In my last blog post, I argued that Roth-IRAs and Roth-401(k)s don’t actually save most people money.
That argument boils down to a single point: A taxpayer’s top “working years” tax rate is usually a lot higher than his or her “retirement years” tax rate.
And what you want to do is calculate your taxes using the lower rate and not the higher rate. Obvious, right?
But three common “worst-case” scenarios, I am sorry to have to report, make the Roth-style option even worse than the simple tax rate comparisons suggest. And you and I ought to consider these scenarios if we’re still attracted to Roth-style accounts.
Roth Worst-case Scenario #1: Savings Shortfall
A first thing to consider: If you come up short on your retirement savings, you are not going to need to worry about paying taxes on the money that comes out of your IRA or 401(k). Heavens no.
Say for example that either a late start or adverse circumstances mean you and your spouse retire with annual Social Security benefits of $30,000 and a $250,000 IRA nest egg from which you’ll draw $20,000 a year.
In this scenario—and any that are less optimistic—you won’t pay any federal income taxes. And you probably won’t pay any state income taxes either.
By the way? The overwhelming majority of people don’t retire with $250,000 in their IRA.
In fact, some studies indicate that the average savings for someone at retirement is not much over $10,000, and maybe only ten percent of the population retires with more than $250,000.
Given this, you probably aren’t crazy to say to yourself, “Hey I’m first going to worry about stuffing as much money into my IRA as I can, and I just hope I have the problem of paying income taxes in retirement.”
Roth Worst-case Scenario #2: Long-term Care Costs
Let me point out another worst-case scenario that affects the Roth-style account versus a traditional IRA account analysis: long-term and nursing home care.
Here’s the deal: Because long-term care costs count as an itemized deduction, if you or your spouse end up requiring long-term care, funding that expense out of a traditional IRA or tax-deferred investment account should be pretty tax efficient. And so for this stuff, there’s not reason to worry about the Roth-stuff. Seriously.
For example, say you’ve accumulated a $2,000,000 IRA or 401(k) balance. That sounds like a sure-fire recipe for a big tax hit if you need to start taking big taxable distributions, right?
But if you draw $10,000 a month to pay for a nursing home, you’ll actually accumulate a $10,000 medical expense itemized deduction each month. In such a scenario–and even though 85% of any Social Security benefits will be taxable–you may actually pay only one or two percent of your income in taxes.
Note: You can use most other big itemized deductions to shelter income from an IRA, too. For example, if you make large charitable contributions, those donations effectively shelter IRA distribution income. If you pay large property taxes, those taxes effectively shelter IRA distribution income. Ditto for mortgage interest and other Schedule A itemized deductions, too.
Roth Worst-case Scenario #3: Short or Shorter-than-expected Retirement
A final worst case scenario to at least mention in passing. (Sorry.)
Any IRA balances you hold when you die are untaxed to you. So you may be worrying about taxes you won’t ever have to pay.
By the way, yes, your heirs may need to pay taxes on the balances. But you by definition won’t. So you want to recognize this.
The logic of you paying taxes while you’re alive so your heirs won’t have to pay taxes after you’re gone isn’t very rewarding.
And a couple of notes: If you are interested in gifting money to your heirs, you have options that work better than using Roth-style accounts. (Talk to your accountant.)
Further, note that an heir should be able to stretch out withdrawals from your IRA over a very long time. And that means that the tax rate heirs ultimately pay will very possibly be very low.
A thirty something heir who stretches out a $1,000,000 inherited IRA might, if they have a mortgage and children, pay no income taxes on the roughly $50,000 annual distribution they draw from their inherited IRA. (This scenario would assume they don’t have other income bumping them into higher tax brackets.)
Tying Things Up with a Bow
So let me tie up this blog post with nice little bow by suggesting the following take-away: While a best-guess scenario concerning a Roth-style account is that the accounts don’t make financial sense (this is point of my earlier post), in any of the common worst-case scenarios (like those described here in this post) a Roth-style account really, really doesn’t make sense.
That’s my point.
And maybe just a final postscript: I would not be bummed out that the Roth-style account delivers less than it promises.
Rather, I would suggest you focus on fact that the traditional tax deferral benefit built into a regular old IRA and 401(k) accounts actually works pretty darn well for most people.