Roth and Traditional IRAs: Yes, One of Them Is Better
I respect you and your intelligence. Because you're reading a financial blog, you probably don't need the details comparing Roth IRAs and Traditional IRAs.
What you really care about is, "which one should I contribute to?" But, given the aforementioned acknowledgement of your intelligence, you probably already know the answer for your situation.
Well, I'm about to try something. I'm about to answer that question in a way that you've never heard before.
Taxes, the only Variable that Matters
The party line on identifying which IRA is right for you depends on one thing: taxes.
The advice goes like this: "If you current tax rate is higher than what it will be when you withdraw, then a Traditional IRA is right for you. Otherwise, a Roth is the best choice."
In SAT terms:
Enter Current Tax Rate: (NYSE:A) ____
Enter Retirement Tax Rate: (NYSE:B) ____
If A > B, Then Traditional IRA
If B > A, Then Roth IRA
If B = A, Then Flip Coin
Indeed, taxes really are all that matters. The whole point of an IRA is to get the largest deduction possible (in percentage terms). If you're in the 25% tax bracket while working and still in the 25% tax bracket when you retire, then your IRA balance looks like this.
If your bracket when contributing is 25% and drops to 10% in retirement, then here:
If your bracket while working is 10%, then 25% in retirement, then here:
If you're still with me, great.
After advisors say this, there are usually some caveats:
- you can't know what your tax rate will be during retirement;
- having your contributions always available at no penalty (a feature of Roth IRAs only) is awesome; and
- the meddling tax-hungry congress are but a floor vote away from tripling your taxes.
In the end, the client is usually sent away with a shiny new Roth and a promise of tax-free withdrawals 40 years from now.
I'm here to tell you, in about 2,000 words that have never before been written on the internet, that the Roth IRA is almost universally a bad idea.
IRAs: Not Mutually Exclusive
Before I go too far into specifics, I should make a few points very clear.
- Either IRA is better than neither. Investing outside a tax shelter means your contributions were taxed when you earned them, dividends and capital gains are taxed throughout the investment period, and capital gains are taxed at withdrawal.
- You Can Always Contribute to Both: You can't predict with certainty what your tax rate will be upon withdrawal. So, you can always hedge your bets by contributing to both a Roth and a Traditional IRA. Once you're in retirement, you can draw down strategically (withdraw from Roth in rich years, withdraw from Traditional in poor years).
Are You Worried about the Best Case Scenario?
Keep in mind that the whole point of an IRA is to maximize your tax deduction in percentage terms.
Let's envision two scenarios.
Scenario A: "Poor Retirement" - You enter retirement without a lot of investments. Your primary income is from social security. Your IRA is respectable, but won't provide a huge lifestyle boost. You will have a decent, but not extravagant, retirement. Your taxable income in retirement will be very low. Advantage: Traditional IRA.
Scenario B: "Rich Retirement" - You enter retirement with a fair amount of investments, both inside and outside of IRAs. You will be getting a social security check, and combined with your other investments, you won't have any real money concerns for the rest of your life. You feel good, and your taxable income will remain quite high for the rest of your life. Advantage: Roth IRA -but, it doesn't really matter, since you can easily afford the taxes.
If you will have a lean retirement with a lean income, then a traditional IRA is best (since you got the big deduction while working). This is where most YOLO Americans will be. The average American approaching retirement has about $140k in retirement assets.
If, for whatever reason, you retire with a lot of investments, then it would be nice to have a Roth around, since you can avoid your high retirement tax rate. However, as we learn from watching political debates, you can afford the taxes.
Remember, the whole point of an IRA is the tax deduction. If you waste the deduction, then an IRA is just a taxable brokerage account with a bunch of withdrawal restrictions.
The one thing you don't want to happen is to waste that deduction. The only way that can happen is if you contribute to a Roth, then withdraw from a Roth at a low/no-tax rate. Since a bird in the hand is worth two in the bush, if you get your deduction at the point of contribution, there's zero chance you'll forego it.
Lastly, let me cut off this counter argument at the pass:
"But Eric, what if you really can't afford the taxes during retirement? Won't it be nice to have a tax-free resource at the ready?"
No, because if your circumstances are that dire. You're describing a scenario where you wouldn't be paying taxes from either IRA type.
Effective Tax Rate vs. Marginal Tax Rate
Every so often, Retire29 stumbles upon some rather unique insight. This is one of those times.
Contributions to Traditional IRAs reduce your taxable income in the year which you make the deposit. As such, traditional contributions will be a small portion of your income, and these will save you your marginal tax rate.
Withdrawals from Traditional IRAs are ordinary income, and withdrawals will likely make up a larger proportion of your retirement income, and will thus be taxed closer to your effective tax rate.
Let me illustrate this as follows. Don't get too hung up on the numbers because it works for nearly all incomes and rates.
Imagine your family of four makes $90k per year. After the standard deduction of $18.5k and four exemptions, your taxable income is $57.5k. You are in the 15% marginal tax bracket. You make a $5,500 Traditional IRA deposit. After you do this for 40 years at 8% compound interest, you'll have a $1.4M nestegg in your IRA.
At a 4% withdrawal rate during retirement, your IRA provides about $56k in annual income. Add to this $17k in social security income for each spouse (the median SS benefit), and you'll have that same $90k of income during retirement that you had while working.
It looks like this.
Even though this family is in the exact same tax bracket in both their working years and their retirement years, they are better off using a traditional IRA. Why? To reiterate, when contributing to a Traditional IRA, the tax benefit is at your marginal tax rate. Conversely, when you are withdrawing, it is reasonable to assume that your withdrawals will be far larger (in absolute dollars and as a proportional of total income) than your contributions. Thus, your withdrawals will be at a lower effective tax rate. This is due to the progressive income tax structure in the U.S. and most developed countries.
Your Retirement Will Be Leaner Than You Think
At least from an IRA perspective, the amount of expenses you have during retirement will drive how much you're withdrawing from your IRA. If you need a bunch of money, then you'll have a bunch of withdrawals. If you don't need much money, then you'll probably let the balance ride (unless you're 70.5 and are subject to required minimum distributions).
Since withdrawals from a traditional IRA are treated as ordinary income, it would stand to reason that if you will be spending less during your retired years, then you can expect to be earning less during your retired years.
Thanks to data by JPMorgan Asset Management's Guide to Retirement, we can clearly see that we tend to spend significantly less as we grow older.
A haphazard analysis of this tells me that I should be requiring less money as I age. This makes sense to me: my mortgage will go away, kids will get out on their own, no commuting, less education, less entertainment. There will be some additional healthcare costs, but those are more than offset by declines elsewhere (and healthcare costs above 10% of AGI are deductible, anyway).
Lower expenses means lower incomes which means a lower tax bracket.
However, this doesn't mean that tax rates within those brackets will go down. If only we could know what will happen with tax rates…
Tax Rates Tend To Go Down Over Time
There seems to be a common misconception that our revenue hungry government only pushes taxes in one direction: up.
That is untrue. The data, courtesy of The Tax Policy Center, shows that tax rates over the last 35 years have quite consistently trended lower.
While you can't know for certain how your tax rate will change between when you contribute to when you withdraw, if you expect to maintain a similar income, then it has historically been reasonable to expect that your tax rate will fall.
The Age 59.5 Fallacy
One major selling point of Roth IRAs is that the contributions that you put into the account can be withdrawn at any time for any reason. This is a nice benefit, as you can essentially use your Roth IRA contributions as your emergency fund. The extension to this is the similar belief that all funds in Traditional IRAs as well as investment gains in Roth IRAs are locked up until you turn age 59.5, lest you pay a gut-wrenching 10% penalty (along with income tax, for Traditional IRA withdrawals).
Speaking strictly by the book of the internal revenue code, this is true. However, some clever and legal tax maneuvering can get around this.
As I've previously laid out extensively, the age 59.5 constraint is a fallacy. A Traditional-to-Roth conversion along with a five-year waiting period removes the 10% penalty altogether. Combine this with a thoughtful conversion strategy (i.e. convert funds only to the extent they can be written down by deductions and exemptions), and you can also avoid the income tax.
As if the other reasons weren't enough to persuade you toward Traditional IRAs, this strategy, by itself, makes Traditional IRAs the clear winner. Your deposits are tax deductible, your growth is tax-free, and your withdrawals can be tax- and penalty-free as well.
When Does a Roth IRA Make Sense?
The short answer is: rarely. However, I see two scenarios when a Roth IRA would be preferable to a Traditional IRA.
- If you currently pay no taxes. If your household is one of the 77.5 million American households that pay no federal income tax, then a contribution to a Traditional IRA doesn't make much sense for you, given that you will receive no tax deduction. You may, however, qualify for a retirement savings contribution credit for up to 50% of your first $2,000 IRA deposit. However, that credit applies to both types of IRAs.
- If you might need the money right away. Because Traditional IRA deposits cannot be had penalty-free without waiting at least five years (see section above on the age 59.5 fallacy), Roth contributions might be the preferred choice if you may need the money in the near future.
You can argue that if you'll need the money right away, then you shouldn't be investing the dollars in the first place. That's a fair point, but "investing" doesn't have to be in stocks. If you have some funds sitting idle, then contributing those to a Roth and allowing them to grow tax-free in a bond ETF might be a smart solution. In the unlikely event you need access to the funds, then your contributions are at the ready.
The Real Reason I Hate Roth IRAs
In his book The Paradox of Choice, psychologist Barry Schwartz posits a thesis that having too many choices as a consumer can lead to anxiety. The general thinking is that when somebody is faced with several options, he or she develops a worry over choosing wrongly.
This is why I hate Roth IRAs. I've spoken to many people about investing and retirement planning. In general, folks know what is going on and what to do. However, for beginners, there is a significant fear of making a poor choice. "401k or IRA? Roth or Traditional? Stocks or Bonds?"
It can, rightfully so, become overwhelming for a populace that is woefully undereducated about personal finances. This consternation generally leads to excessive risk aversion or, worse, complete inaction.
Traditional IRAs were around for 23 years (since 1974) before Roth IRAs (since 1997). While Roth IRAs are touted as a savior to retirement planning, I see them generally as a hindrance. It begs the question of the true motivation for the Roth plan. Call me a conspiracy theorist, but I suspect that that Roths were made available not so much as a means to help Americans save for retirement, but as a surreptitious attempt to extract more tax dollars today behind the veil of helping Americans save for retirement.