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.