You probably know the attraction of a Roth-IRA or Roth-401(k), right?
Unlike a regular retirement account, you can withdraw money from a Roth-style account without paying income taxes. This free lunch appeals to many people. And in some of the online investment forums, posters regularly go delirious about these account types.
But here’s the reality: You probably shouldn’t put your retirement money into a Roth-IRA or Roth-401(K).
In this backgrounder blog post, I’m going to explain the math behind this suggestion. Math which few of the Roth aficionados understand, sadly.
Then in a couple of follow-up blog posts, I’m going to provide a bit more background. Next week’s post, Worst-case Scenarios for Roth Accounts, identifies three factors which make the Roth option even worse than the math suggests. And the week after that in The Only Times You Should Use Roth Account, I’ll describe three or four situations where either the math or special circumstances actually makes a strong case for using a Roth-style account.
A Simple Example of When a Roth Account Fails
Let me start by sharing with you an example that shows the fundamental reality of the Roth option.
Say you have a $10,000 bonus to invest. You haven’t yet paid any taxes on this income. Because you don’t know how you’ll invest the money.
But say you can invest the money into a regular traditional IRA account. And that’s attractive because then you’ll get a $10,000 tax deduction on your tax return.
Or you can invest the money into a Roth-IRA account. That means you’ll need to pay taxes on the money upfront. But on the leftover amount you’ll be able to invest, you’ll be able to earn a tax-free return.
For the sake of illustration, assume that you pay a 30% tax on your income.
Finally, just to keep things simple initially, assume that your money earns no return. The return on the investment, in other words, equals zero. (I’ll make things more complicated and realistic in a minute, don’t worry.)
Here’s what happens with a regular IRA. You put in the entire $10,000. So far so good. Then when you later withdraw the money, you have to report the $10,000 withdrawal as income—which means you pay $3,000 in taxes. Your net after-tax proceeds with the IRA option equals $7,000.
And here’s what happens with a Roth-IRA. You have to pay the $3,000 in tax upfront. So that’s unfortunate. You put only $7,000 into the Roth account. But here’s the attraction: When you pull the money out, you don’t pay any income taxes. You get the whole $7,000.
But see what happens? After you correctly account for the front-end or back-end taxes, the withdrawal amounts equal each other.
And the reason is simple: The tax rates equal each other.
The take-away? If the rates are equal, a Roth-IRA and a regular IRA result in the same tax bill.
Another Simple Example of Roth Weirdness
Okay, so when would the regular IRA and Roth-IRA amounts differ? Well, only when the tax rates differ. So let’s look at that next.
To keep things simple, let’s again assume the return on investment equals zero percent.
But now assume that while you work, your top tax rate equals 30% but that when you retire, your top tax rate will equal 20%.
So here’s what happens with a regular IRA. You put in the entire $10,000. And when you later withdraw the money, you have to report the $10,000 withdrawal as income. At a 20% retirement tax rate, you pay $2,000 in taxes which means your net after-tax proceeds with the IRA option equals $8,000.
Now compare that to what happens with a Roth-IRA. In this case, because the top tax rate during your working years (according to our example) equals 30%, you have to pay the $3,000 in tax upfront and so put only $7,000 into the Roth account. But when you pull the money out, you don’t pay any income taxes. You get the whole $7,000.
When you compare the net cash amount you get after the front-end or back-end taxes, the traditional IRA after amount of $8,000 is better than the Roth-IRA amount of $7,000.
And the reason is pretty intuitive. You want to avoid the highest top tax rate. Instead, you want to pay lowest top tax rate on the money. That means paying the 20% rate on withdrawals from the traditional IRA rather than having to pay a 30% rate up front on the money you want to put into a Roth-IRA.
The big insight here? The decision to use or not use a Roth-style account rests almost entirely on the top tax rate you pay today versus the top tax rate you will pay in retirement.
Furthermore, because we live in a society with pretty progressive tax rates and because most people enjoy higher incomes when they work as compared to when they’re retired, almost always, a Roth-style account only costs an investor more taxes. Ouch.
A More Complicated Example of When a Roth Account Fails
If you understand the math in the preceding paragraphs and accept the conclusion, go ahead and skip the next example.
But let me delve into the details just a bit more to address the issue of compound interest and its effect on the math. Because I can guess some people may think that compound interest changes things. (It doesn’t.)
To illustrate the effect of compound interest, let’s again assume that you’re thinking about how to invest a $10,000 bonus. You’re considering using a regular IRA or a Roth-IRA. Let’s again assume that the top tax rate you pay and which you’ll pay in the future equals 30%.
But let’s add this complexity. Let’s assume that that you’ll earn a 6% return on your money and that you’ll invest the money for 12 years.
Note: A 6% interest rate over 12 years causes your money to double.
Here’s what happens with a regular IRA in this example. You put in the entire $10,000. Over twelve years, if the money earns 6%, the account grows to $20,000. When you later withdraw the $20,000, you have to report the withdrawal as income. And so with a 30% tax rate, you pay $6,000 in taxes which means your net after-tax proceeds with the IRA option equals $14,000.
Here’s what happens with Roth-IRA. You have to pay the $3,000 in tax upfront and so put only $7,000 into the Roth account. Over the twelve years you invest, the account grows to $14,000 if you annually earn 6%. The good news here, so to speak: You don’t pay any income taxes when you withdraw the money. You get the whole $14,000.
But look at the result: Compound interest doesn’t change things. If your top tax rate when you work equals the top tax rate when you’re retired, the IRA and the Roth-IRA options deliver the same result.
Just to repeat this point, then, the big (massively big) insight one wants to keep in mind? The decision to use or not use a Roth-style account rests almost entirely on the top tax rate you pay today versus the top tax rate you will pay in retirement.
And just to repeat a point I already made (because it’s so important): Most people enjoy higher incomes when they work as compared to when they’re retired, so almost always the Roth-style account only costs an investor more taxes.
There’s another aspect of the tax rate differential between front-end and back-end taxes that you didn’t mention. The applicable tax rate on the front-end taxes is your marginal tax rate. If the only source of income in retirement is the retirement account, the applicable tax rate will be the effective tax rate. Even if the highest tax rate in retirement is the same as the marginal tax rate today, there will be slices of the withdrawal in retirement that will be taxed at the lower rates on the ladder.
Thanks for demystifying the hype though. I, too, can’t understand how prominent personalities can go around recommending Roth accounts over traditional accounts without considering the math!
Unfortunately, Samir, I think your comment probably misleads (though perhaps unintentionally).
In any case, one really does want to compare marginal rates. Using effective tax rates–if by effective tax rate you mean the average tax rate–will overstate the benefits of using a traditional IRA or 401(k).
That’s probably not that bad. Most people probably should use a traditional IRA or 401(k).
But your approach will hide situations where someone saves money by using a Roth-style account.
Steven S. says
100% agree, Sir. I think what is even more telling is the tax savings one receives in traditional 401k now. As someone who made six figures i consistently had under 15% effective tax rate thanks in part to maxing my 401k contributions. I couldn’t. Have done that with a roth 401k. I believe if the roth ira was “sold” more as a savings account it would make more sense. I also max out my roth ira but only after going all out on my 401k.
I’ve been struggling with this decision. I have 72K in a traditional IRA after rolling over some 401Ks. I’m 35 years old and unsure if I should pay the tax (~20K) to convert to a Roth or keep it as-is.
I’m not sure how retirement tax rates are calculated, but I assume I can just retire and then with only Social Security income I’m in the bottom tax bracket. Presto, that should limit my liability at retirement to a poverty level income.
The two issues as I see it are that longterm it’s only responsible that tax rates go up with deficit spending and the big elephant in the room that with the Roth I get tax-free gains. I expect my 72K to follow the market to 250K in 25 years from now.
So I’ve viewed it more as, do I want to pay taxes on 72K? Or on 250K? I’m begging you to correct me if I’m wrong, this has been a tough decision for me.
You should be able to draw down your $250K IRA without paying income taxes. For example, say you draw 4% or $10,000 a year…
In this case, your Social Security benefits won’t be taxed… and then your $6,300 standard deduction and then your $4,050 personal exemption will shelter that $10,000…
So you can pay the extra $20K in taxes today… or not… but either way you probably won’t need to worry about the income taxes:
Lynn Beaulieu says
What about a situation where a retirement from government provides a base income with social security of $65,000 yearly with inflation adjustment. A Roth will keep me in a 15% bracket, while, in a couple years, the traditional IRA RMD’s will put me well into the 25% bracket. Isn’t this a case for IRA to Roth conversions? My wife and I have about $400K each in traditional IRA accounts. We also have about $150K each in Roth’s to cover possible long term medical needs since LTC insurance is unavailable.
Great questions… and here are two things I think you want to consider: First, regarding the 25% tax bracket in retirement, whether that rate means it makes sense to go with a Roth depends on what your top tax bracket is now. If it’s 28% or higher now, you want to avoid that 28% or higher tax rate now… and then pay the 25% rate later. (This rate difference is the thing we want to focus on.)
Second, regarding long-term care and and medical expenses, these seem to me to be exactly the sorts of expenses that should come out of a traditional, non-Roth account. Here’s why: If you pull, say, an extra $50K out of a traditional account for medical expenses but you get a close to $50K medical deduction, the $50K is mostly tax-free even with a traditional account in many cases.
Hope that helps!
Lynn Beaulieu says
Thanks for your reply, didn’t expect anything so quickly!
I understand your logic as it applies to current tax law. Does the same apply if the Senate GOP gets its way and changes the deductibility of medical expenses? If more than 15% is no longer deductible, won’t that throw me into a higher tax bracket? Also I have heard nothing about indexing the brackets, have I missed that?
If nothing changes for this tax year, which is my assumption for this late in the year, should I take my RMD as cash and use the Roth if I were to need additional withdrawals?
Thank you for your enlightening articles.