suggests its worthwhile to invest in the roth option (for my contribution beyond the company match) so that it grows tax free. Your opinion is muc appreciated.
I just found your site this week and I really enjoy it. I may be missing something, but what are your thoughts of using the back-door Roth IRA conversion method for high-earners who are already maxing out their 401k. Because of my AGI, any contributions to an IRA would be with post-tax dollars. The back-door conversion method at least allows me to convert some of those post-tax dollars into a Roth IRA that is (as of now) forever tax-free. Obviously, things could change, but this would simply be a method of tax diversification. The benefit of putting money in an IRA even if not deductible is: (1) grows tax-deferred (or completely tax free if Roth), (2) creditor protected exempt asset, (3) systematic forced savings program. But since I get no deductibility now, might as well convert to a Roth and hopefully escape any further taxation. Do you agree? If I’m missing something, please let me know.
Have you maxed out your 401(k) yet? If so, then going the ROTH is not a bad tax diversification strategy.
Yes, I’ve been maxing out my 401k for years. Thanks for the reply.
To be blunt – you are completely wrong. If you want to see the mathematical representation of a ROTH vs a before tax retirement computation I would be happy to share with you personally. This can easily be represented over time and the after-tax contribution wins 100% of the time assuming a certain duration. Your formula is far to limited and does not take into account earnings growth or the value of compounding. Further, you can not monetize something as RMD’s. Many employers now offer an option to distinguish a 401(K) contribution as a ROTH 401(K) – whereas after-tax money is contributed versus before-tax money to the plan. Anyone who argues this is not preferable, does not fully understand the mathematical representation of each before-tax contribution vs after-tax contribution to a retirement plan. Hopefully you were just talking about the idea of investing in a 401(k) versus an IRA plan but you did not leave it at that. You are completely wrong in numerous statements. I enjoy reading your thoughts and they are usually very accurate, very frusturating to read something though that is so completely far from the truth.
Id love to have you back up your assertion with the mathematical examples you talk about instead of just saying I’m wrong with no back up.
Please do so and shoot me an email. I’m happy to publish on article here why my position of maxing out a 401k and not giving in to the government by paying taxes up front is wrong.
My biggest curiosity is how you will calculate earning more in retirement than while you were working. Please also be sure to state your age, net worth, tax rate, and current retirement contribution balance so we get some background of where you are coming from.
Thanks!
I just don’t see how anyone can state with certainty what tax rates they will be in the future. If one’s tax bracket is always going to be the same, then it makes no difference. But there is no one who can assure that will always be the case.
Thus, in general, I would prefer to not pay taxes now, which is more of a certainty. Unless I was in a very low tax bracket now.
Ideally, you would max out your 401(k) and then contribute to a Roth to get some tax diversification. Both accounts have creditor protection and both are forced savings that have disincentives to touching them until later in life (which is a good thing).
Contribution to a 401K vs Roth essentially boils down to what your tax rate is today and what you think you will pay when you withdraw those funds. If your tax rate were to remain the exact same now and in retirement, then mathematically it would make no difference. Compounding actually doesn’t matter either way. 401K will compound with a larger balance, but you’ll pay the tax when you withdraw. Roth will start off lower, but will compound tax free. In both accounts, you do not pay taxes between the contribution date and withdrawal date (if you did… THEN there would be a difference between the two).
I like what others have said. The truly best strategy is to save in a 401K & Roth (the real benefit of either account is deferral of taxes between contribution and withdrawal). Outside of that, it’s a wash. Assuming you can save $23K+/yr, max out both accounts and you’ll be doing great!
The only disagreement I have with Sam is for those of us who cannot max out both accounts and are expecting to cross the income threshold for Roth at some point in the future. In that case, it may be beneficial to have Roth in early years (even if you cannot max out the 401K) and then switch to 401K when you cross the income limits.
Regardless, passive income is the best! Even if it is taxable…
Here’s to all of us becoming Donald Trump (minus the media coverage).
401k contributions should be considered to come off the top of your income (as it reduces your overall income from the top down) and would have been taxed at your highest rate. The more you make over your career, the bigger the tax savings.
401k puts more into an account to compound over time, you didn’t have to pay the tax first.
401k withdrawals are not all taxed at the maximum rate. There is a progressive taxation where you avoided your maximum rate when you first contributed the money, but when you take it out (today’s brackets for married/joint) the first 18k (about) is 10%, the next 55k (about) is 15%, and then you get to the 25% bracket that all your contributions avoided assuming you were in that bracket.
Like Sam said, if you’re young and in the lower bracket, then Roth may work out. But in a higher tax bracket right now, I don’t see how a person would not max out their 401k first, then do the Roth.
There are calculators out there that calculate whether you should do a Roth vs 401k, and when I punch in my numbers, I come out ahead with a 401K.
If the question is which of Roth or IRA will lead to a larger nestegg in retirement, then all the arguments about government efficiency are simply besides the point.
We do know that a person who expects to be in a higher marginal tax bracket in retirement than they are now has a good argument to choose Roth. An interesting situation arises however when we assume the same income now and in retirement. For moderate savers (and by that I mean retirement income of less than about $5,000 a month), the IRA benefits from years of applying a standard reduction to annual taxes.
The Roth has a couple distinct advantages. For one, it allows a larger contribution than a 401k. This is a bit non-intuitive but it happens because the (say, $17,500) contribution limit of a young person in 2013 is the same amount for Roth or 401k, but the Roth is figured on after-tax dollars. So e.g. if the applicable tax bracket is 0.25, the maximum Roth contribution is effectively 17,500/0.75 of pre-tax dollars. The other advantages have to do with better flexibility for loans before retirement and rules for distribution in retirement.
My opinion ? The choice has to be made in the wider context of retirement planning. Examples of pertinent questions include anticipated income during retirement years and money left for the next generation.
Second opinion ? Roth vs IRA/401k is more a religious argument than real for most people. Do both if in doubt.
RE: the math or Roth Vs 401k
If the tax haircut is equal — same tax rate, then the returns are equal
A = A(o) * (1+i)^T * tr
where tr is tax rate,
A is amount
A(o) is initial amount
T is years of compounding
If tr is the same, it does not matter if it is the beginning or end of the math expression :)
Sorry, I should have added to comment above that the equation is for one year of savings. But subsequent years follow the same logic.
1. Put $5k in a traditional IRA….it grows to $50k. You cash out at age 60. Your tax bill is 20% * (50k-5k) = $9k in taxes!
2. Put $5k in a Roth IRA….you are taxed now. your tax bill is 20% *5k = $1k in taxes….it grows to $50k. You cash out at age 60….you pay no taxes when cashing out…earnings grow tax free.
The Roth IRA costs you $1k in taxes. The traditional IRA costs you $9k in taxes. Clearly the Roth IRA is superior to the traditional IRA.
Thank you JP. That was as simple as it gets
Ignore my previous post. It is deeply flawed.
1. Put $5k in a Traditional IRA. Contribute $5k every year. Growth rate 10% a year. 30 years later it is worth $909,717. Let’s say you withdraw it now. Your tax bill (20% tax) is $181,943. After tax total is $727,773
2. Put $5k in Roth IRA. You are taxed now (20%). You are left with $4k after tax. Contribute $5k every year. After tax you are only contributing $4k a year. Growth rate 10% a year. 30 years later it is worth $727,773
Conclusion: Roth and Traditional are the same if your tax bracket stays the same now and in retirement. Roth is only better if you will be in a higher tax bracket when you retire. Or if you expect tax rates to increase in the future.
I’m glad you figured out the math as I’ve stated in my post.
Just wanted to say that the first time I read this post months ago. I thought there must have been some problem with your math. However, today I stumbled upon an article talking about IRA’s and realized that you were correct.
There are 2 ways that a ROTH IRA is actually better though.
1)
Roth IRA:
Lets say you make a contribution of 5k to a ROTH this year (and are in the 28% income tax bracket). You pay $1.4k in taxes but now have 5k in a ROTH IRA. Let’s say over 30 years, the 5k is now worth 50k (8% compounded annually).
At the end of it you have 50k and paid 1.4k in taxes.
Traditional IRA:
Lets say you make a contribution of 5k to a Traditional IRA this year (and are in the 28% income tax bracket). You pay no taxes and now have 5k in the IRA (and have 1.4k extra cash to invest in a non-tax advantaged account). Let’s say over 30 years, the 5k is now worth 50k. The 1.4k is now worth 9k averaging (6.4% compounded annually after tax of 20% [mix of tax on long term and short term capital gains]). You pay taxes on the 50k at only 20% tax so 10k on taxes.
At the end, you have 49k and paid (10k + 5k) in taxes. (The 5k is a mix of loss of profit and tax loss).
You do give more money to the government with the Traditional IRA. The difference here comes from the fact that what you initially pay in taxes is not part of your contribution to the ROTH. This is effectively allowing you to put more money in at once.
2)
If you invest the money in your ROTH in a business you found with a friend. IRAs don’t allow you to hold more than a 50% interest in a business. However, if you found a company with your ROTH money, it effectively allows earnings that you are making personally to enter your ROTH untaxed.
Hopefully this made sense.
I’m glad you realize my math isn’t problematic.
At any rate, a ROTH IRA is fine if you’ve maxed out your 401k and want to diversify your tax liability, especially if you aren’t making much at an earlier stage in your career. But I suggest always maxing out the 401k first.
$66k is (was) the income limit *IF* you have a retirement plan at work. If you don’t then it’s not a limit.
I agree with you that the drum beat of ROTH ROTH ROTH is way overblown. But, in many (not all) ways it’s better than after-tax investing.
I make 500k a yr, and maxed out my roth 401k. I can only make a trad IRA, NON-DEDUCTIBLE..which sucks, since that means i paid income tax upfront and will pay income tax on the way out again!
question is, should I convert my TRAD IRA into a ROTH IRA…so at least I wont pay income taxes on the way out?
BUT BUT….the gamble is this. When I retire in 20 yrs and expect 100k/yr income for retirement….will 500k income tax rate today be lower than 100k/yr tax rate 20 yrs from now?
…would suck if 100k/yr in 2034 has a tax rate of 50%….
Don’t do any conversions unless you have a year where you make no income, and then calculate the amount of conversion to pay minimum taxes. Basically your conversion amount gets added to your income calculation for the year.
In short, It doesn’t matter WHEN you pay your taxes, It matters AT WHAT RATE. You manage your tax rate not the timing. IF the rate is the same than the net results to you are the same regardless of whether you are in a Roth or a traditional IRA.
Joe, this is old but people are dumb so I will post. You don’t pay taxes twice. You only pay income tax on the earnings in a no deductible Ira. If you are playing that game you must keep track of your non deductible contributions and earnings to calculate the tax due.
Pablo is right. Your non-deductible IRA contributions should including filing IRS form 8606 to tell irs that you have contributed X amount (non-deductible) ira contributes in year Y.
When you retire, after 59 1/2, or take RMD at age > 70 1/2, then all those 8606 FORMS you sent to IRS over the years will sum up your lifetime amount of non-deductible ira contributions.
Let’s say you have a lifetime of 8606s totaling $50,000. This is your BASIS.
if you have TOTAL IRAs (sum of all IRA balances of ($200,000) for example,
then the RATIO of amount you have to pay (as income) from withdrawals from your IRA
(assuming no pre 59 1/2 withdrawal)
is
RATIO r = 50,000/200,000 = .25 is the ratio of my IRAs exempt from taxes; therefore, I pay taxes on 1 = .25 = .75 or 75% of whatever I withdraw.
So if in some year I withdraw 1,000 from ANY ira fund, then the taxes I pay is not taxes on 1,000, but on .75 of 1,000 = 750.
The more your BASIS is (the more non-deductible amount over your lifetime) the more this ratio is and thus the less you pay in taxes as ordinary income from your IRA withdrawals including your RMD.
I’m 21 and graduating college this year. I have manageable student debt to pay off, and no credit card debt. But I’m not looking at a six figure salary for a very long time. I intend to allocate some of my earnings to an emergency fund, long-term savings (retirement), and the rest to other expenses. This is all very new to me, but the Roth IRA I’m looking at requires a minimum payment of ~$1,000. I know I can stand to invest this amount my first year out of college even with my monthly student loan payments, plus small amounts for the foreseeable future. Is it worth investing with comparatively limited funds annually from the start in my 20s? Or do I simply need to earn/save more money before getting started? Is it better to just pay off my student debts first (<$25,000 all "low-interest" federal loans at 3-4%)?
100% pay off all debt before you begin investing.
This is what can be done with one’s first goal being home ownership. 100% do not pay off student loan debt before you begin investing. Applying for forbearance will allow you to reduce your payments and increase the length of your loan to 25 years. This lowers your DTI when you apply for a mortgage. Assuming 6% RTI on your investments, you will be ahead of the maintenance on your student loans and the first $2,500 of interest paid/year is tax deductible. The path to your first mortgage includes building credit and saving for a down payment. Open several credit cards and always pay them off in full. Make all 401K contributions necessary to get the employer match. After tax income should be used to max out a roth ira whose purpose is to save for a down payment – $5,500 per year. All contribution amounts can be withdrawn from this account when it is time to purchase a house, as well as all earnings up to a maximum of $10,000 without paying the 10% penalty. If you plan on getting married, than get your future spouse on the same plan. If you and your spouse do this for 3 years, than you will have a 20% down payment on a $200,000 house by saving ~$460 a month each.This means that you can obtain a mortgage without paying pmi. If you need more house than you can also save or invest in other ways, but this method will give you a good start. After the house purchase, it’s a good idea to max out your 401k contributions before investing any money into a roth ira.
Damn, Pete wish someone had offered this advice to me 15 years ago. Saving now
I use ROTH because I’m above the limit to defer under traditional, and below the limit to contribute to ROTH. Otherwise, you’re right–traditional is always better as long as you get the deferral.
OP, I applaud your dedication to blogging and sharing your insight but a few things to note:
While I do believe that the Roth vs Traditional discussion depends on the situation of the person you did forget several important things for Roth.
1.) No required distributions – assuming you can amass a decent nest egg you are never required to take distributions unlike a 401(k) or a Traditional IRA. This means if you can continue to grow your nest egg, better than investing outside the Roth construct, ceteris paribus. This also goes for estate planning. If you were to die, the money could stay in a Roth for your designated beneficiary.
2.) Choice of investments. In a 401(k) you are limited to your company custodian’s investment choices. Don’t see a fund you like, too bad. With an IRA you can choose any fund. Note: This argues for Traditional/Roth IRA over 401(k)
3.) Maximum contribution. You can contribute the same after tax dollars to a Roth as pretax dollars to a Traditional, thus you can contribute more to your nest egg compared to traditional if you can max out, all things being equal.
—————————————————————-
Also the below are opinions (not facts) and I don’t think they should impact the decision on whether you should put money in a Roth.
(1) The government is inefficient. – Sure, but who is to say that they will not be inefficient in the future? At least we have a chance to realize what we can change now; throughout our lifetime than giving tax dollars to the gov’t when we are say.. 70. If we wait we may never see some of those policies or return on our social money. I disregard this because it really doesn’t have anything to do with choosing Roth vs. Traditional.
(2) The government is smarter than you. We have a say in how our money is used. Some of this Roth education is simply due to the fact that many people don’t know how to save, especially at the lower income levels. Wouldn’t you want to have the option to choose what you think is best for your future? Make your own educated decision, based on your research. Again moot point. Just because someone advertises something doesn’t mean it is always propaganda.
(3) You allow asymmetric reward or punishment between equals. – There are ways of funding a backdoor Roth, so you can get around the system. Most of the time “rewards or punishments” are meant to act as a buffer to the less fortunate so that they have some help catching up in the wage gap. Again doesn’t really impact why you should save for retirement.
(4) You may never reap the fake rewards. Then why save at all? Again moot point, whether it is in your 401(k) or your IRA, Traditional or Roth. If I follow your argument and don’t save for retirement at all, there’s probably a 99% chance I’m going to live past 65. I just gave up a significant amount of savings incentive by the gov’t. I’ll take the chance that I live rather than that I’ll die. Even if I die those savings go to my family.
(5) Withdrawal penalty. – Same thing, 401(k) and traditional IRA both have withdrawal penalties just like Roth. Doesn’t impact decision on Roth basis.
Not to be rude to the OP, but most of your arguments are opinions and not facts. They should not impact why you should chose a Roth vs a Traditional IRA, let alone retirement savings.
FYI for those interested here are the benefits of a ROTH (which albeit I agree is NOT always the right choice for someone)
The reason I chose Roth vs Traditional is because of the no distribution option, meaning you can continue to grow your nest as long as you live. The reason I chose to max out Roth before my 401(k) is that I can invest in any fund whereas in my 401(k) I am limited to my company custodian’s investment elections. (FYI: My company does not match, if it did that would be a different story)
It’s not bad to link to a ROTH provider who makes money when you open a Roth IRA with them. But I hope you do realize that is the case. I like Fidelity.
Here is a better link: https://www.financialsamurai.com/the-only-reasons-to-ever-contribute-to-a-roth-ira/
Not sure how that is relevant, if the argument is opening a Traditional or Roth -> Fidelity makes money on both accounts…
Additionally, assuming you are able to max out your retirement you can actually put more into your Roth than a Traditional through the backdoor (not really viable if you already have IRA assets, check your tax situation) -> thus saving more. $5,500 after-tax > $5,500 pre-tax. Thus you can grow that money faster through compounding. Now understanding not everyone can max out, so this isn’t true for everyone.
Didn’t see your Roth post before, but overall still thanks for sharing. Kudos for your blog.
Ok I am 47, make $110k a year and am putting 3% in an Roth and 2% into an traditional IRA and this is through my company’s 401k w/Fidelity (and I do have the ability to manage where the money goes (stocks, bonds, etc.,). I read the article and all of the comments but am still somewhat confused as to whether I should leave my Roth or switch it all to an traditonal. Thanks for all the info!
I max all 3 roth ira 5500 for ny wife and myself each 5500 to trad ira in my wifes name and max out 401k. That way ill get the best of all of them when i retire. Onky about 60% of my retirement income will be taxable thanks to the roth
You can only max out a traditional IRA OR a Roth IRA per person. You can contribute to both but the total still can’t exceed $5,500 (currently). So if you’re actually maxing out both ($5500 in wife Roth and $5500 in wife trad) then you’re exceeding the IRS limit and could get in hot water.
https://www.irs.gov/retirement-plans/traditional-and-roth-iras
Then trowe price and my tax person have been lying to me
If you are late to the saving for retirement game then a Roth is the way I had to go. A regular 401k will make me take Minimum Distributions at 70.5 I will surely still be working trying to put money into the account and did not want it coming out until I retire.
James, if at 70.5 you are working for the company that holds your 401k, you do not have to take your RMD’s until you retire. This is not the case if you are the owner, but for a “non-keyperson” employee you don’t begin taking RMD’s until you retire. You are also able to save more annually in your company plan than a Roth IRA.
Samurai-
Your points are essentially “one” point: tax savings. You also focus in on one income group (briefly mentioning young people but not going into specifics).
401k’s offer up front tax savings however their high fees and expense ratios are well documented:
https://www.bankrate.com/finance/investing/secrets-401k-fees-1.aspx
https://www.bogleheads.org/forum/viewtopic.php?t=50211
People that work for small businesses can often have 401k plans with the worst of these fees. You also fail to mention that if you have a 401k then contributions to a traditional IRA are not tax deductible. Where’s the advantage of doing a traditional with after tax money in that situation?
You seem truly paranoid about the government, and let that affect your financial advice. I agree, pay as little as possible in taxes, but with retirement accounts they’re going to get it on one end or the other. You seem to think for some reason that the government will NOT raise taxes on everyone… you have more faith in them than me. Tax rates going up and down aside, there are two really big advantages of the ROTH IRA over traditional (and these also apply to Roth 401k’s over traditional).
1. Roth means BIGGER! If you save $5500 (the max for me) in a traditional IRA, when you retire you still have to pay taxes on it, so it’s only 75% of that (assuming I’m only taxed at 25% when I retire, like I am now). If you save $5500 in a Roth IRA (also the max for me) then you get 100% of that at retirement because you’ve already paid the taxes. I agree this is too little to really fund a retirement, but in combination with a Roth 401k and taxable savings it is better to have more in the tax shelter accounts. See my BONUS TIP below.
2. Roth = backup emergency fund! Nobody likes to tap into retirement because of an emergency, but lets face it, life happens sometimes. If you keep an emergency fund around, which you should, you are basically letting the money sit in an account and essentially lose value due to inflation. Everyone should have an emergency fund to some extent (think of the lost investment income as an insurance premium on the unexpected), but if you invest into a Roth IRA you can pull your contributions out if that emergency hits beyond what you can handle with cash reserves. I had to do this recently when I went through a divorce (not fun, but that’s another subject), and the ability to pull out my contributions was vastly superior to going into debt (just ask my ex). You should definitely keep a few months of living expenses outside the Roth IRA to help protect it, but if the options are:
A. Put money into a traditional IRA
B. Put money into an emergency fund
C. Put money into a Roth IRA
Then I’d do C all day long because it has the effect of A and B together.
BONUS TIP: Oh and a side note on #2. If you’ve been contributing to a traditional 401k and leave that job, that is a HUGE opportunity! If you can roll over your 401k into your Roth IRA without it pulling you over the maximum contribution limit and you can take the hit on taxes to pay them now, then you can roll over your 401k into a Roth IRA and have your entire 401k balance (deposits, interest, employer contributions and whatever) become a DEPOSIT into you Roth IRA. Note you MUST make this as a rollover, NOT get a distribution and then make a payment (that will nail you on penalties). For example, if you have $20k in your 401k and you switch jobs and will make $80k that year. You can rollover the full $20k into a Roth IRA, pay the $5k extra in taxes (less painful if you just do extra contributions at work) and then have the full $20k in a Roth IRA where you can withdraw it in an emergency. You can even contribute your full $5500 to the Roth IRA that year if you are able since it is considered a rollover, not a contribution (if you’re not able, just think of your extra taxes as your retirement contribution that year and relax a bit). This is a great strategy for maximizing your backup emergency fund and retirement in one.
I don’t know why the original poster of this overlooks these advantages, but do yourself a favor and IGNORE his advice!
You must not have paid very much to the government in your career yet.
Haven’t you heard? Only the paranoid survive.
But, I do thank you for what you have and will continue to contribute through a ROTH IRA.
As one who is there now, I realize the problem with IRA’s. My husband and I started contributing when they first were created in the 80’s, believing the marlarkey that you’d be making less and therefore paying less taxes when you retired. By today’s standards our incomes weren’t that much then and I was subsequently laid off in the mid 80’s, so we lived on my husband’s income alone, still diligently socking away our IRA’s. My husband passed away in the 90’s and I had to go back to work. I retired two years ago and now receive half of my husband’s pension, my own pension and my Social Security, so I thought I was very lucky and could manage nicely, but even with three checks coming in my income has dropped considerably from when I was working. But now I am required to make the Required Minimum Distribution in order to pay taxes on the money we saved. The amount of the RMD is determined by a formula and then added to my income, and it is that total that I pay tax on. The RMD is a much larger chunk than I expected and is just enough to bring me up from the 15% to the 25% tax bracket. I can’t help but feel if we had paid the taxes on our earnings as it was earned, we would have paid far less tax overall. I have gone from thinking I had a fairly secure retirement to watching my money drain out in estimated tax payments like sand in an hourglass.
If you are in the 25% bracket that means you have taxable income of over $75,000. This seems like it should be enough to live on for a single person. Pretty well actually.
This article is very silly. It reads like you have a choice between giving your money to the government or not (don’t give them your money!!!!! lol). News flash: the government is going to get their share in either case, whether you do Trad or Roth. So that is not a valid point of argument. I do agree that Roth may not be the best choice for everyone, however it does make more financial sense for many. I do agree that people should figure out how to keep more of their money, but what the poster fails to realize is that for many people the Roth may result in fewer total taxes paid, which seems to be the goal he is going for.
Not to mention, when you consider the size of the current federal budget deficit and debt, it seems highly likely that everyone’s tax rates may go up in the future, which makes the Roth an even more attractive option if you feel that this is a likely occurrence.
Unless you are making less than $59,000 MAGI a year, Traditional IRAs are, to put it bluntly, absolutely terrible. You wind up paying taxes on the front and back end.
You also are insistent on maxing out a 401(k), when that makes absolutely no sense prior to maxing out an IRA. There are many IRA accounts available with no fees, where you will likely be paying 1%/year on a 401(k).
Also, if you are trying to maximize your tax savings, you can have a much larger effective tax advantaged Roth IRA than you can a Traditional IRA ($5,500 after tax money is worth more than $5,500 before tax).
The order you should be going in is as follows:
Maximize Employer Match
Max out Roth IRA
Remainder to 401(k)
For illustration, we’ll do an example. Somebody makes $50,000 per year (we won’t bother figuring in raises). Lets say we determine $10,000 of that is available for retirement. Assuming your employer does a 50% match up to 6%, according to you, you should simply just put all $10,000. You will wind up with $11,500 invested each year. Knowing the stock market averages about 10.5%, you should make about 9.5% per year after fees. You will wind up with $40,000 taxable income per year (~$36,000 after tax and investment dollars), and a $4.445 million nest egg with taxable distributions (assuming 40 years).
Instead, lets say you just max the employer match, then max the Roth IRA, then further pump money into the 401(k). To get the same ~$36,000 after tax and investment dollars, you can put $3,525 into 401(k) (+$1,500 match), and $5,500 into a Roth IRA. The $5,025 will grow at 9.5%, and the $5,500 will grow at 10.5% (no fees, remember). You will wind up with a $1.942 million taxable nest egg, and a $2.790 million nontaxable nest egg.
So what is the difference?
100% 401(k)=$4.445 million taxable distributions
401(k) max match + max roth IRA + remainder 401(k)=$4.732 million, only $1.942 million of which is taxable.
So Mr. Financial Samurai, even if the tax rate is only 15%, you just lost these poor investors $662,000 (after tax). Wow.
Now, regarding Traditional IRAs. If you instead put $5,500 into a traditional IRA, you are left with $4,500 (+$1,500) for the 401(k). You will wind up with $2.790 million from the IRA, and $1.739 million from the 401(k), for a total of $4.529 million of taxable distributions (still higher than the 401(k) option, but still worse than maxing out a Roth IRA by a LONG shot).
Did you include the benefit from the 401(k)-Trad. scenario with maxing the 401(k) you avoid Med/SS taxes (taken as a payroll deduction), where you still pay these with Trad. IRA contributions?
This is incorrect. Traditional 401(k) contributions only reduce your taxable income for federal income tax purposes. It has no impact at all on medicare and social security taxes.
The only problem with this solution is the 401k or traditional IRA (up to a certain income level) also is pre-tax so to contribute 5,500 only costs most people around 3,740 bucks (1 – Fed tax of 25% – state tax of 7%) while the Roth costs a full 5,500. That’s $1760/year in savings that you can reinvest or spend to live a good life that you aren’t counting in the equation.
Sam….many arguments here are saying the ROTH is better because your distributions are tax free and the traditional is taxed at income bracket. Well, what about the retiree who has most of her assets in tax free muni bonds? They will have a very small tax bill and hence low tax bracket. Therefore shouldn’t worry about traditional IRA distributions being taxed at say 10% vs. today’s income bracket of I’m certain much more.
The argument would be that with today’s incredibly low tax rates, the minimum rate in the future may be say 20% instead of 10%.
How many politicians do you know got elected on the platform of raising taxes?
Taxes are not going up. We eill experience these “low” taxes for our lifetimes.
Very few indeed. I doubt anyone would run on that platform, but that doesn’t mean it can’t happen happen while in office. I think it’s fairly obvious what politicians run on to get elected can be far from how they behave in office.
We’ve [U.S.] gone from a minimum rate of 0% all the way to 23% and now we’re at 10%.
I am less confident to say with certainty that taxes won’t be raised in the future. Taxes have been raised in the past, so it wouldn’t be unprecedented if it happened again. As recently as 2013 the top marginal tax rate was raised 4.6%.
Depending on the size of one’s Traditional IRA, RMDs can easily push one from the lowest tax bracket.
With all that said, I hope you’re right about taxes!
I am no expert, but the government is GOING to get there taxes one way or the other. Correct me if I am wrong, but you are going to be paying taxes on a a traditional IRA or 401k when it is withdrawn and also can only roll your 401k to a traditional IRA to begin with but can be converted to a Roth IRA by adding the money into your income the year you convert it and will pay ordinary income tax on the amount rolled over. But would you want to pay taxes on that lesser amount vs in the future when you could possibly be in a higher tax bracket and with more money being taxed if you kept it in the traditional or 401?
I’m late to the party, but wanted to comment on such a strange post from you, FS. Certainly you make some good points in there that I agree with wholeheartedly (like the futility of converting Traditional to Roth). But other points just don’t seem to hold water. Here’s a few I would challenge you to reconsider:
#3) Asymmetric Reward/Punishment – You seem to be suggesting that since not everyone can participate in Roth IRA’s we should boycott them and instead participate in Traditional IRA’s. But Traditional IRA’s are limited to an even smaller subset of the population, so, uh, … what was the argument again? I must have missed it.
#4) The Math Is The Same Before and After – Well its only the same if your income stays the same and the tax code stays the same. I agree with you that our incomes will likely be lower in retirement but I fully expect the tax rates to be higher. Who can predict the net result? Not me.
#5) What Difference Will $5000/Year Make? – The question you ask is easily answered. Compared to just filling the 401k, an extra $5k/year would increase your savings by over 28% and hence it would increase your nest egg by 28% if done over your investing lifetime. Not insignificant at all. And really this underestimates the impact since the 401k money gets taxed as it comes out while the Roth money does not.
But you go so far as to recommend, for singles making $66k to $105k, that they should blow the money before putting into a Roth IRA??? (“you probably will get more out of spending your $5,000 on life now.”) Then you imply that the same is not true for the single making less than $66k because to them you say “CHOOSE THE TRADITIONAL IRA OVER THE ROTH IRA WHILE MAXING OUT THE 401K”.
So in the first case, if I’m making more money and maxing the 401k that’s fine, stop there, after saving 17% – 26%. But in the second case I’m making less money and saving 27% isn’t enough, I should be saving 34% or more (($17.5k+$5k) out of $66k). Doesn’t make sense.
You could had said “go ahead and invest the extra $5k, but do it in a taxable account”, which would have been a tough pill to swallow since it would mean giving up the ability to pull the gains tax free. Yet I can buy into the idea of having some money that’s accessible rather than tying it all up for decades. But the idea that I’d be better off blowing $5k than saving $5k goes against other posts you made which recommend an ultimate savings rate goal of 50%.
For individuals in the $66k to $105k range who want to save more than $17.5k for retirement, the 401k + Roth IRA combo is universally accepted as the best option out there for the typical American. As a bonus, it provides you with two separate pools of money that are taxed differently. So when you retire you can decide where you want to pull from first to get the best tax efficiency. You’ve added tax diversification to your portfolio instead of trying to predict what Uncle Sam will be up to decades from now.
When choosing between Roth vs. Tradition, I can agree that Traditional wins. But if its Roth vs. nothing then Roth wins every time. You are showing an unreasonable bias against the Roth.
Roth vs. nothing, Roth wins for sure.
Here is a follow up post that is a little more balanced after all the feedback:
https://www.financialsamurai.com/the-only-reasons-to-ever-contribute-to-a-roth-ira/
Thanks for the link, FS.
You aren’t actually getting 28% more with a ROTH though. The roth costs you $5500 out of pocket (8088 pre-tax) while the 401k only costs you around $3740 (5500 pre-tax income) out of pocket due to federal income and state income tax reduction. You have to account for a) the 1740/year extra you save (+- depending on your state, marginal fed tax bracket) + the fact most people have a lower tax rate in retirement + the fact that the government can change the tax code on Roth’s at any time and make them taxable + the fact that you may die early and not get any of the benefit. The Roth IRA only makes sense for people in the 10%-15% marginal income bracket who expect to make a lot more some day (so in other words people in their early 20s who didn’t go college and least likely to put money into an IRA/401k Period)
except that all earnings in a Roth are tax free, there are no RMD,s, no penalties for withdraw, no taxes on distributions, and you can start drawing from a ROTH at 59.5 years old. Great vehicle to retire early if you are a DGI investor and combine with SS at age 62, simple to just live off tax free income, and principle never lowers. FOr example, if the growth of your roth is earns you say 1 million in principle in the roth account, and you are DGI invesing at the typical 3.5 % you will earn an additional 35,000 of tax free dividends per this example. Thus, combined with SS, a paid for house, a paid for vehicle, if you live comfortably in retirement, it should be easy to life off about 5.5k (Tax free) a month (dividends+SS distributions). With a traditional, you would be hit with RMD’s that raise your tax bracket, and all of the dividends would then be taxed at the 15% rate (current rate)
Some good points. My feeling on the Roth has always been that if it’s really effective, we’ll see an increase in the sales tax.
I think an argument might be made about effective tax rates on the young being far lower than effective tax rates for the old (due to mortgage and student load deductions as well as child tax credits), but that’s not too helpful in this case — I may have an effective tax rate of 18% because i’m so busy building a family, but if I make an extra $1000 I’m only going to keep about $600. Shifting savings from the 401k to the Roth is going to be taxed at that top dollar rate.
Hello,
I have a question for you all, I am a 44yo single mom of 3. I’ve been divorced now for a few years & to be very honest was left with pretty much nothing after everything was said & done. I am a waitress as a profession, I do ok but definitely dont make boat loads of money. My kids are also teenagers & really dont ask for much so I do have a little at the end of the month.
My question is what would be the smartest way to invest that extra money & for how long?
Would a Roth IRA still be a good choice for me even though I have no other savings?
If so what should I invest monthly to yield the greatest return by retirement age?
Thank you for your time : )
This is definitely a couple years late but hopefully it could still help. As you can see from the other comments, there’s a lot of disagreement about the “right” answers.
My personal advice would be to start by saving 1-2 months of your expenses in a separate savings account. Then contribute as much to a Roth IRA as possible each month. Just setup an automatic monthly bank transfer and forget it.
These recommendations are based more on behavioral psychology than pure numbers. In the first case, an emergency fund ensures you don’t have to tap into expensive credit cards when your car breaks down or between waitressing gigs. The Roth IRA is a good choice because it’s”loosely locked up” in a tax-advantaged account. That is, you really don’t want to touch it til 59.5 but if there’s ever a real emergency you can withdraw your contributions without penalty. Also, it’s super easy to setup and automatically contribute, has lots of good low-fee funds, and doesn’t require any special stuff for filing your taxes
In any case, keep reading, learning, and asking for guidance on forums and blogs like this and you’ll soon know more than most folks. I’m proud of you for reaching out.
-Cody
I didn’t follow all of this, but it seems like you’re leaving out the value of compounded tax savings over the years. In my case, I converted a traditional IRA of about $11,000 in 1998 and paid about $2,200 in taxes over a couple years. I eventually withdrew all of the original contribution to cover life expenses, but my investments did quite well and the account now worth $463,000 as of today. I would hate to have to look forward to paying taxes on all that when I retire.
I would love to know more about this. Those are tenants gains over a very volatile 16 years. How do ride through things so well? Were you going on shopping sprees during the crises and buying stocks on the cheap? How else could these numbers work out?
Sam,
I respectfully disagree. First of all, taxes are currently at historical lows. It’s much more likely to go up than down in the future for various budgetary and demographic reasons. When you are young and earning less (thereby benefiting less from tax deductions), it makes infinitely more sense to favor Roth IRA over 401(k) or traditional IRA; although, I advocate always contributing enough to 401(k) to get the employer match. With a long investment horizon and low starting salary, it makes sense to favor Roth IRAs. You can always ramp up your 401(k) contributions as your salary increases, at which point, the tax benefits becoming more desirable.
Second of all, the reason that the government set an income cut-off to Roth IRA eligibility and also set a low annual contribution limit is because the Roth IRA is intended to help regular people build wealth, rather than allow high-income people to stash away tons of money and avoid taxes. However, where there is a will there is a way (anyone ever wonder how Mitt Romney managed to put so much in his IRA? Albeit probably not Roth). There is the “backdoor Roth IRA” for high-income people. Furthermore, if you are high-income and your company offers a Roth 401(k), you can actually contribute after-tax money up to 401(k) limit and then simply roll the Roth 401(k) into your Roth IRA upon retirement, all entirely tax-free. This will also allow the person to avoid required minimum distributions.
Third of all, yes, anyone can theoretically die at any time without ever enjoying the benefits of tax-free distribution. But how would a dead person benefit from a 401(k) either? In reality, the overall life expectancy in this country is increasing for both men and women. In fact, a child born today can expect to live longer than ever in U.S. history. The chance that a person is going to need the retirement fund to last longer than expected is high for someone of good health, which makes Roth IRA’s lack of RMD desirable, especially if you have other available sources of income. There are hoards of actuaries banking on life expectancy increases–one of the many reasons as to why insurance companies are always trying to sell whole-life insurances, especially to people with excellent health and habits.
Sounds good. Thanks for sharing. How did you find my post?
Here is a follow-on, more balanced post I wrote about this topic after taking in everybody’s objections:
The Only Reasons To Ever Contribute To A ROTH IRA
Hi Sam,
Found your post by accident! I was researching people’s experience with p2p lending and was surprised to see a post with an anti-roth stance. Had to check out the argument :)
Ah, interesting how google works! I hope you subscribe and stick around for the journey!
Hello. I posted this question a month ago but never received a reply. So im re-posting with hopes of receiving one.
I am a 44yo single mom of 3. I’ve been divorced now for a few years & to be very honest was left with pretty much nothing after everything was said & done. I am a waitress as a profession, I do ok but definitely dont make boat loads of money. My kids are also teenagers & really dont ask for much so I do have a little at the end of the month.
My question is what would be the smartest way to invest that extra money & for how long?
Would a Roth IRA still be a good choice for me even though I have no other savings?
If so what should I invest monthly to yield the greatest return by retirement age?
Thank You for your time!! :)
I recommend to put it all on black.
I’d call Vanguard (I have some of their funds through my 401K, so I don’t use them directly myself) and set up an IRA with them, put the cash in there (Fidelity is another pretty good company to work with, but I think Vanguard has lower minimums, meaning you can get started with a smaller initial investment). The two biggest money mistakes are raiding the account, and rapid buying and selling of investments. Because the math should work out roughly the same, Roth or not, I’d go with a normal IRA, and invest in a 2035 fund (or whatever date you expect to retire, just know that they use 5 year gaps, so your alternate choice is 2030 or 2040. All three of those choices will yield similar results, so don’t freak out about which one… just give it your best guess and move on. Choosing any of those three will eliminate the more difficult choices of stocks vs bonds vs flavors of stocks and bonds…) – Vanguard will manage the fund with low fees, shifting the investments to become more conservative the closer you get to retirement. I will tell you this: deciding to put the money to work for you is far more important than the Roth or Not decision. Don’t let it hold you up, and don’t worry that one is slightly better than the other. Both will get you started on a good path, and that’s the key thing. How much you save at the front end will be the biggest driver of how much you’ll have waiting for you on the back end (when you retire). 20 years is enough time to build a decent size fund to supplement your Social Security. It is addictive to watch it grow.
Your math is correct but not for this situation. My understanding is that with an employer Roth 401K even highly compensated employees can contribute the maximum to the Roth that they can to a Traditional 401k. If that is the case, the math depending on the tax rate and estimated earnings the Roth can be a great advantage even if you are in a lower tax bracket at retirement. As it turns out most people are not in a lower tax bracket upon retirement because they generally lose the necessary deductions to itemize. This year I start taking out the mandatory withdrawals from the IRA – losing 25% is pretty hard. Do a spread sheet with a expected growth rate on the IRA and the amount saved each year from the tax savings and compare it to the Roth – do it with 30 years and then 25 to 30 years in retirement and it may surprise you using different tax rates and purpose growth rates on the savings account. The statement the Roth is only good if you are going to be in lower tax rate is exactly true and with the Roth you have do mandatory withdrawals.
I have a question. I’m 39 going on 40 in march I lost everything including my 401 k in the 2008 collapse. After the past 3 years struggling to get back on my feet financially. I landed a union job with a pension. My work offers a 401 k with no match. I’m currently looking at ira options to start to get my retirement plan going again. Can anyone help lead me in the right direction. I’m making 60 k a year easily. What should I do
1. Open a traditional IRA for tax year 2014 at a discount broker such as Scottrade,
2. Fund it with the max $5500,
3. Invest in a ETF with a 60% equity/40% bond mux and a low nanagement fee (less than 0.4%).
4. When/if more money is available fund your 2015 IRA as well any time after Jan. 1st.
– Zack
Since your 401K is yours no matter what happens to your company, I assume you withdrew the entire amount (and paid penalties as a result). The reason I mention this is that otherwise, your 401K is still yours, that is one huge benefit of a 401K over a pension – if you fund it and don’t withdraw, nobody can take it from you, it’s yours legally (pensions are kind of a mixed bag as far as that goes.)
Also thought I’d be ok with social security and a pension but in having second thoughts now that our pensions could possibly be reduced.
Is my Roth IRA supposed to be losing money? :( So far, I’ve only put in $300 and it’s eaten $9.00. I know it’s just 9.00, but >.<
And the next day it will go up $20. Don’t swear the fluctuations. If youre well diversified in Index funds at the right allocation, you’ll make money in the long run. Worrying about the short term gains and losses is a losing recipe since youre then emotionally tied to it. Maintain consistent contributions over the long term for dollar-cost averaging and don’t get scared in market swings. If i may recommend a site called Betterment, they do a great job at managing your portfolio, keeping you balanced in low cost index ETFs and minimizing your tax liabilities. Thats who I have my Roth IRA through and will more than likely open a taxable account there eventually. They are very cheap since they use technology and Vanguard funds.
You may have been a math rockstar, but you were not an economics rockstar, because the math is not the same in terms of paying taxes now or later. If you pay later, you are better off, because you are earning a return on the “loan” from the government, which compounds. This mathematical reality obviously favors a traditional IRA, assuming the same marginal tax rates now and in retirement.
Nonetheless, a Roth is still a useful vehicle because of (a) early retirement, before age 59.5 and Roth’s ability to access those funds without a 10% penalty; (b) required minimum distributions (RMDs) of traditionals, and their interaction with (c) Social Security Income. Withdrawals from tax-deferred accounts are taxable income, and can trigger a huge hit on your Social Security Income, and finally (d) income management for ancillary benefits in retirement such as various localities’ property tax abatements for seniors of sufficiently low income. (My father-in-law’s RMD was sufficient to cause him to lose his NJ abatement. This was a very marginal amount of income that cost far more in property taxes.)
Lesson here: know your Roth BENEFITS as well as your traditional IRA DISADVANTAGES!
If you retire earlier than 59.5 from an employer where you have money in their 401K, you can access those funds penalty free also. But only that employer’s 401K. If you roll the funds over to an IRA, you can no longer take early distributions penalty free.
Regular income taxes apply to all non-Roth distributions, of course.
Also of note, the first block of your income is not taxed anyway due to personal exemption(s) and standard or itemized deductions. So if your 401K/taxable IRA is your sole source of income, a good chunk of it pulled out each year is never taxed. This is why it’s good to have tax-deferred retirement savings. Use the tax-free money to fill in income gaps when you need to avoid getting bumped up to the next income level. And Roth income doesn’t affect the calculations for how much of your Social Security is taxable.
This is why I have 4/5 of my money in 401K/pre-tax IRA, and 1/5 in a Roth.
Just curious: why are you stating that you can access your Roth funds before age
59 1/2 and not pay the 10% penalty?
Because you can pull out contributions tax-free (because taxes have already been paid on the $) and penalty free. You are only penalized if you take out gains. For example, if you contribute $5000, and make $2000 on that after some time (giving u $7000 total), you can pull out up to $5000 without any extra tax or penalty… No different than taking $ out of your savings account really (except u must tell tell the irs u did it when you file taxes), but if you touch the $2000 gain, you will pay income tax + 10% penalty. A roth is basically dual purpose: emergency fund + retirement savings. Just make sure you keep track of contributions over the years so if you must withdraw contributions, you can report appropriately.
One caveat that people seem to forget, your Roth IRA account needs to be opened for 5 years before you can pull contributions. After 5 years though, you are free to pull them out.
“There is a reason why there are $2,000 staplers and $10 staples in the government bureaucracy!”
___
The reason isn’t government inefficiency; the people who buy those staplers and staples know good and well how to buy cheaper goods.
The reason is that private interests– who *also* know the true price of staplers and staples, mind you– get certain laws passed because they can.
The Canadian government, or the Singaporean government, or the Hong Kong government, or, heck, even the Mississippi government, does not buy $2000 staplers.
This isn’t about inefficiency; it’s about corruption. The answer isn’t to condemn “government”, but to take charge of a specific government (if you care to do so). “Government” knows good and well not to buy $2000 staplers.
Inefficient/corrupt… two sides of the same coin.
Source? The only reason I’m aware of that the gov’t buys really expensive common items is that they are modified in ways that make them resistant to damage in the event they are subjected to a dangerous (i.e. military) environment – some things become more dangerous when damaged, so the gov’t buys more expensive items that are less likely to shatter or combust.
Don’t get me wrong, the gov’t is a human organization, has all the same faults we do. I know major weapons programs are often ordered because of who is make the decision and where the bulk of the economic activity will take place (so the Senator from Wisconson on the Appropriations committee approves the bid from the supplier with a factory in Wisconson…for example). But what you describe sounds like it’s a different flavor than the situation I just described, so I’m curious.
@Financial Samurai, sorry but your 2nd grade math skills don’t translate into real world math skills. I’m actually kind of shocked at how many non-sensical arguments you could put into one list.
There are many reasons why a Roth is beneficial. For instance, 1) If your tax rate is low now you’ll likely save on taxes 2) If you expect higher tax rates later you’ll likely save on taxes 3) It offers good flexibility with the ability to withdraw contributions penalty free 4) You aren’t required to take minimum distributions at any point 5) You can continue to contribute as long as you have income.
Yes, we would all prefer to not pay taxes to the government; however, you have done nothing to show there’s a better alternative than funding a Roth.
Thanks for your kinds words. Perhaps show some of your own math skills to help demonstrate my math is wrong and your math is right? That’s what math battlers do.
Perhaps you will like this post: The Only Reasons To Ever Contribute To A Roth IRA
Well, for one, you state that Y = A*B = B*A. No one is going to argue that, but this assumes that each number is the same under either scenario. It’s easy to argue your retirement account would be the same (let’s call this one A), but your tax rate is definitely unlikely to be (call this one B).
Now, of course if you project your tax rate later in life will be much lower, then I agree, you don’t need a Roth. However, you don’t know this with certainty and for many people the converse will be true.
Say an individual’s marginal tax rate now is 25% and it turns out to be 35% when the person retires. Also, let’s say for illustration their compounded return = 10 over the time the money is in his/her account. Finally, we’ll look at one deposit of $5,500 to make things simple.
Traditional account: 5,500(10)(1-.35) = $35,750
Roth account: 5,500(1-.25)(10) = $41,250
Roth wins. Again, obviously this won’t turn out best for ALL people, but for many it will. Thus, referring to it as “pissing money away” and making claims that a “traditional IRA is hands down the way to go” is naive, at best.
Other article is better, but you still ignore a lot of the other favorable aspects of the Roth (see points 3-5 in my first post, for examples).
You can make tax rate assumptions all you want, but a bird in the hand is worth more than two in the bush.
Most people will earn less in retirement than when they are working. To put it as clear as possible, most people will make less working than they will make when working. Sure, it’s nice to believe that you will accumulate multiple millions of dollars in retirement that will generate more income than while working, but that’s not going to happen for a large majority of people.
I’m assuming you are not in the higher tax bracket, or have never been in the higher tax bracket, but let me tell you from someone who has been in the highest tax brackets for over a decade that there are many ways to legally not pay the highest tax bracket through deductions, deferrals, changing of incomes, establishing of corporations, etc. If you pay your taxes up front now, the government wins.
You’re free to take my advice as someone who has been there, or not. It’s up to you. I would pay more attention to those with experience, than those whose experience is based off pontification. May I ask how old you are and what is your net worth?
Here is another post you might like: How To Pay Little To No Taxes For The Rest Of Your Life
“Say an individual’s marginal tax rate now is 25% and it turns out to be 35% when the person retires.”
Ok, what does that translate into in real terms? The max gross income for single filers in the 25% bracket is currently $90,750 annually and $151,200 for married couples. The 35% tax bracket is the rarefied air of $411,500 to $413,200 for single filers and $411,500 to $464,850. Realistically, most people will not see that kind of a jump in income, it will go down for the vast majority of Americans.
Let’s make this more concrete. The monthly income of $90,750 for a single filer is $7562.50 a month. To make the leap to the 35% bracket, one has to assume that the distributions from investments plus social security will deliver $34,291.67 per month. Who, other than financial executives, media moguls, some actors and politicians, and defense contractors lives or has assets that will deliver a cash flow like that?
Even if you bring this closer to the real world and say that it moves to a 28% tax bracket, which is $90,750 to $189,300 for singles or $151,200 to $230,450 for married couples, the monthly income maxes out at $15,775 a month for a single filer or $19204.16 a month. Those have to be some pretty incredible investments.
Reality check: Most seniors end up living off of social security and maybe a modest 401k and IRA income.
https://www.cbpp.org/cms/?fa=view&id=3261
“For nearly two-thirds (65 percent) of elderly beneficiaries, Social Security provides the majority of their cash income. For more than one-third (36 percent), it provides more than 90 percent of their income. For one-quarter (24 percent) of elderly beneficiaries, Social Security is the sole source of retirement income.[21] ”
For those people, a Roth makes no sense because they are making a lot less now than they were when they were working. That means that they paid more taxes on the contribution than was necessary. And if they have always been poor but tried to save, ending up in the same tax bracket, it is better to pay later than sooner.
So in a nutshell, the Roth only makes sense if you are very wealthy and expect to become a hell of a lot wealthier.
“So in a nutshell, the Roth only makes sense if you are very wealthy and expect to become a hell of a lot wealthier.”
Nonsense. The prime example of people it’s good for is people who aren’t wealthy who expect to become wealthier later on. It makes 100% sense for lots of people in their 20s, since many of them aren’t in high tax brackets now. Many of them are probably at 15%.
Let me point out that you’ve assumed the only way your tax rate will increase is if you make more money. HELLO!!! That’s a big assumption. We don’t know that the current tax brackets will stay the same forever. If eventually we get serious about addressing our debt situation, perhaps we’ll need to raise tax rates. Having a Roth and a Traditional account is a way of hedging against tax rate uncertainty.
I agree that not everyone stands to benefit from a Roth account. The average American probably isn’t worrying about whether to put their money in a traditional retirement account vs a Roth, because the average American is barely saving at all. They may not have either.
In summary. The Roth probably makes a lot of sense for young people and not as much sense for older people. If you’re wealthy and expect to become very wealthy, it’s great. If you’re poor and expect to make a good salary later on, it’s great. Otherwise, it’s not that useful.
One last comment. I will say that if I knew my current tax rate would be the same as my future tax rate, I would go Roth hands-down, contrary to some of you. So many added benefits.
All that matters is tax brackets at the time of tax being paid.
If tax bracket now > tax bracket at distribution, do not put money into a Roth.
If tax bracket now < tax bracket at distribution, put money into the Roth.
For most people, they are told all the wonders of the Roth but the downside doesn't compute, media is tilted heavily toward a Roth but that only makes sense if you expect to be much more wealthy than you are now.
For someone starting out, it may seem like a good idea (and in some cases may actually be a good idea) but if you think you will be in the same tax bracket as you would be when taking the distribution, why bother with the Roth? Paying the same tax now or later, keep your money now! Just the time value of money. Oh, and:
https://www.forbes.com/sites/financialfinesse/2014/01/31/7-reasons-why-your-retirement-calculation-could-be-wrong/
Time value of money is not an argument to pay the tax later, because you’ll be paying more in total tax dollars. That is, it already takes into account the effect of time.
If you expect to be equally wealthy, you might as well use a Roth because it provides much more flexibility. You can withdraw contributions tax and penalty free whenever, there are no RMDs, and you’re able to contribute as long as you have income. Additionally, if you’re maxing out every year, you’re effectively able to put more into the Roth.
My wife and I are in our mid 40s and both of us plan to retire in 11 years. She’s a teacher and with her current contract would get about $90K/year pension. I have $575K in my 401k and we have about $280K in Roth IRAs and we’ll continue to contribute to that as long as backdoor Roth IRAs are allowed. For my 401k contributions, would you recommend that I continue to do pre-tax or should I start contributing to a Roth 401K to have tax diversification in my 401k? I contribute the max and my employer matches 8%. I also have a small pension worth about $60K but it’s no longer being funded. Thanks for your information.
I am currently in the lucky position to have enough income that I max my 401k (as much as they allow me to they cap me at 8% because I am designated “HCE”), a traditional IRA in my wife’s name and the ROTH IRA for both of us. Are you saying that I should not invest in the ROTH IRA? You don’t think it will be good for me long term?
Hello All,
I greatly appreciated in advance if you guys can help . I currently self employment ( salon owner) and look for to investment for my retirement . I am 43 year old and have no retirement plans . I only have $10,000 in saving account and it not give me any return . My annual income around $55,000 . Can you please advise me what best option out there for me ?
I thank you in advance for your helps .
I did the math. Roth makes zero sense.
The math is the same assuming the same tax rate now and after retirement. So it really becomes a bet that your tax rate now is lower than it will be after you retire. Is that a good bet? Depend on your situation. But I doubt it.
Another huge risk of Roth is you are assuming the government will keep its promise and not tax you at retirement.
Does anyone trust Congress?
I don’t. Entitlement spending growth is unsustainable. In the 2020s Congress will face incredible political pressure to find (erm I mean appropriate) more resources to pay entitlement commitments. Don’t think for a minute they won’t grab your Roth (or 401k) in a “temporary” measure.
Finally someone speaking some sense about the Roth. The Roth is a terrible deal.
I ran the numbers on it just to make sure I wasn’t missing something. Yes, assuming the same tax rate the numbers are exactly the same regardless of whether you pay tax now (i.e. Roth) or when you withdraw after years of growth (i.e. regular IRA).
For a Roth to work out to your advantage, 2 things must happen:
1) Your tax rate must be higher when you retire than it is now.
2) The government must keep its promise not to tax your Roth IRA withdrawls.
Both of these seem unlikely to me.
Re tax rate: We all know that tax rates go higher with time. On the other hand, your post-retirement income is likely to be lower. Will your tax rate be higher? I doubt it.
Re government keeping its promises: Ya, right!! In the 2020s and onward Congress will come under MASSIVE political pressure to keep unsustainable entitlement spending flowing. Do you really think they won’t make grab at the trillions sitting in 401ks and IRAs? I’ll bet money (and I am betting money) that they will.
Just look at what the Obama gang tried to do by taxing college saving 529 plans. Like a Roth, capital gains in 529 plans are not taxed. Obama tried to change the rules. It failed, but it’s just a matter of time before the gubment grabs what they said they wouldn’t grab.
I was really puzzled by all the articles about why ppl should convert to Roths. Then I realized that the gubment loves it because they get their hands on your money now. And the financial industry loves it because it generates business and fees for them.
Roth vs Traditional seems like a no brainer to me:
GOOGLE IPO’s for $40 a share & you invest in the stock completely in 2005.
If you had $10,000 in a ROTH IRA & invested it in GOOG you would now have millions of dollars TAX FREE
If you had $10,000 in a traditional IRA and invested it in GOOG, you are giving the government millions of dollars in taxes once you cash in.
SO EXPLAIN HOW A ROTH IRA IS THE WRONG CHOICE!!!!!
You are so against giving the government money, & yet, a traditional IRA rewards the government off the savvy entrepreneurs that choose the right stocks and see their ira explode.
Anyone not scared of risk, & wants aggressive growth, should have a ROTH IRA.
If you are just going to invest in safe CD’s for 2% interest, then a ROTH has no purpose, and you should go with a traditional ira.
You forgot #3. A Roth will work to your advantage when you are right on the edge of a tax bracket increase. You need an extra $15k one year in retirement, but taking it out of your IRA will move you into the next higher tax bracket. A Roth would bridge that gap with no tax impact.
You make some big assumptions in saying that the Roth IRA is not a good vehicle. My 401K offers squat in employer match. My income is highly variable. In lean years, between income and a dance with the Schedule C, my effective tax rate can be almost down to the single digits. When that’s the case the Roth IRA is a godsend.
FS could you please clarify your paragraph on ” Withdrawal Penalties “?
You state that there is a withdrawal penalty on money that your Roth contribution earned – a penalty of 10%, plus you are taxed on the amount you earned. So in other words, I put $10,000 in a Roth IRA, let it sit there with no further contributions, and after age 59 1/2 I have $50,000. And what you are saying is that I will pay a 10% penalty and owe taxes on $40,000? My research shows that when you take withdrawals from a Roth you are not taxed on contributions nor any earnings from it. Am I wrong?
Hi Maggie,
The earnings from your principal cannot normally be withdrawn prior to age 59½ without paying the 10% early withdrawal penalty. Earnings can generally be withdrawn without penalties after age 59½, provided you meet the five-year rule
Roth IRA five-year rule: Withdrawals from your Roth IRA will only be classified as qualified distributions if it has been at least five years since you first opened and contributed to your Roth IRA, regardless of your age when you opened it. For instance, an IRA owner can make penalty free withdrawals at age 59½, but if he or she made the first contribution at age 58, the plan participant would need to wait until age 63 to withdraw any earnings made on that portion of the original contributions.
A qualified distribution from a Roth IRA is tax-free and penalty-free, provided that the five-year aging requirement has been satisfied and one of the following conditions is met:
Over age 59½
Death or disability
Qualified first-time home purchase
A non-qualified distribution is subject to taxation of earnings and a 10% additional tax unless an exception applies. For Roth IRAs, you can always remove post-tax penalty contributions (also known as “basis”) from your Roth IRA without penalty.
Hope this helps. Bottom line: try to wait until you are at least 59 1/2 to withdraw any government retirement vehicle like the Roth IRA, IRA, and 401k!
Let’s say you don’t make any interest on your money (to make an easy comparison) and two brothers (both married) test out the effects of both the ROTH and 401k. Brother1 contributing only to a ROTH and Brother2 to a 401k. They are both in the 25% tax bracket while working, so Brother1 contributes $7,500 to the ROTH, and Brother2 contributes $10k to the 401k.
After 10 years, Brother1 withdraws the $75k from the ROTH tax free.
After 10 years Brother2 has 100k in his 401k. When makes a full withdrawal it comes to:
$18,150 = $1,815 tax (first 18k at 10%)
$55,649 = $8,347 tax (next 55k at 15%)
$26,201 = $6,550 tax (25% up to 148k)
Total after tax amount Brother 2 has $83,288.
Tax rates for those making under $100k are going nowhere, and maybe even lower if they chop up that area into more brackets.
Most people aren’t going to be withdrawing more than $100k a year from their deferred income accounts, so I think the example is sound even adding in say 10% a year in gains.
No one has mentioned it yet, but are actually contributing more through a ROTH than a traditional since the contribution limits are the same. $5,500 in a ROTH > $5,500 in a traditional, unless there is something I am missing, please let me know.
Also, the ROTH makes sense for me being (military career) since my taxable income is 60k/yr. I am stationed in California and don’t pay any state income tax since my claimed state is Arizona. Factoring in BAH and BAS and my 15k/yr (taxable) retention bonus, this is equivalent to a California civilian salary of ~115k (assuming I would be paying federal + CA state tax). My weekend gig makes me about 19k/yr which is taxable federal and CA state.
I am early in my career but I believe I would be making more after retirement since I would likely be working as a civilian at that point and making a higher salary. If I retire from the military I have to add in my pension as well which would further increase my tax bracket. Just more reasons the ROTH makes sense to military members.
It is nice to be in a “lower” tax bracket for purposes of contributing to a IRA (since BAH and BAS are not included in tax considerations) and hence I could contribute comfortably and not worry about income limits rendering me ineligible. Big downside is that we get no match on the TSP from the government under the old retirement system.
Hi FS. Great post. This topic seems to be evergreen, based on the years of comments on this string. I respectfully disagree with your assessment. I believe Roth IRAs are the better investment vehicle if for no other reason than a Roth removes one uncertainty (my future tax rate). As a Roth investor I don’t care about taxation. Also, I’m sure someone in the comments above already mentioned this but Roths are not an exclusive club. I make too much money to invest in a Roth, but I fund two IRAs (me and my wife) every year and immediately convert them to Roths. There are no tax implications if converted before any new earnings. It’s called a backdoor IRA and it literally takes 30 seconds to complete with an online broker.
I do the same thing – max out pre-tax contributions to both my wife’s and my own 401Ks, then contribute $5,500 to each of our Roth IRAs through a backdoor conversion (total $11,000 per year). We started this a few years ago and are currently in our mid-40s.
My plan is to use the tax-free money from the Roth IRAs first (after retirement) and let the pre-tax investments (401K) compound for a few more years.
If I end up retiring before age 59 1/2, I’ll probably use post-tax investments first, then Roth investments, , then pre-tax investments (401K).
I’m 25 and just starting to learn about IRA and I can honestly say that I thought this article was terrible and it doesn’t sound like you know what you’re talking about.
I’m with you Will. I think there is some confusion on Roth’s. I do see his point about the tax implications tho.
Roth IRA contribution money is taxed in your regular income for that year. Any money you put in (contribute) you can take out at anytime, at any age even before you are 59½, for any reason without paying taxes on it by using a IRS form 8606. If you start withdrawing the earnings (money earned from the contribution) then you will have a 10% penalty. Once you’ve had a Roth open for over 5 years and you are over 59½, any money you take out is tax free whether it be contributed cash or the earnings on those contributions. I personally use our Roth IRA’s for stashing emergency money in (it earns better than a savings account). If I don’t use it then I’ll let it ride to earn as much as it can and then have it for later.
I have a 401k at work that I’ve been putting 20% into for the last 17 years and will continue for the next 3 years. Once I quit the railroad at 58 I’ll start receiving a monthly check at the age of 62 (minus 30% because I’ll start collecting at 62 instead of 67, just like SS does) from railroad retirement and my wife (at 62) will receive a check for approx ½ of my RR retirement. I also have a military pension. So between my two pensions, my wife’s check and the 401k money, I figure that Roth money (which has no RMD time limit) will have well over 20 years to grow and be all tax free if I or she needs to withdraw from it later in life (without raising our tax rate) plus any extra cash we might have left over in retirement will go into the Roth.
FS, have your finally revised your opinions on the Roth? Given the current political landscape, it certainly seems that at some point in the future we could see some sort of government program to make education more affordable as well as nationalized healthcare. I don’t think this will happen right away, but we seem to be moving in that direction.
Fyi, I’ve executed some pretty awesome roth conversions recently. I saved money in a traditional 401k at my prior job, and recently have been moving it into a roth throughout my lower income PhD years. How far ahead will I be when not only am I in a higher tax bracket, but all tax brackets are higher?
… 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 $500 million dollars!……
Isn’t this an advantage of ROTH
That is a hypothetical great advantage. But imagine if you invested $7,000 without paying tax. Imagine how much more over $1 billion that return would be!
It’s good to diversify. Doing a Roth IRA after maxing out a 401k and or IRA is fine.
Not one penny of that 1 billion dollars would be taxable along as they follow the rules of a Roth distribution. But if it was in a traditional IRA the income would be taxable. I think you’re missing something about Roth IRA’s.
Trust me, he’s not missing anything, but you are
Okay, I give, what is it that I’m missing?
There are several reasons why a Roth is important and should be utilized. Also, I happen to have a 401K plan that has a Roth option, in addition to a pre-tax and post-tax option. I believe in maxing out my 401K. I contribute some to pre-tax and some to Roth. I am, in addition, also directing additional monies to post-tax 401K contributions which happen to have the advantage of acting like a “deferred Roth.”
Upon leaving the company, I can rollover the “post-tax” portion of my 401K to a rollover Roth IRA account without triggering the Roth yearly limit! Taxes will have to be paid on the portion that has earned interest (but not the principle amount) at time of rollover, but this is still a great way to increase Roth contributions and without having to do a backdoor approach. That’s why it’s considered a “deferred Roth.”
As for why Roth is important, there are all kinds of tax consequences that can hit upon retirement that people don’t think about. SS benefits + RMDs + capital gains on taxable accounts can push you into a higher tax bracket quickly.
1. With a Roth, you never have to withdraw the monies if you don’t want to, which means you can keep those Roth monies growing.
2. In addition, even before the age of 59.5, you can withdraw the base amounts you contributed (but not the earnings on those amounts) without any penalty. This makes the Roth a very smart ’emergency’ fund because you can absolutely get to that money if you need to, long before you retire.
3. Having the ability to keep your taxable rate lower by using some of your Roth monies in retirement and only withdrawing traditional IRA monies to the limit of a 15% tax rate is a useful strategy. Better if you can get a lower effective tax rate. Roth is a way to achieve this.
4. Most people think their income at retirement will drop a lot, but that may not be true! People who invest and do well will have those RMDs to contend with in addition to SS benefits, if the bulk of their investments are in traditional IRAs or pre-tax rollovers. Never assume; run the numbers.
5. There are consequences that affect what you pay for Medicare coverage. I don’t know them all but I know it’s an area of concern and it’s connected to your retirement wages.
6. It’s important to seek assistance from a qualified tax expert to help optimize and structure your retirement monies so you get the maximum income with the least tax hit you can. There is a method to the madness. I don’t know what that optimal mix is exactly, but I’ll be seeking the expertise of a tax professional to assist.
So the takeaway is this: learn about all the tools at your disposal and don’t get caught up in the government conspiracy bits as that doesn’t really help you at all. Roth absolutely has its place and its not only for those starting out in their working lives. Get educated!
Sam,
I am 100% with you on the Roth IRA. When I first started saving/investing for retirement back in high school, I considered the Roth IRA. I was very attracted to the idea of putting after tax money in, and pulling out tax free money in retirement. However, even back then, when I probably would have just barely been able to meet the maximum annual contribution… that is the main thing that convinced me otherwise. I knew that it would not be long before I would be wanting to invest MUCH MORE than what the maximum contribution amount was.
After starting my own business and owning investment properties, I found that there are so many better (even tax friendly) ways to save for retirement.
For me, it is no longer just “saving for retirement,” but building long term generational wealth for me and my family. There is simply no place for the Roth IRA for this type of plan.
So I think you may be mistaken here sir. The roth ira is a tax exempt withdrawal. That means if you’ve held your roth ira for at least 5 years and are over 59.5 years of age all withdrawals are tax free with no penalties. So why is this a bad idea for people earning lower incomes?
From what I can tell if you are paying less taxes on the income you are depositing than the extra you would be able to deposit into a pre-tax retirement account it makes sense to utilize a roth ira as long as you plan to hold the ira until retirement and your retirement is more tha 5 years in the future. If your income is substantially lower now than your anticipated retirement income it makes sense to pay the taxes now at your lower rate rather than hoping your growth rate will be high enough in a traditional ira to compensate for your higher tax rate in retirement. Because your roth ira withdrawals are going to be tax free assuming you withdraw them at lead five years from now and you will be at least 59.5
Zachary, you are right. A Roth IRA will probably good for those who are in the 25% income tax bracket, or preferably lower. For those paying 28%, 33%, 35%, and 39.6% Federal Income tax, I think a Roth IRA is a bad move, especially if you haven’t fully maxed out your 401k of 18K for 2016 so far.
See this post: The Only Reasons To Ever Contribute To A Roth IRA
I agree that traditional IRA is better than Roth IRA contributions, but not because of taxes paid….but because of being able to spend your tax savings better than the government. Roth Ira:
a.) earn 1000 pay 300 in taxes
b.) 700 invested earns interest tax-free
c.) You can withdrawal 700+ X years of compound interest tax-free (you already paid the tax)
II. Traditional IRA:
a.) Earn 1000 pre-tax
b.) Contribute 1000, earns compound interest tax-free
c.) Get $300 back right away in tax savings, $700 invested earnign compound interest for x years
d.) Withdrawal for retirement, pay tax on initial 1000, AND tax on the compounded interest
1.) The advantage of the Roth is that even if you save a meager 5-20% on the taxes on $1000 (Difference of paying 300-500 dollars on the principle), net benefit=$50-200 dollars. The real benefit is that you are not paying taxes on the compounded interest which is what makes up the majority of the account value. Ex. 700 invested for 34 years (I’m 31 years old) at 6% interest is ~$5000 of spending money that I do NOT have to pay future taxes on. I spend 300 today, I invest 700. The $4300 of interest is tax free (at 30-50% tax rate that is 1300-2150 in future taxes saved + you still have your 700 principle ). Total taxes paid: $300. Total spending power: $5000 dollars
2.) Now let’s look at the traditional Roth. You invest $1000, you save $300 in taxes. Your 1000 investment becomes $7250 after 34 years at 6% compound interest. But you have to pay taxes on that 7250, so total tax payment of 30-50% is ($2200-3625):
Total taxes paid: $2200-3625, Total spending power $3625-5000
The BUT (What happens with that $300 saved?:
Your argument is that you can spend that initial $300 better than the government. I agree. Here’s why.
Now that first year you have $300 which you can choose to spend. Let’s say it gets put into real estate and the equity keeps rolling along in various properties along with inflation at 3% for 34 years. After 34 years, that $300 is worth $820 in equity. And, because of tax loopholes for real estate, you pay no taxes on it.
IF you invest the $300 saved, total taxes paid remains the same, but now spending power has increased $820 to ~$4450-$5820 (avg $5135)- a smidge higher than the spending power of a Roth IRA (2.7% difference)
So you’re looking at having 2.7% more spending power on average if you take the money today and invest it in real estate and it keeps up with inflation at 3%. At the very least, it’s probably safe to say you equal out.
Now let’s say you earn an average of 6% compounded, instead of 3% on that $300 outside of a tax-sheltered account. The worth after 34 years would be $2175 but you have to pay taxes on the earnings: 2175-300 principle =1875 interest gains, $1875 with 30-50% tax is $562.50-937.50.
Total spending money of $300 invested for 34 years at 6% interest, corrected for taxes = $1237.50-1612.50.
With that model, you’re looking at a range of $4862.50-$6612.50 (average $5,737.50), 14.75% higher than you would have with a Roth IRA.
So Yes by doing a traditional IRA over a Roth IRA, you will have 2.7-14.5% (avg 8.6%) more spending power (and more money that is in a more liquid asset leading up to age 65).
It REQUIRES that you invest that initial tax savings.
But you are actually paying the government a LOT more tax, but that’s okay because you’re also earning more, and if you die before 65, then you made a better bet with your money.
It is probably best to have a mix of Roth, Traditional IRA, SEP IRA and Real Estate so you have liquidity plus hedge on both having a higher tax rate.
THE BEST VEHICLE IS AN HSA account. It rolls over year to year, it is NEVER taxed and after age 65 you no longer pay a penalty on withdrawals and so you can pay for both living and health expenses out of the fund. Plus health expenses are the number one reason for bankruptcy even for those with insurance at the time of their illness/injury.
I think most people are unaware of how taxation of Social Security benefits can affect their marginal tax rates in retirement. It really does mess with the assumption that you will be in a lower tax bracket while taking Social Security benefits. Check out this article from Michael Kitces:
https://www.kitces.com/blog/the-taxation-of-social-security-benefits-as-a-marginal-tax-rate-increase/
For my own case, my 10% bracket becomes mostly an 18% bracket, my 15% tax bracket will turn into a 27.75% tax bracket and the lower end of my 25% tax bracket will be taxed at a 46.25% marginal rate! Yikes!
So ask yourself, if you are in the 25% bracket now, how much of your money would be coming out in a 27.75% (instead of the expected 15%) tax bracket in the future? And if that happens, would you wish you had used the Roth option?
I think the author missed a most important point: the time value of money. The value of money now does not equal the same value later. If I give you five dollars today, I better get back more than 5 dollars in a year. That difference is the time value of money. The compound interest (time value) you get in a retirement account is NOT INSIGNIFICANT if you have lots of time and have good investments that earn a good “interest rate” (we hope both are true for our retirement accounts!)
Predicting taxes in 40 years is not easy. But considering our national debt, how it is going up, and that you can only borrow so much before people don’t want to lend to US, I think it is safe to predict that they will go up. Plus, there is some value in not having to guess and predict and account for “randomness”. (Otherwise, people would never buy insurance from insurance companies that have to charge more than your statistical risk to make a profit). I know what the tax rate is now. I don’t know what it will be in 40 years, but it’s probably higher. There MAY be some benefit to subjecting my money to the predictable (tax) instead of the unpredictable (tax).
Ok, so that last paragraph was a side issue. Back to time value of money. Traditional IRAs tax as it comes out, after it has grown (we hope it grew in 40 years!). Roth IRAs tax the principle as you put it in, so what comes out of the account (when you retire) is tax free “because it’s already been taxed”. But the rules are ignoring something important: part of the Roth IRA money is compound interest that has never been taxed. It’s like tax evasion, without the “illegal” part. Maybe you say, “Ok, but the compound interest is just a (smallish) part of the whole piece of money, so that effect is not significant.” Ok, let’s do an example: Say I’m 22 and just graduated, so I can save 5,500 since I’m not putting it to college anymore. I have 43 years to 65. Say I get 5% a year in my retirement account. That will be 786,400 when I get to 65. How much (already taxed money) did I put in? 5500*43=236,500. So I made 549,900 in compound interest. More than two thirds of my retirement fund. If it’s in a Roth, I don’t pay taxes on 549,900. If it’s in a traditional, I pay taxes on 549,900. I think the difference of paying taxes or not on more than half a million dollars matters more than what tax bracket I paid on 236,500.
How I see it:
401K: Pay taxes on all of your retirement money. Invest in only what your company’s program has. Could restrict you, especially if you want to do “socially responsible” investing. But always try to take any match your employer gives you: you just made a 100% gain on your investment. After getting the match, go look at an IRA (Roth or Traditional).
Traditional IRA: Pay taxes on all of your retirement money.
Roth IRA: Pay taxes on only some of your retirement money. Legally. WHAT? How does the government not see this is bad for them?!
Your above example neglects one very important aspect of the equation. If you invest 5500/year (already taxed) in a Roth IRA and want to compare it to a tax defered investment then you have to use 5500/year plus the tax your not paying for an apples to apples comparision. Even if a traditional IRA limits you to 5500. the tax money still gets invested somewhere. If you invest X tax defered amount in a tax defered account and X minus tax paid in a roth, recieve the same return and remain in the same tax bracket, in the end the money you receive after taxes is exactly the same.
There are lots of good arguments in favor of both types of accounts on the forum like time value of money, estate planning, lower or higher tax bracket in retirement, etc. I couldn’t decide so used both types. I did ,however, end up in a higher tax bracket in retirement.
First timer here.
I lost 100% of my Roth IRA in the stock market on one bad investment in 2016. I contributed for almost 20 years to grow this account. Now wiped out.
Is my Roth IRA loss deductible?
Sorry about that. Did all your holdings go to zero? It’s hard to get wiped out without leverage.
The Roth IRA loss is not deductible.
See: The Proper Asset Allocation Of Stocks And Bonds By Age
Is a traditional IRA loss deductible? I could have sworn I read an article stating that the money earned from your contributions wasn’t deductible from a loss but that your contributions were deductible?
As someone who is also quite untrusting of the government, your post definitely makes me question my decision to contribute to my Roth IRA. I think the big thing for me comes down to investment choices in the Roth IRA. Most companies only have 10-20 mutual fund options so it is just luck of the draw on where your money goes. I currently pay 1.21% in fees in my 401K and 0.75% in my wife’s 401K. Not much I can do about it unless I want an all bond portfolio. Our Roth IRA accounts are around 0.1% in fees. That means that for the same amount contributed I’m losing around $500,000 in 35 years in the 401K. Not cool.
Take into account that my ETF portfolio in my Roth is outperforming my 401K mutual funds and my ability to easily manage and rebalance the Roth IRA and you could be talking about another $500,000.
People must watch out for the fees. When looking at an investment over 30 years and you factor in compounding interest just a few tenths of a percent make a massive difference.
Those are good points, and I’d imagine those are reasons why some people may want to take advantage of their IRA contribution before maxing out their 401k (obviously getting 401k matching is top priority when it exists). All too often people seem to be completely oblivious to the fees they’re paying.
That being said, if you agree with all the points made in the article you should be able to open up a traditional IRA with similar investments to your Roth, but with a tax deferral instead of contributing after tax dollars with growth that is tax exempt. I’d imagine you’re probably doing the smart thing by having a mix of both (traditional 401k and roth IRA), but I don’t know your individual situation. In general, the roth accounts are pretty great and you’ll be relieved to have a decent balance in there if tax rates ever skyrocket in an effort to close the deficit or fund some sort of unnecessary govt program.
Our combined incomes are too much to allow for an IRA tax break, so I max out my pre-tax 401k. This lowers our taxable income such that my wife and I can max out the Roth IRA contribution at Vanguard. In this scenario, I don’t see any reason not to invest in a Roth IRA.
My preferred method is to contribute up to the company match in the 401k (gotta love free money), then max out the Roth, then go back to the 401k. I don’t go for the traditional IRA because I’m kind of hedging my bet as to what tax bracket I will be in when I retire. Very tough to predict my income in 30 years and certainly difficult to say what the government will decide to do.
I also disagree with point 7 in the post about the withdraw penalty. One of the things I like about the Roth IRA is I can (hopefully will never need to) withdraw the principal tax and penalty free. That is rarely the case with the 401k or traditional.
Andrew, that is a great point as my wife and I are getting very close to that line and this would be a great way to get us a few more years of eligibility.
I have to disagree and say that your bias toward tax-deductible retirement saving is misplaced. The point you’ve been driving hardest is that the government wants the consumer’s money now, which was pretty much the reason in all of your points. The Roth IRA isn’t a government ploy; it’s a great place to save for retirement! It’s important that people have both taxable and non-taxable dollars in retirement in order to be most efficient during those “happy to be here” years. Obviously, there are some shortcomings to the Roth IRA, but those who are able to should contribute as much as they can into one… but only after taking full advantage of an employer matched 401(k). It’s smarter to assume taxes will be higher in the future rather than lower. Knowing US historic tax rates, current national deficit, and the declining health of social security, it only makes sense that taxes will be higher for at least some period of time in the future. Why would you want to save on taxes now, and potentially pay taxes at a higher rate in the future?? But since no one knows what the future of taxes has in store for us, it makes sense to have dollars that are both tax-free and taxable (deducible now) in retirement. This is why affluent people who understand this take advantage of a “backdoor Roth” for some of their retirement dollars. To say a Roth IRA is a bad place to save for retirement is just wrong… What people need to be more educated about is being well diversified across not only asset classes, but in both market-tied assets such as IRAs and 401(k)s and non-market-tied assets, such as a savings account or cash-value life insurance (which can function with the same tax treatment as a Roth if done properly) to ensure never to have to liquidate market-tied assets at a loss when the market has a correction during retirement. The uncertainty of future taxes should be considered just the same. That’s prudent planning!
Either I’m not reading #4 correctly or you’re making a mistake about how ROTH IRAs are taxed.
If I contribute to a ROTH, I pay the taxes now just on my contribution. Then nothing is taxed on the way out. Not the initial contribution or the earnings. If I contribute to a deductible IRA then I pay no taxes now and everything is taxed on the way out. Your claim that the math is the same seems to be based on the idea that you are taxing the ROTH earnings, which is not the case.
The longer you can let a ROTH contribution grow and the lower your tax rate is now, the more sense a ROTH makes. If you expect your tax rate to be higher in the future, pay the tax now. If you expect it to be lower in the future, pay the tax later. Regardless, the longer you have to let it grow the more a ROTH makes sense because a larger percentage of your distributions will be tax free earnings.
The key difference is your tax rate. If you think you are going to be in a HIGHER tax rate come retirement because you aren’t working (hard to do) and/or because your investments are making much more than your current salary (also hard to do), then go for it!
Related: Long Term Investing Is All About Saving Yourself From Yourself (2017)
I always felt how could I possibly be in a higher tax bracket in retirement and if I end up there it’s probably a good problem to have. So my wife and I, both working good jobs but not great, went all out for tax deferred accounts. Now I am facing retirement with 2 social securities and 2 small pensions that puts us up in 6 figures. Then add in another 6 figures from required minimum distributions from tax deferred accounts. Then add in our investments and we are in the 33% bracket. I’m glad that toward the end I have been funding and converting some into Roth’s. Now add in 6% state tax and my tax bill says I’m rich but I certainly don’t feel or live that way. I am considering a move to a no tax state to aleviate at least the state portion of my taxes. Another problem of having decent income in retirement is medicare part B cost more and there is always talk of means testing for any benefit/entitlement that retirees receive.
Any ideas? I think it’s too late for me but some of you younger folks may want to consider this.
Hi there,
31 yr old, single, male who was recently laid off and has a few questions.
I am in the process of rolling over my 401k to a vanguard group traditional IRA. What should I look for when choosing investments for my IRA? I am youngish so I wanted to be more aggressive.
I was also going to invest in a Roth IRA as well. Which leads me to another question. When I fund my Roth IRA, does the money go to say pre-selected investments or is it funded to an account and then I manually pick my 5500 worth of investments? Or is it all the same like 5500 invested at fidelity Roth IRA is the same as 5500 invested in vanguard Roth IRA etc.?
Thank you very much and I hope my questions weren’t to confusing. Please let me know if you have any questions I’d be happy to answer.
Cam
I would get a brokerage account for both Traditional and Roth IRA’s. You can buy stocks or ETF’s and Vanguard ETF’s are free to trade. I think you can also buy Vanguard mutual funds if you prefer, but I think the ETF’s will have you covered w/ lower expenses. VTI is a nice broad ETF. Putting 90-100% of you money in that would be pretty aggressive yet diversified. Put the rest in BND (broad bond ETF). Set it and forget it. When you turn 40-50 re-eval your VTI/BND ratio based on your time horizon and risk tolerance. @see https://personal.vanguard.com/us/insights/saving-investing/model-portfolio-allocations
A Roth IRA is effectively the same as a 401k, if you ignore the tax consequences.
They BOTH are simple accounts that are used to hold your money for investing in stocks/bonds/funds.
If the money to fund your Roth IRA is coming from the 401k, then it is usually a taxable event – meaning you very likely will have to pay taxes on it and any early withdrawal fee which is 10% from the last time I can remember. So, if you want to deposit $5,500 into the Roth and use the money from your 401K, you’d better plan on withdrawing 1.111x that amount at a minimum to pay the 10% fee. To make sure that you have enough income taxes taken you’ll have to add your effective tax rate to the 10% fee for being under age 59 1/2.
Mathematically it’s like this. To have enough taken out for the fee it’s:
1 / (1 – 10%) = 1 / (1 – 0.1) = 1 / 0.9 = 1.111
Now if your effective federal income tax rate is 5%, then the numbers become:
1 / (1 – 15%) = 1 / (1 – 0.15) = 1 / 0.85 = 1.1765
That gives you the multiplier that you need to multiply by and be able to pay the taxes/fees.
Note: This doesn’t account for state tax if you have that.
So if you want to transfer $5,500 from your 401k into your Roth IRA, you’d have to take out this much from your 401k:
1.1765 x $5,500 = $6,470.75
ETFs and index funds are the simplest methods to invest and your retirement/brokerage accounts.
FWIW, I would use $0 of your 401k and transfer it over into a Traditional IRA account with an investment company like Fidelity, Schwabb, Ameritrade, etc. That is unless your income is so low that you would be paying 0% on the transfer.
]Best of luck to you in your investing!
My Roth IRA is strictly for transferring wealth to my children, tax free. I am covered by my 401K. I already did the math. In fact, I am planning on having them work for me (self employed) when they turn around 9 or so, until they go off to college. That 7-8 years when they are young, $5.5K a year into a Roth IRA, a total of $44,000 investment (at age 18), and even if they NEVER invest in it again, at 8% annual returns will net them $2.5 million of tax free money at age 62 (which is more than most people who work all their life and don’t save), and $5.1 million at age 70.
My Roth IRA balance will be turned into a trust fund for them too. I’ll teach them about being a responsible person and contributing to their 401K (and Roth IRA of course), which will increase this number BIG TIME.
If they continue to put 20% into 401K, at starting pay of $20 (age 24) and a 4% raise (this is including changing jobs for 20% wage pays, promotions etc. since my OWN average “wage increase” per year is about 6% – it’s all about how ambitious a person is), and max out the Roth IRA, my kids each can:
1. Retire at age 50. ($2.8 million total)
2. Age 60: $4.7 million
3. Age 70: $8.4 million
4. Age 80: $15.7 million
5. Age 90: $30.8 million
If they’re lazy, they can retire at 40 and money will last way past age 115 so they can focus on their passion.
I’m all for my kids. What about you guys?
You are dreaming. No kid is going to put 20% into an 401K
My oldest 2 kids are currently putting 80% of their pay into a savings account as their initial buffer, and then they plan on putting that same amount into retirement accounts, first starting out with the Roth IRA since their income is lower and they won’t be paying taxes on it.
After all, if they earn $10,000/yr and put $5,500 into a Roth and another $2,500 into a savings/brokerage account, then they won’t pay a dime in taxes because their income is so low. Of course that is if I don’t claim them on my taxes. While that is my choice to do or not do, I don’t want them paying taxes at my rate on their minimal income just to reduce my own taxes a little bit.
For middle income earners, I like Roths over Traditional IRAs for the following reasons. #1 The investor can purchase income producing investments and never pay taxes on that income during retirement. #2 There are no RMDs, whatever a person’s age he/she can limit the withdrawals to the income produced and never have to sell the golden goose. #3 Lowers one’s taxable income during retirement.
I agree with you. The vast majority of my retirement savings is before tax but now I want more ROTH money “just in case”. No RMD, and a nice option for occasions when I need money for something special but don’t want the tax impact.
I’ll admit I have not read the 70 million comments on this article, so apologize if redundant! I also note that this was written many years ago, so viewpoints change and evolve as do tax laws, etc.
I’m not going to comment on the obvious tax implications of Roth vs Regular IRA as I think that has been fairly beaten to death, but maybe because most are so young that there are some nuances that are not being realized.
With a 401k\Regular IRA, Required Minimum Distributions (RMDs) will kill you. Many…many years ago I rolled a 401k over to a IRA which has since grown to over $650k. Sounds great but my RMD is a little over $40k a year. That amount plus my pension, my 401k RMD, My wife’s 401k RMD, my wife’s pension, my social security, and my wife’s social security have put us right up against the top of the 25% tax bracket. Any little hiccup such a $1,000 lottery win would immediately push us into the 28% bracket, which is where I spent the majority of my working years. In retrospect, I wish I would have had a Roth 401k or IRA just to give me access to funds that would not impact my tax bracket.
I’m finding out that the higher your tax bracket is in retirement, the more everything costs and the less access to resources one has. Monthly medicare payments are based on your taxable income. I could easily save hundreds of dollars a month if I didn’t have to take monthly RMDs. There are many, many examples like this.
There is the mental health side, which is more difficult to quantify, but still there. We scrimped all our lives just so we could always save the maximum in each of our retirement accounts as well as other savings. We are well off and know I am blessed by that. The hard part to swallow is that the the entire RMD from my IRA literally goes to pay my taxes. So, I’m forced to take money that I don’t need out of my IRA to then be taxed on it and then give the entire amount to the Government. There is no way to avoid taxes, but to know that all that money saved and invested currently serves to purpose other than to pay for taxes is depressing!
Finally, we are all going to die. If you get to that point with money left over and family that you love and they love you in return, you are lived a good life. If you give a Roth IRA to family then it just goes to family. A regular IRA, is another hot mess. The IRA becomes a inherited IRA and RMD’s will now be a factor for those that receive it, albeit in a smaller amount. I know this is not the deal breaker in the IRA\Roth IRA, but just another factor as you think about your entire portfolio and estate planning.
I guess I wrote all this just to say if you are looking at today’s taxes vs future tax rates as a roth\non-roth determination, you are making a decision with only partial facts. There are literally so many factors, both known and unknown that its mind boggling. My recommendation based on my situation is to utilize both a Roth and non-Roth in either/both IRA or 401k. You can’t anticipate future tax laws, Congress, world and financial events, so having multiple baskets is a prudent path.
I have all kinds of accounts, because I don’t know the future, so I diversify among types of accounts. I had a Roth 401, and I rolled it over to a Roth IRA. I’m so aggressive in my Roth I did over 50% return, so for me, the Roth paid off. For most people, I’d recommend this: rather than buy a Roth IRA, buy shares of non-dividend stocks… such as Berkshire Hathaway and Copley Fund COPX and FANG, they don’t pay dividend, so there’s no taxes until you sell, just like a Roth, except if you need money in an emergency, you can get at it without penalty. One of the secrets to wealth is to leave your good stocks alone.
If you plan on retiring abroad, it is another reason not to pay into a RothIRA. The foreign government likely won’t care if you had already paid taxes or not!
This topic needs to revisited and updated in light of the recent tax reform. In most situations in the past for middle to high income earners, I would agree that a Roth IRA was not a great idea; however, given the new changes I’m beginning to believe that there are more scenarios where it is advantageous to at least put a portion of savings into a Roth.
For example, as an owner of a pass through entity (S-Corp) currently netting $300k per year ($144k in W2 : $156K in pass through income) it may be better to put at least some of the $54k solo 401k contribution into a Roth based on the fact that I will lose my 20% deduction on pass through income when I retire (i.e. I will no longer be generating income through my S-Corp) and will pay a far higher effective tax rate on withdrawals from my Traditional 401k. I also believe that the likelihood of even lower taxes in the future is very low – so a Roth may be the be the best opportunity to take advantage of the current low tax environment if you adhere to the old adage of choosing a Roth if you believe future taxes will be higher.
Sam,
I converted part of atraditional IRA to a Roth.
A terrific benefit of having a Roth is you are not forced to take a Required Min Distribution on Roths the way you are on 401Ks or IRAs when you reach 70.5.The government forces you to draw down your non-Roth retirement acct by 3.7+%, and then you have to pay taxes on the distribution.
I figured it was best to split btwn. a Trad. IRA and Roth, so the 3.7+% is on a lesser amount in the traditional IRA.
Your thoughts?
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.
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.
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!
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