“Disadvantages Of A Roth IRA: Not All Is What It Seems” ignited a flurry of responses from people who have already been contributing to a Roth IRA. Anybody who followed my advice since the post was first published during the Obama administration has been rewarded handsomely. Income tax rates declined under the Trump administration. Let’s look at the only reasons to ever contribute a Roth IRA in this post.
With Joe Biden as President, at the margin, investors should be more wary because there’s a likelihood that taxes will go up again. Taxes must be raised to pay for all the stimulus being spent to combat the virus. Further, Biden has said he will raise taxes on households making more than $400,000.
Hard To Trust The Government To Contribute To A Roth IRA
One of the main things people have learned is that the government manipulates individuals into forking over more money than they otherwise should due to gross mismanagement of their own budget.
Massive deficit due to record stimulus spending during a coronavirus pandemic? Let’s announce this huge “benefit” to allow people to convert their pre-tax retirement funds into a Roth IRA! We’ll raise the specter of higher tax rates to get more people to bite.
It’s sometimes daunting to go against the government because they employ some of the smartest people on Earth to keep themselves in power while keeping the rest of us dependent on their largess. But I’m here to help you fight back and live a better life.
If you contribute to a Roth IRA or convert your pre-tax retirement accounts into a Roth IRA, you aren’t going to be damned to hell. You’re just not maximizing your wealth over time if you are in a federal income tax bracket higher than 24%.
For those of you who already have a Roth IRA account, what you are about to read probably makes so much sense you might feel a little bad. But don’t worry. The number one solution when you are in a hole is to stop digging and slowly climb out.
The Only Reasons To Ever Contribute To A Roth IRA
1) You’ve maxed out your 401(k) already.
If you’ve contributed $19,500 to your 401(k) for 2021, then go ahead and contribute to a Roth IRA if you are eligible for tax diversification purposes.
Contributing to a Roth IRA is more tax-efficient than simply investing in a taxable brokerage account. Roth IRA money compounds tax-free and all contributions and earnings can be withdrawn tax-free once you’ve kept your Roth IRA open for more than five years.
Related: How Much Should You Have Saved In Your 401k By Age
2) You’re in the 24% marginal income tax bracket or lower.
If you earn under $86,370 / $172,750, you are in the maximum 24% marginal federal income tax bracket I recommend for contributing to a Roth IRA. A 24% federal marginal income tax bracket is a reasonable rate to pay.
Feel free to contribute up to $6,000 to a Roth IRA now because you will be completely creamed by the IRS in the future as your income and marginal federal income tax rate increases.
The reality is, once you earn more than $140,000 per person or $208,000 per married couple, you can’t contribute to a Roth IRA anyway.
3) You’re going to make over $140,000 or your spouse is getting a big raise.
After you make over $140,000 as an individual or $208,000 as a married couple for 2021, you can’t contribute to a Roth IRA. You can contribute the max if you earn $125,000 or less as an individual or $198,000 or less as a married couple. It is still unknown how the government comes up with such arbitrary amounts, independent of location.
Don’t they know that San Francisco is much more expensive than Des Moines? Contributing to a Roth IRA is particularly useful for those who are on the hunt for sugar mammas or sugar dads. If your prey actually proposes, then contribute as much as you can during the engagement before it’s too late.
4) You think World War III is on the horizon.
If you think world leaders no longer respect the United States’ might and plan to invade, conquer, and bomb neighboring countries around the world, you should consider: 1) withdrawing all your money and keeping it under a mattress, 2) make sure your savings accounts are no larger than $250,000 for an individual or $500,000 for a married couple to comply with the FDIC guarantee amount, 3) sell equities and keep cash, 4) or contribute to a Roth IRA because the government will likely raise taxes on everyone to fund a long war.
I still think if you make under $200,000, you’re relatively safe. However, with an expense as large as World War III, the government may have no choice but to raise taxes on people paying 25% or less.
Related: How To Prepare For World War III
5) You feel tremendous guilt for not paying your fair share.
Let’s say you’re having a guilty conscience for not paying enough taxes because you either cheated on your taxes for years, run a cash only business with two sets of books, mooched off the government longer than you should have, or feel so bad taking advantage of all the loopholes, then go ahead and contribute to a Roth IRA.
I’ve spoken to a lot of the 47% who don’t pay income taxes during my time off from Corporate America, and a couple have admitted they feel bad that 100% of the tax burden is paid for by only ~53% of the people. Some of my 47% friends have side jobs that are cash only and never pay taxes.
6) You’re undisciplined and expect to have a lot of problems in your life.
You may have the best intentions of saving for your retirement, but you know that you have poor discipline when it comes to money. Perhaps your experiences as a relapsing cigarette smoker or drinking alcohol have given you doubt about never needing to raid your retirement accounts.
Maybe you’ve got outstanding debts that must be paid or else goons will visit you in the parking lot and break your kneecaps. Who knows.
The “good” thing about a Roth IRA is that you can withdraw the money you put in penalty free, just not the earnings. The only times you might be able to get away with the early withdrawal penalty before 59.5 is if for college expenses, medical expenses greater than 7.5% of your adjusted gross income, or paying for a first-time home purchase (up to $10,000).
7) You have inside information knowing that Roth IRAs will get favorable treatment.
Let’s say you work in the US Treasury and overhear that the government plans to pilfer all 401(k) and traditional IRA accounts by raising taxes on withdrawal rates and extend the penalty free age of withdrawal from 59.5 to 69.5.
You’ve seen draconian measures executed with bank deposits in Greece in 2013 so you have no doubt America can do the same. You also hear that anybody who contributes to a Roth IRA will get a one-for-one dollar match and get two votes to raise taxes on others to benefit yourself. Clearly you should contribute all you can to a ROTH IRA until the government changes its mind again.
8) You live in one of the no state income tax states.
Federal income tax is one thing, state income tax is another. If you live in Texas, Washington, Florida, Alaska, Nevada, South Dakota, Wyoming, or New Hampshire, it is less of a sin to contribute to a Roth IRA because you aren’t paying any state income taxes. Everybody else should figure out a way to retire in one of the seven no income tax states and then start withdrawing pre-tax retirement funds.
Related: States With No State Tax Or Inheritance Tax
9) Someone is paying you to promote a Roth IRA.
Money makes people do anything. If some organization is going to pay you to promote the Roth IRA then I guess you’re better off than others who don’t have the same money making opportunities.
If you can earn more promoting the Roth IRA than what you can earn from the returns of your Roth IRA, then you would be a fool to ignore all the wrong reasons for contributing to a Roth IRA in order to pad your bank account.
Be especially aware of financial advisors or CFPs who aggressively push the Roth IRA without providing other benefits besides tax free growth and gains. Make sure pitchmen practice what they preach.
10) You are an income tweener.
If your income is between the deductible IRA max ($66,000 income limit to contribute the max) and Roth IRA max ($140,000 income limit to contribute the max) and you can afford it, making a Roth contribution could make sense.
For those over the Roth income max, you can do a “backdoor” Roth contribution – by making a non-deductible contribution to a traditional IRA and then converting it to a Roth.
11) You’ve got a working child.
If you’ve got a child who is working for someone else or for your business, then you might as well contribute to a custodial Roth IRA. The child will pay no taxes up to the standard deduction of $12,550. Further, your child will learn about the importance of saving and investing for his or her future.
There is no age limit to open up a custodial Roth IRA for you child. So long as your child is earning income doing work, he or she is eligible.
Contributing To A Roth IRA Isn’t The Worst Thing In The World
Mathematically speaking, the most taxes you will pay on a $6,000 contribution is roughly $1,440 (24% tax bracket). You can’t contribute to a Roth IRA once you’re in the 32% federal income tax bracket due to the $140,000 individual income limit threshold for 2021.
It is really unlikely that you will earn more in retirement than while you were working. Interest rates have plummeted, which means it requires a lot more capital to produce the same risk-adjusted income. Therefore, we should all lower our safe withdrawal rate in retirement to be more aligned with the times.
You will unlikely earn enough in retirement to pay higher than a 24% marginal federal income tax bracket. This would require an individual to make over $165,000 a year or a married couple over $330,000 a year in retirement to pay the 32% marginal federal income tax rate.
However, to generate $165,000 / $330,000 a year in income from your retirement portfolio would necessitate having a $4,125,000 – $8,250,000 generating 4%. But since interest rates have come down, you would need perhaps double the amount.
Yes, I do believe many personal finance readers will become multi-millionaires in retirement. But most Americans will not. The retirement numbers don’t lie.
If the choice is between not saving anything at all and saving in a Roth IRA, then definitely save in a Roth IRA even if you haven’t funded your 401(k). But the best sequence is to max out your 401(k) and traditional IRA first before paying more taxes up front.
Diversify Your Retirement Sourcs
In 2022+, I have come around to contributing to a Roth IRA because I’m now a father of two kids. So much of one’s perspective changes after becoming a parent.
When I reflect back upon my time working minimum wage jobs as a teenager and then working jobs in college and a year after college, I regret not contributing to a Roth IRA. If I did contribute a Roth IRA back then, I would have over $100,000 in a Roth IRA account today.
I plan to put my kids to work at some point, pay them the Roth IRA contribution limit, teach them about online entrepreneurship, and also teach them about the importance of saving and investing for the future. Being able to pay 0% tax to contribute to a Roth IRA and then withdraw the money tax-free in the future is a no-brainer.
Joe Biden and Kamala Harris are likely going to raise taxes for higher income earners and keep taxes the same for the rest. Pay attention to tax laws and tax rates going forward.
For those of you in a marginal tax bracket above 24%, doing a Roth IRA conversion to try and save on taxes when you’re in retirement is probably not going to save you money. But if you are in the 0%, 10%, 12%, 22%, and 24% marginal income tax brackets, it’s not a bad idea.
Diversify Your Investments Into Real Estate
If you want to dampen volatility and build wealth at the same time, invest in real estate. Real estate is my favorite asset class to build wealth.
The combination of rising rents and rising capital values is a very powerful wealth-builder. By the time I was 30, I had bought two properties in San Francisco and one property in Lake Tahoe. These properties now generate a significant amount of mostly passive income.
In 2016, I started diversifying into heartland real estate to take advantage of lower valuations and higher cap rates. I did so by investing $810,000 with real estate crowdfunding platforms. With interest rates down, the value of cash flow is up. Further, the pandemic has made working from home more common.
Take a look at my two favorite real estate crowdfunding platforms. Both are free to sign up and explore.
Fundrise: A way for accredited and non-accredited investors to diversify into real estate through private eFunds. Fundrise has been around since 2012 and has consistently generated steady returns, no matter what the stock market is doing. For most people, investing in a diversified eREIT is the easiest way to gain real estate exposure.
CrowdStreet: A way for accredited investors to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities with lower valuations, higher rental yields, and potentially higher growth due to job growth and demographic trends. If you have a lot more capital, you can build you own diversified real estate portfolio.
Recommendation To Build Wealth
Whether you have a Roth IRA or a traditional IRA, I would sign up for Personal Capital to run your retirement funds through their Investment Checkup tool for free. You’ll get a snapshot of how much in portfolio fees you’re paying a year and how you can optimize your portfolio based on your risk tolerance. I found out I was paying $1,700 a year in fees I had no idea I was paying!
Definitely also run your numbers through their newly launched Retirement Planning Calculator. They use real data that you’ve linked to produce as realistic a future financial scenario as possible to see how you’re doing. You can adjust the various expense and income variables to see the different results.
Check out a sample output below and see if you can get to excellent shape as well!
The Only Reasons To Ever Contribute To A Roth IRA is a Financial Samurai original. Financial Samurai has been around since 2009 and is one of the leading personal finance sites in the world.
There are other advantages to the Roth including a lack of mandatory distributions, passing it on to heirs, etc. So it’s not as black and white as you wrote before. Roth 403(b) in particular aren’t subject to the income limits the IRAs are and this could be done once you contribute the full $57K minus the $19.5K employee contribution limit. Again for me it is about tax diversification. Even if you do have tens of millions of dollars in retirement at age 70, it’d help to have at least some fraction of that be tax free so you can make large withdrawals if needed without feeling pain.
Partial Roth conversions from a traditional IRA are an alternative to using the 72t SEPP to turn tax deferred income into nontaxable income without paying any taxes or an early withdrawl penalty. The way I like to use my early retirement is to be a mega tax optimizer as opposed to a mega wealth generator. The goal of my working career was to store as much income as possible in tax deferred accounts, and the goal in retirement is to get all that money out without paying any federal or state taxes. I moved about $440K last year from tax deferred to available or spendable categories last year, paying $0 Fed and $0 California tax, and I am happy as a clam with that!
I’m very familiar with Roth conversion ladders and all kinds of tax optimization tricks such as those GCC shares. But can you share more info on how on earth you moved $400k of tax-deferred pretax over in a year without paying tax? I can’t think of any way that could be done that wouldn’t also have cost you a lot of money in other ways.
I was referring to my focus on mega tax optimization with that figure. About $370K of that was a capital gain on a primary residence I held for six years. The other $70K came from multiple tricks due to married filing jointly status, but heck, avoiding the Federal component of taxation is simple for under $70K just from the long term capital gains or qualified dividends exclusions! The state portion is actually easy to hide anyway in California since the tax structure is *so* progressive compared to other states.
Quick follow up on my comment about my focus on tax optimization over wealth generation.
First, you can generate as much wealth as you want in tax deferred accounts, especially with Solo 401(k) that let’s you choose *any* investment vehicle. So wealth generation is always doable and important, but not my focus.
Second, at some point I realized that someone making $47K retired could live *exactly* the same lifestyle (if not better) as the majority of people who make $100K working. Since I am content with a $120K lifestyle with no need to “live large” I decided to focus more on maximizing every dollar I made vs making as much wealth as possible.
That, in a nutshell, is why I am a FIRE guy that focuses on optimizing taxes instead of generating wealth.
Besides, generating wealth requires a lot more effort than optimizing taxes. :-)
My company offers a mega-backdoor roth (in-plan after tax 401k conversions to a roth 401k) which lets me put away the IRS maximum of $56k. I see no reason not to do this because my earnings will grow tax free, I’m already maxing out my pre-tax 401k, and I can use the roth 401k as an emergency fund (well, my contributions). I see no reason not to do this, even though I would like to start using the 30k or so I’m putting into my roth 401k into a house eventually.
I understand your points in this system, but don’t believe they account for all situations. You make some statements that I am sure are true for many, if not most, of your readers. However, by the shear fact that I am a reader, they’re not true for all. I am an expat reader. You probably have more readers than me in my situation. Thus, I have to disagree that these are not the only reasons to ever contribute to a Roth IRA.
In your post:
1. “You’ve maxed out your 401(k) already.”
As an American citizen who lives and works abroad, I don’t have a 401(k). You could argue it is maxed out because the amount I can contribute is zero, but, really, I haven’t contributed anything to it either.
2. “You’re in the 24% marginal income tax bracket or lower.” And “You’re just not maximizing your wealth over time if you are in a federal income tax bracket higher than 24%.”
I am currently in the 22% bracket, but have not been far away from the 24% bracket the past couple of years. Even if I enter the 24% bracket, I think it is still to my benefit to enter the Roth IRA as an expat American in Germany. Right now, I can take a tax credit on my German income taxes, and then put the money into a Roth IRA. I get no deduction benefit from putting it into a Traditional IRA.
If and when I make enough in dividends, capital gains, and other distributions from my investments, I can just exclude all of my German earned income and contribute to the Roth as if I only had 6k in US income.
Correct me if I am wrong, but being an expat almost guarantees a Roth IRA is a better choice than a traditional IRA. The only situation I could see that being otherwise is if you can still exclude your foreign income under the foreign earned income exclusion while earning enough dividends, capital gains, and other investment distributions to be under the US income max for the traditional IRA deduction while being able to really take advantage of the tax deduction.
3. “You live in one of the no state income tax states.”
I’m guessing that you meant with this section: “you don’t have to pay state income taxes.” I do not live in one of the states with no income taxes, but I also don’t live in any state. Years ago, I formally renounced my residency in that state and have that state’s confirmation. I no longer pay state taxes, only federal taxes. And there are ways to reduce federal income tax liability substantially, if not completely. For those interested, I wrote about two of the primary ways to do so: the foreign earned income exclusion (expostriate.com/foreign-earned-income-exclusion/) and foreign tax credit ( expostriate.com/foreign-tax-credit/).
We won’t be converting tIRA to Roth IRA…our income is low and will be so in retirement, so any taxes on tIRA withdrawals will be low.
OTOH all our kids are going into the military after college, so they will be putting their retirement savings into the Roth TSP since their tax brackets will be low at first (plus they get generous non-taxed “allowances”) but they’ll be in much higher tax brackets later in their careers.
It wouldn’t matter if they are going to be in higher tax brackets. what matter is in their retirement income tax ratio. SO it would be better for them to use traditional..
Here’s another reason for people to invest in the Roth: After 35+ years spouse and I have saved in the tax deferred 401ks and as a result, wee have over $2.5 million in the tax deferred accounts. Now… we recently read the writing on the walls… Unless we do some major converting in retirement, Uncle Sam is gonna take an enormous chunk of our tax deferred savings when RMDs kick in at age 72. So, we wised up and changed our paychecks to 100% Roth 401ks until we retire. We are definitely going to have to create a drawdown strategy or Roth conversion strategy between our retirement at age 61 and RMDs at 72. So there, you have it! Another great reason for investing in the Roth!
Originally I was like you and I worried about RMD’s. However, a while ago I decided to create a spreadsheet to see what my RMD’s would look like if invested in my 401k and had a $2.5 million balance when I turned 70.5. The spreadsheet was created before the RMD was raised to 72, but it still gives you a general idea.
Here’s my sheet:
https://docs.google.com/spreadsheets/d/1szCTL1f18r-R7Mfo_fJAt9qEW_S0Xnt_cuO06aB58ao/edit?usp=sharing
Historically, the average rate of return on investments while in retirement is about 5% since the investments are mostly moved into safer vehicles while in retirement which means lower rates of returns but more stable returns. Also, historically, since the early 1920’s, inflation has averaged 2.9% per year.
As you can see in the spreadsheet, I ran out the numbers year by year showing what my RMD would look like each year.
To the right you’ll see what my taxes will look like the first year in RMD’s and also what my highest RMD tax would look like.
My max RMD occurs when I turn 84 years old in which I’d be required to take out $108,596. Using a gross of 108,596 you can see that my effective tax rate would be 16.09% after my standard deduction and my AGI is funneled through the different tax brackets.
I’m not sure what marginal tax bracket you’re in right now, but I’m in the 24% marginal tax bracket right now. Meaning any money I invest in a ROTH is going to be taxed at 24%. Ouch!
However, as you can see from my spreadsheet, if I invested in a 401k instead and had a $2.5 million balance when RMD’s start, my first year of taxes would be 14.66% and my highest RMD year would be 16.09% in taxes.
I’d much rather pay taxes later at a lower rate even when forced to take RMD’s on my traditional 401k vs paying ROTH taxes now. For me the taxes would be about 50% more, 24% for a ROTH now vs 16% later on for a traditional 401k with RDM’s.
Hope that helps people understand RMD’s a little better.
Josh,
Great spreadsheet. However, at the beginning of RMD, you’re paying a 14.66% effective rate on $79k after your standard deduction.
With a ROTH you are paying 24% (your marginal rate) only on your $6000 contribution which is $1440. In 40 working years you’ve paid ~$57,600 in taxes. Have you done the spreadsheet of the max allowed ROTH and how much total taxes are paid when you reach age 70.5 (or 72)?
With a ROTH, you pay no taxes on earnings and compounding. I’m thinking it’s great when you’re young and at some age it transitions to where it’s no longer profitable to pay the taxes up front, unless you are planning to let someone inherit it.
Hi Jim,
I understand what you’re saying and I’ve had a lot of talks with people relating to that as well.
You’re thinking of taxes now vs later in absolute dollar amounts. In that way you are correct.
With that said however, the way you should be thinking about taxes is what percentage of my income am I paying in taxes. Yes, you’ll pay more dollars quantitatively in retirement in taxes on a 401k, however your nest egg is also a lot larger with a 401k in retirement and your taxes are a smaller percentage of your retirement income later in retirement than they are now with a ROTH.
If you want a more complete concrete example, I created this a while back comparing the Roth to a Traditional 401k.
https://docs.google.com/spreadsheets/d/1IBt7ro1z97OnBRyP7PZgkZ3CevpSHKFEaOPeHRcQol4/edit#gid=0
You’ll notice, that yes, you’ll pay more taxes (in raw dollars) on a 401k in retirement, however, again, your 401k nest egg is a lot larger than the ROTH and you need to look at what percentage of your income you’re paying in taxes and what your net income is in retirement after all the taxes are paid. That’s what matters to me. The bottom line is which investment gives me the highest take home pay in retirement after all the taxes are paid. I personally don’t care if I pay more in taxes (raw dollars) later in a 401k if my net take home after those taxes are paid is greater than what I would have had if I invested with a ROTH.
The example linked shows the full circle picture of the retirement vehicles as it pertains to our actual tax code. And more importantly, it shows who actually has more money to live on per year after all the taxes have been paid. In this case, Sam (401k) has more money to live on each year than Dave (ROTH).
Hope that helps!
For giggles, I just updated/created a new spreadsheet for the 2020 tax brackets and standard deductions. See below:
https://docs.google.com/spreadsheets/d/1EZ4ig90jgVgAnPKzBxbM1uPSO8mu5dWiHbXkV0cUicU/edit?usp=sharing
As the original one indicated, Sam and Dave are both saving 15% of their income for retirement. The first tab shows this comparison.
However, I expanded on this. Why?
Because Sam and Dave are not like most Americans.
The average American is only saving 6.9% of their income for retirement. The second tab shows what Sam and Dave’s situation would look like if they are an average Americans saving 6.9% for retirement.
I also went the other extreme, what if Sam and Dave were absolute rock stars and wanted to max out their 2020 contribution at $19,500. The third tab shows this comparison. As an fyi though, only 13% of Americans maxed out their 401k’s in 2017 (I can’t find 2018/2019 data).
In the end, all three tabs show the same thing. The 401k is more advantageous than the Roth and Sam has more money to live on per year than Dave does after all the taxes are paid.
Other things to think about, these scenarios show Sam and Dave contributing for 40 years. Which the typical American also isn’t doing. I could easily create a spreadsheet where they’re only investing for 30 years instead. But the same thing would happen: A shorter period of time investing means a lower retirement balance, which means less money taken out every year in retirement which means an even lower effective tax rate on their 401k withdraw in retirement. So even when time is taken into consideration, the 401k comes out on top.
Hi Josh,
Thanks for the second and third spreadsheets!
It’s a win-win for the individual and Uncle Sam.
Amazing that in 40 working years Dave would pay just $105,600 in Federal income tax whereas in 25 retirement years Sam would pay over $340,200… yet Sam will have higher income throughout retirement.
It’s a bit of a shame that the stretch IRA was removed as part of inherited IRAs. I was relieved to learn that the QCD age stayed at 70-1/2 and was not increased to 72 like the RMD age. I turned 70-1/2 this year.
Hi Josh,
Thanks for sharing your spreadsheets! Great stuff!
I’d say the only real fly in the ointment is that you’re assuming the tax codes stay unchanged. That’s not an assumption I’m prepared to make, as I explained in my comments on this Financial Samurai post: https://www.financialsamurai.com/disadvantages-of-the-roth-ira-not-all-is-what-it-seems/.
I think it makes the most sense to tackle an uncertain future by diversifying your approach: I use a trad. 401(k), a Roth IRA, and a brokerage account. Each has advantages and drawbacks, and I’ll be okay regardless of whether or not the tax code changes.
Maybe my approach is not optimized, but it keeps my options open. And I won’t be quite so fuming mad when Congress changes something in a way that screws over one of these groups.
Thanks for the spreadsheet but what happens when the government raises tax rates in the future. I’m currently in the 24% tax bracket and will also have SS and a federal annuity in retirement. Both will be taxed. Shouldn’t I have a Roth to off set all the taxable income I will have in retirement? I’m still 20 years away from retirement.
I’m confused by your position, can you help me better understand?
If you contribute $5,000 to a Roth, you’ve already paid taxes on that money. It grows tax free, and you get to spend it in your golden years. The only alternate option would be to invest that same money elsewhere (I max out my 401k), and pay capital gains on the earnings.
Am I misunderstanding something?
Yes because you’re paying taxes on a ROTH investment at your Marginal tax rate, which is your highest tax bracket. If you invest in a regular 401k, the withdraws are treated as normal income so you get to take a standard deduction and then the money is taxed in tiers. This is considered your effective tax rate. Your effective tax rate is always lower than your marginal tax rate. If you don’t believe me look at your tax summary for the past year.
For example, My marginal tax rate last year was 24%, however my effective tax rate was 12%.
Every dollar I put into a ROTH would be taxed at 24%. Ouch!
I agree with the author 100%. The vast majority of the people reading this will retire on less income per year in retirement than they had while they were working. In fact, most financial advisors suggest 80% income replacement is a good goal to strive for. And in that case the regular 401k is definitely better. If you’re one of the unicorns that can retire on significantly more money in retirement than they had while working, then it would be beneficial to diversify.
The sad reality is that the vast majority of the public won’t even hit 80% income replacement and their retirement fund is severely underfunded. So why would you want to pay high taxes right now on a ROTH when you can pay lower taxes later on a regular 401k? That doesn’t make sense.
I think it depends on where you are at in your career. It is true that most people will retire in less money than they make at the end of their career, but most people will retire making far more than they did at the beginning of their career.
So early in your career it probably makes sense to co tribute to a Roth and then transition more and more of the contributions into a traditional as your income increases.
I also suspect tax rates in general will go up, so having some money in a Roth to mitigate tax risk is nice, but I know that’s speculative.
Another point is that if you contribute $10k to a traditional and $10k to a Roth the Roth will win 100% of the time because the withdrawals are tax free. The only way the traditional can compete is if you also invest the tax savings. So for example you contribute $12k to your traditional instead of $10k to your Roth, because Both reduce your take home pay by the same amount.
Max,
Of course if you invest $10k into a Roth and $10k into a 410k the Roth will win, everyone knows that because you’re investing MORE money in the ROTH that way. That’s a no brainer. That’s also not an apples to apples comparison because your take home pay right now suffers because you’re paying the taxes on your $10k ROTH investment from your take home pay.
How is that a fair comparison of which one is better?
If you want a true apples to apples comparison, you need to take your Roth investment of $10k, pay the taxes on it and then invest the remaining amount. If you’re in the 24% tax bracket that means that you’re investing $7600 into your Roth and paying $2400 in taxes or you’re putting $10k into your traditional 401k. That is the only way to get a true apples to apples comparison because your take home pay stays the exact same right now. If your take home pay is the same now, then you can compare which is better in the future.
There are a lot of people claiming the ROTH is better, but I have yet to see anyone run an apples to apples comparison with actual Math calculations comparing them using real income and realistic inflation and rates of return.
I have, I have tons of spreadsheets just like the Samurai does which proves the traditional 401k is better for most people. If you don’t believe me, then give me your stats and I’ll run a scenario for you. I am a tax, math and excel nerd, I have run hundreds of scenarios so I know that for most people the traditional is better.
I understand equal contributions isn’t an apples to apples comparison. I only made the comment for other readers that might not be aware that you have to also invest the tax savings in order to receive the benefit of the traditional 401k.
My larger point is still valid though. I have a financial blog of my own where I run the numbers for several different scenarios. Financial samurai doesn’t let you post links in the comments but if you’re interested I can probably find a way to show you the article with the math. But if you’ve run your own spreadsheets you probably already know the big picture.
If you are looking for a specific example where the Roth makes more sense I would offer this one, which applied to me:
Young married couple has a combined household income of $100k. Both have a very reasonable expectation of making $250k combined when they retire (Government jobs with defined pay scales). The difference between their current tax rate and their anticipated future tax rates dictates that they should contribute to a Roth. However as they start to realize their raises, their current tax rate gets closer to their retirement tax rate they should transition their contributions to the traditional.
I’m interested to see what your spreadsheet would say about that scenario.
Mine show Roth as the clear winner.
I agree that for many people, especially with flat income profiles traditional is better.
The one thing that you’re not taking into consideration is inflation.
I mean if I’m making $100k right now, I’d suspect 30 years from now I’ll probably be making around $250k as well. Using some online calculators (https://www.cchwebsites.com/content/calculators/AnnualReturn.html), this works out to a 3.1% raise per year, which again, is more than the national average raise of 2.7% per year. So if you’re getting a 3.1% raise each year you’re doing better than the average person out there.
We can break this problem down two different ways: We can forecast what the tax brackets will be in the future based off inflation OR we can back track $250k to see what it would be worth today based off inflation and then compare it to our current tax brackets.
Lets take the first option: Adjust the tax brackets each year for inflation.
So if the couple makes $100k right now that puts them in the 22% tax bracket. Right now, inflation is about 2% per year and the brackets get adjusted every year based off inflation. For 2019, the 22% tax bracket maxes out at $168,400 for a couple. If we adjust this up 2% every year for inflation, in 30 years from now, the 22% tax bracket will be maxing out at $306,692. So in this case, even though the couple is making $250k/year when they retire, they’re still squarely in the 22% tax bracket.
Now lets look at it from the second point of view and adjust our $250k backwards based off inflation over 30 years.
Here is an online calculator to figure out present value based off a future value and inflation. If we enter $250k as our future value, 2% as inflation, and 30 years as the length, we can see that $250k 30 years from now would be worth about $138k right now. As we saw above, the 22% tax bracket for 2019 tops out at $168,400. So at $138k, we’re still squarely in the 22% tax bracket.
https://financialmentor.com/calculator/present-value-calculator
Technically, there’s also a third way to do it….
As I’ve posted above, the math formula is (1 + ror ) / (1 + inflation) – 1. This gives you what the inflation adjusted raise would be. From above, if you start at $100k and end at $250k 30 years from now that’s about a 3.1% raise per year, which again, is above the national average of 2.7%. But anyway, plugging the numbers into the formula, we see that (1 + 3.1% raise) / (1 + 2% inflation) – 1 = 1.078%. So the couple you mentioned is basically getting an inflation adjusted raise of 1.078% per year. $100k * 1.078% per year for 30 years gives the couple an inflation adjusted income of about $138k/year 30 years from now, which is basically what we found in option 2 above. It’s good to see that we did the math two different ways and the math came out the same!
No matter which calculation option you choose (1, 2, or 3), the couple still ends up squarely in the 22% tax bracket making $250k 30 years from now. Given your scenario, this couple never leave the 22% tax bracket.
My example is one of a starting teacher salary and a GS-11 government employee. Expectations of promotions to GS-15 and maxed out MS degree teacher salary put their combined pay scales at $100k in the early years and $250k in the late years BEFORE cost of living adjustments. If you’d like to project the COLA adjustments into the future and take a guess at how tax rates will move you are welcome to do so. However, I think it is just as useful to assume that inflation adjusted tax rates will be roughly the same then as they are now and apply the current tax rate for the $250k household income to the decision. Essentially doing all of the math in today’s dollars. If COLA’s do not keep pace with inflation, or if tax codes don’t then you are correct the math will change. But I think that it’s fair to say that the situation described above will result in a much higher marginal tax rate in retirement than at the beginning of employment, so I stand by the analysis.
Also, the 2.5x multiplier is in line with typical progression of incomes according to various data sources on income quintiles by age. (Not linking because again I don’t think it is allowed). So not only do I think that the Roth is the best option for that couple early in their career, I also think that there are more people in that boat than you might expect. It’s probably not the norm, but it’s probably not uncommon.
Here is my situation that I think proves the benefit of a Roth IRA. I make too much to make a deductible contribution to a traditional IRA. Therefore, I make a non-deductible trad contribution and then a conversion to a Roth. I make marginal tax rates on this contribution regardless if it is into the trad or Roth. If I were to leave it in the traditional then I would owe taxes in withdrawal AND have an RMD, right? I’d be taxes twice.
Am I right in this thinking?
Scott
After $6 trillion in new spending to combat Corona Virus I like my odds that my Roth will payoff in the long-run…
I have done a lot of math on the Roth vs 401k vs brokerage analysis and I don’t view Roth’s nearly as unfavorably as the author seems to. Generally speaking, I would say that most early career people make much less than they will make when they are in their prime earning years when they retire and therefore a lot of people are in much lower tax brackets than they will be in retirement. It therefore makes a lot of sense for those people to contribute to a Roth. I agree that as your income gets close to your expected retirement income it starts to make sense to transition to traditional, but this could take 10-20 years. I also like that it takes income tax risk off the table, so if the total return from a traditional and a roth are close, I would argue the roth is better because you are immune from income tax increases. I also believe that with the social security/medicare/medicaid insolvency and coronoavirus responses all likely to require additional tax dollars it is fair to assume that someone’s taxes are going up, although I admittedly don’t know whose, or when.
Max, make sure you are taking inflation into consideration. You may start out making $50k/year and then 20 years later you’re at $100k/year. That sounds awesome because you’re making twice as much money as you did when you started. However even at a modest 2% inflation like we have now, that $100k would only be worth $67k in present terms money, so really in 20 years you went from $50k to $67k. That’s a 1.5% increase per year after inflation (3.5% a year with inflation). FYI, the average pay increase last year was 2.7%, so at 3.5% you’re considered better than average for wage increases but your income really isn’t exponentially growing.
I do agree a ROTH is good if you expect exponential income growth,for instance going from $50k to $100k in 2 years, but if you’re an average person getting a 2.7% raise each year, the Roth doesn’t make much sense.
But for what it’s worth, the one area I 100% suggest a Roth for is if you make under the standard deduction every year. For a single person that would be $12k. So if you make under $12k, I 100% say invest in a ROTH since you will pay $0 in taxes on that investment right now.
I don’t know that the pace of growth or inflation matters nearly as much as how much you make. For one, tax brackets aren’t inflation adjusted, so whether my wages are keeping pace with inflation or outpacing it my tax rate is still going up. Also even if the growth is slow it just means that you would transition your money from one to the other more slowly it would change which vehicle you choose.
The rate of inflation most definitely is important. If not, then please show me where I can find fuel for $0.25/gallon? How about a brand new house for $30k? Recent inflation has been around 2%. However historically, inflation has averaged closer to 3% since the 1920’s. Inflation most definitely matters!
Secondly, I have no idea where you’re getting your information from, because yes, the tax brackets are most definitely adjusted every year for inflation. Just look at the bracket maxes for the past two years. The max 24% rate topped out at $82,501 in 2018 and it maxed out at $84,201 in 2019. Which, btw, is basically a 2% inflation rate like I said before. If you got a 2% raise last year and inflation was also 2% last year, you effectively didn’t get a raise as your buying power stayed the exact same. And since the tax brackets got adjusted up 2% last year, that means you’re not jumping any tax brackets either.
For giggles, since we’ve already established that the tax brackets are adjusted each year for inflation and that in 2019, the 24% tax bracket maxed out at $84,201, if that max is adjusted every year by 2% inflation, then in 20 years from now the 24% tax bracket will max out at $125,571. So making $84k now would be equivalent, tax wise and buying power wise, to making $125k in 20 years. Your wages went up 50% over that 20 year period ($41k), but your real buying power hasn’t done anything! And tax-wise, you’re still at the top of the 24% tax bracket, you haven’t moved anywhere even though you’re making 50% more than you did 20 years ago!
There’s a math formula to figure out what the true raise would be after accounting for inflation:
(1 + pay raise rate) / (1 + inflation rate) – 1.
So if inflation last year was 2% and the average raise last year was 2.7%, then your actual raise after inflation would look like this:
(1 + 2.7%) / (1 + 2%) – 1 = 0.69%.
So even though the average raise was 2.7% last year, the inflation adjusted raise was only 0.69%. If you made $50k last year and got a 2.7% raise, your real raise after inflation is considered would only be $345 ($50k * 0.69%). You’re not exactly exponentially jumping tax brackets when your real raise only went up $345 last year after inflation was taken into consideration.
Lets drag this out further, if you made $50k/year and you got 2.7% raise every year and inflation was 2% every year, your $50k income in 40 years would be $65,887 after being adjusted for inflation. So even though you’re getting 2.7% raises every year, you never left the 22% tax bracket after 40 years of working. If you make $100k/year you’d currently be in the 24% tax bracket. Using the same 2.7% raises and 2% inflation, in 40 years your inflation adjusted income would be $132k. You’re still in the 24% tax bracket! Again, you didn’t move anywhere!
As I said above, inflation most definitely makes a very real difference and if you’re not accounting for it in your calculations then it’s going to bite you!
Lastly, the formula above is good for calculating rates of returns for investments as well. If you get a 10% rate of return on your investments and inflation is 2%, your real rate of return is (1+10%) / (1 + 2%) -1 = 7.8% after inflation is taken into consideration.
I like what you said about using a Roth IRA if you make less than $84,200 a year. My sister has been telling me about how she wants to make sure that she’s preparing properly for retirement. I’ll share this information with her so that she can look into her options for using a Roth IRA.
What is your opinion on gifting to a ROTH IRA for another person under the assumption they would not have contributed to an IRA otherwise?
In general, contribute to a Roth if you are currently in a lower or the same tax bracket now than what you anticipate in retirement. If using it as a legacy play for your kids, you are then comparing your current tax bracket to you kid’s anticipated bracket when you and your spouse die. If the stretch IRA is shortened for non-spouses such as your kids, having to empty a large regular IRA can increase their taxes tremendously. One more reason to use a Roth is that you can in a sense shelter more of your money. Most illustrations show contributing $6000 to a traditional vs $4500 to a Roth because of the 25% tax bracket. But you can put $6000 in it. The more you can shelter from taxes forever, the better, as long as your retirement tax bracket is the same or more.
The reason people compare $4500 in a Roth to $6000 in a Traditional is because that is a true apples to apples comparison. Meaning your take home pay right now stays the exact same.
If you try comparing putting $6000 into a Roth and $6000 into a 401k, of course the Roth would win because you’re putting in way more money! That’s because you’re paying your taxes on your Roth contribution from your take home pay and not taking it out of the investment. Meaning you’re take home pay right now is not the same between the two investments. That is not an apples to apples comparison.
If you want a true apples to apples comparison, you need to take the taxes out of the investment right now which is why they illustrate $4500 into a Roth vs $6000 into a 401k.
Also, assuming your income is steady, why would you want to pay 25% tax on your ROTH right now (marginal tax rate), when you can pay less in taxes later on? Your 401k withdraws are taxed as normal income meaning you get to take a standard deduction, and then the remaining AGI goes through the various tax tiers to come up with an effective tax rate. Think about this way, because of the standard deduction, if you’re single, the first $12,000 of your 401k withdraw is 100% tax free! You’re effective tax rate is ALWAYS lower than your marginal tax rate. ALWAYS!
Maybe this was mentioned already, but it appears that you are comparing Roth Contributions to deductible Traditional IRA contributions. In many cases the T.IRA is better, but in many cases income is too high to take the deduction. Then the backdoor Roth is a great choice, as opposed to saving to a taxable account with cap gains on the growth. Gift to your kids who work so they can contribute to Roth accounts – the taxes saved really adds up when you start early.
Also, finessed Roth Conversions can save a ton in future taxes when there’s a significant dip in your marginal tax rate (sabbatical year, large loss, after retirement but before social security and RMDs, etc.). For HNW, the savings can easily be over a million.
I am not paid to promote Roth accounts, but I do see that the vast majority of people who could benefit significantly from Roth IRAs (which is a higher number than you would think) are not taking advantage of them.
11) You’re a US citizen living and earning entirely outside the US.
My understanding is that if you earn within the brackets, this is pretty much the only tax sheltered US vehicle open to you… and you have to elect to take the Foreign Tax Credit (form 1116) instead of the Exclusion (2555). No?
Unless I missed it, you left off one very good reason to contribute to a Roth:
it is more favorable to inherit a Roth than to inherit a Traditional IRA, and I expect to leave much of it to my nephew after I’m gone. Under current stretch rules, he’d be able to get a nice chunk of change tax free stretched out over perhaps the final 40 years of his life.
Hmmm, could you elaborate more on this? Could be a good point!
There’s also a debate on how much one should give. Check out: Three Things I Learned From My Estate Planning Lawyer Everyone Must Do
Mike, he would also get a nice chunk of change from a Traditional IRA stretched over 40 years except that he would owe taxes on each distribution. In the beginning, distributions would be quite small if he’s young.
OTOH if he doesn’t read Financial Samurai, he just might treat himself to a Ferrari!