If you read other personal finance blogs, you probably noticed that yesterday was the Roth IRA Movement — a day where many personal finance bloggers got together (at the suggestion of Jeff Rose from Good Financial Cents) to promote the Roth IRA to young investors.
Most of the articles I saw were well-written, and I think it’s great to encourage investors to save via tax-advantaged accounts.
That said, I also ran across a few poorly-reasoned arguments in favor of the Roth as compared to tax-deferred savings vehicles, such as a 401(k) or traditional IRA. (I’m not naming names, because my desire is not to pick on anyone but rather to challenge ideas.)
I thought it might be beneficial to sort through some of the good reasons to contribute to a Roth and some of the poor reasons to contribute to a Roth.
Good Reasons to Contribute to a Roth IRA
In many cases, a Roth IRA is the right choice. For example, Roth IRA contributions are likely preferable to saving via tax-deferred accounts if:
- You think there’s a meaningful chance that you’ll have to spend the money in the not-so-distant future. (Remember, Roth IRA contributions can be withdrawn free from tax and free from penalty at any time.)
- You think your marginal tax rate will be higher in retirement than it is now.
- You think your marginal tax rate will be approximately the same in retirement as it is now, and you want to take advantage of the fact that Roth IRAs do not have required minimum distributions (RMDs).
- You have no idea how your tax bracket in retirement will compare to your current tax bracket, so you’re “tax diversifying” by using some Roth savings and some tax-deferred savings.
- You’ve maxed out your 401(k) and you earn too much to be able to make deductible contributions to a traditional IRA.
- The investment options in your 401(k) are terrible, and you’ve already contributed enough to get the maximum employer match.
Not-So-Good Reasons to Contribute to a Roth IRA
There are also, however, some commonly-cited yet unconvincing arguments for contributing to a Roth IRA, including:
- “Tax-free” is better than “tax-deferred.” It certainly sounds better. But the commutative property of multiplication tells us that paying, for example, a 25% tax now leaves you with the same after-tax amount as paying a 25% tax later. So unless you expect your marginal tax rate to increase between now and retirement, “tax-free” (via a Roth) is no better than “tax-deferred.”
- You’ll pay less tax with a Roth than with tax-deferred savings. This is usually true, but that’s irrelevant. All that matters is how much you have left after paying the tax. And, as explained above, if the tax rate is the same, it doesn’t matter whether you pay it now or later.
- Tax rates will increase in the future. If this is true, it is relevant, but it’s not a sufficient reason to prefer Roth contributions to tax-deferred contributions. Even if legislative tax rates go up, your marginal tax rate could be lower in retirement than it is now if your taxable income goes down dramatically when you retire — as is the case for many people.
Regarding the topic of the commutative property of multiplication and how it applies to the Roth vs. traditional decision, I’ll leave you with an allegorical explanation via one of my favorite blogs (the now dormant Bad Money Advice):
“Once upon a time there were two farmers named Joe and Bob who lived in the Kingdom of Ira. The King of Ira said to Joe and Bob that they must pay one fourth part of their grain as a tax. But, being a kind and wise king, he gave them a choice. They could pay a fourth of their seed in the spring or a fourth of their harvest in the fall.
Joe chose to pay a fourth of his seed and so could sow only three fields, but kept all that he reaped. Bob decided to keep all his seed, and planted four fields, but had to give the bounty of one of those fields to the king. Both farmers had three fields worth of grain to feed their families and so lived happily ever after.”
Update: Bogleheads author Taylor Larimore wrote in to mention an additional advantage of the traditional IRA:
In a marginal situation, the Traditional may be better. By investing in a traditional IRA the investor gets a tax deduction. She may also be able to later convert to a Roth with little or no tax during the period of low/no income after retiring and before the taxable income from Social Security or IRA RMDs begins. The result is a deductible IRA with tax-free accumulation that is tax-free at withdrawal.
Hi. I'm Mike Piper, the author of this blog. I'm 
Love the allegory at the end. Puts things in a good perspective.
I’m young, so I do favor the Roth because I expect my income and tax bracket to increase in the future .
One important thing to remember is that with a tax deferred IRA, there is an added benefit of increasing cash flow in the near term since taxes aren’t yet paid. In fact, I believe you also gain the time value of money on taxes since they aren’t paid until (sometimes) 20+ years in the future.
Someone please confirm this with me, to make sure I’m not giving mis-information.
Marlowe,
Just as in the allegory- the growth factors out. Consider if you contributed a single contribution to either IRA:
Roth IRA Value = (1-Current Tax rate) *Contribution * Growth
Standard IRA Value= Contribution * Growth * (1-Future Tax rate)
If Current Tax Rate = Future Tax rate then both values are equal, as we assume you invest them identically and get the same growth.
-Rick Francis
As someone currently socking every cent away in Roths this topic is near and dear to me. I just don’t see how the traditional can even be compared (all else being equal). Take a hypothetical situation:
Invest $1000 in a Roth and a traditional IRA, for 30 years, at 8% interest. The internets tell me that will grow to $10,000. For simplicity, let’s say our tax rate is 25%. In the Roth, we pay $250 in taxes, and then get $9000 tax free. Our $1000 turned into $9750.
Now the traditional: The $1000 turns into $10,000, and we pay 25% tax on that – $7500. $2250 less than in the Roth. BUT! I had to stop myself here, because I was feeling awfully smart for my own good. What about the other $250 we saved? We can also invest that, and over 30 years it turns into $2500, so I guess it is pretty much a wash 😛
Now, we need to know more about Taylor Larimore’s idea. What is a marginal situation?
Chad,
By “marginal situation,” my understanding was that Taylor simply meant situations in which it would otherwise be a close call between the two.
One other situation in which a Roth is advantageous:
You think your marginal tax rate will be approximately the same in retirement as it is now, have more than $5000 to contribute, and have no other tax advantaged vehicles available to put it into. In that case a Roth lets you shelter more money than an traditional IRA, because the same limit applies to both but in the Roth case it’s after-tax.
P.S. I miss Bad Money Advice too!
Agreed – the benefit of being able to contribute more to a Roth IRA is a big one. Another big one is that Roth IRAs have a predictable return, for better or worse.
balor123,
What do you mean when you say that Roth IRAs have a predictable return?
It seems unlikely that Roth IRAs will be taxed in the future however traditional IRAs are already taxed but tax rates going forward are highly variable, historically. I won’t retire for ~30 years but I need to plan on having enough money to retire at that point. I already have a variable for inflation and if I use a traditional IRA I need to have one for taxes as well. Saving in a Roth IRA eliminates my tax rate as a variable: I know exactly how much money I’ll have to spend after tax now.
I’ve no beef with this article, and I agree with the math. But it is easy to see that traditional savings may well be better, and I would especially note this for Chad who seems skeptical of the traditional IRA.
When you save pre-tax, you take income “off the top” at your highest marginal rate; not all of your income is taxed at this rate. If your savings are a substantial portion of your income, then you will withdraw some (but only a portion) of your funds at the highest rate. The rest will be taxed at a lower rate. Even if your marginal rate stays the same, it is likely that the traditional IRA is better than the Roth, because you will have saved the income at the highest rate and withdrawn it at a lower rate on average.
I hope link to more detail is not unwelcome: http://allfinancialmatters.com/2008/02/26/roth-401k-vs-the-traditional-401k-one-readers-thoughts/
Would you please clarify:
1. I still don’t understand why one doesn’t come out ahead with a Roth. All the money that is (hopefully) growing over many years is tax free on withdrawal, so all you’ve paid tax on are the contributions, vs paying ordinary income tax on potentially significant earnings upon withdrawal from a traditional IRA.
2. if one does not get a tax deduction when contibuting to a traditional IRA, would that person come out ahead funding a Roth vs a traditional IRA? One of teh ‘good reasons’ seems to imply that.
Thanks for any clarification & further explanation.
@Nancy – I was asking myself the same question, see my post above for the math. It sums up to “if you invest the money you save on taxes now with a traditional IRA it comes out to the same as a ROTH.” However, if your income is low an IRA can bring it even lower to get your adjusted gross into the realm of the “Retirement Savings Contribution Credit” – http://www.irs.gov/pub/irs-pdf/f8880.pdf
A pretty sweet deal if you can get into the 50% credit realm.
As to your second question, if you didn’t get a tax deduction for contributing to a traditional I don’t know why you would want to contribute to one as that is the main advantage.
Nancy,
I’ll answer your easier (second) question first. Yes, if a person qualifies for a Roth IRA but does not qualify for a deduction for a traditional IRA, a Roth would be preferable to a nondeductible traditional IRA.
As to your first question, the answer is that if the tax rate is the same (at the time of contribution as at the time of distribution) it doesn’t matter whether you pay tax on the contribution or the distribution.
Consider the following (entirely contrived) example:
Sue is 55. Her current tax bracket is 25%, and she knows (somehow) that she’ll be in the 25% tax bracket in retirement.
She has (to make the math easy) $1,000 available to invest. As such, she can either contribute $1,000 to a Roth, or she could contribute $1,333 to a traditional IRA (thereby giving her a deduction worth $333 so that her net cash flow would only be affected by $1,000, as with the Roth).
Let’s assume 5 years of 10% growth per year (just making up a number here — any number would work fine). Then she withdraws the money at age 60.
The $1,000 contributed to the Roth would be worth $1,610 after 5 years of 10% growth. And it would be tax-free upon distribution.
The $1,333 contributed to the traditional IRA would be worth $2,147 after 5 years of 10% growth. After taking a 25% tax from that, it would be worth $1,610 — exactly the same as the value of the Roth.
So, with the traditional IRA, more tax is paid (because it’s paid later, on a higher amount), but that’s not particularly relevant, because the after-tax value is the same in either case.
Thanks for the replies. I haven’t seen this kind of analysis in any other discussion about Roth vs traditional. Mind boggling initially, counterintuitive, and useful.
■You’ve maxed out your 401(k) and you earn too much to be able to make deductible contributions to a traditional IRA.
Shouldn’t this bullet point have an ‘or’ instead of ‘and’? I was under the assumption that if you were eligable to contribute to a 401k you could not deduct your traditional IRA contributions?
Ben,
In other words, if your income is under a certain amount, you can deduct traditional IRA contributions, even if you have a 401k at work.
See this IRS page for details.