Poke around the blogosphere and personal finance punditocracy and you will find lots of positive references to Roth IRAs and virtually no nice things said about its dull older brother, the traditional IRA. If you didn't know any better (and why would you?) you might assume that the younger and hipper Roth IRA was the way to go. After all, it is the cool new thing and the latest in retirement savings technology. Here's a rundown of the differences and why you are likely to want to go with the unhip kind after all.
IRAs come in two basic flavors. There is the traditional old-style IRA, in which you put pre-tax money, i.e. your contributions are tax deductible, and then later in life pay taxes on your withdrawals as if they were income. And there is the relatively newer type, a Roth IRA, in which contributions are post-tax, i.e. not deductible, but withdrawals are tax-free.
Which is for you? Obviously, you want the one that will wind up making you more money. To tee that up, consider the following.
Tom Traditional and Robbie Roth have identical incomes, and so pay identical tax rates, and they both have $3,000 a year of that income that they wish to put in an IRA. Obviously, each picks the type that matches their name, so Tom puts in the full $3,000 each year and Robbie puts in $2,250 after paying taxes of 25%. The years pass, and they make identical investment decisions until they retire on the same day. Tom's account is, of course, larger but he needs to pay 25% taxes on anything he takes out, while Robbie can withdraw tax free. Here's the big question: after Tom pays taxes on his withdrawals, who has more money to spend?
The answer, which seems to surprise a lot of people, is that they have exactly the same amount of money. Assuming the tax rate going into the Roth is the same as the one coming out of the traditional, the financial benefit of the accounts is exactly the same. Fire up Excel and run the numbers yourself if you don't believe me.
So why do the advocates of saving seem to universally prefer Roths? It's not about numbers, it's about conceptual appeal. Saving is about sacrificing now for a benefit in the far-off future. With a Roth, you pay taxes now so you can not pay taxes later, and that has a big attraction to the savings crowd.
Symbolism aside, there are good reasons to choose one type of IRA over the other. Primarily, which one is better depends on the tax rate you pay now and the one you will pay when you are retired. Tom and Robbie came out equal because they always paid 25%. If the tax rate had been 25% when working but only 15% during retirement, then Tom would have wound up ahead because he would avoid the 25% and only pay 15%. Conversely, if the rates were 25% while working and 35% when retired, then Robbie would be better off.
Occasionally you see the pro-Roth argument that given the fiscal problems the government has now and is likely to have in the future, tax rates will inevitably rise. That sounds perfectly reasonable, but it is worth reflecting that the same thing could have been said for the past 30 years and so far it's been wrong. Predictions of what Congress will do in future decades is hardly a sound basis for your retirement planning.
On the other hand, predictions of how much money you will be making in retirement, and so which tax bracket you will be in, are more practical. If you have a Roth, you are betting that your income, and your tax rate, will be higher in retirement than it is now. That's some bet. (You do understand that in retirement you won't have a job, don't you?) Furthermore, choosing a Roth over a traditional is doubling down the bet on your own future prosperity. If you wind up being a rich retiree, you'll be happy you have a Roth because you won't pay high taxes on the withdrawals. But if you wind up a poor oldster you'll wish you'd picked traditional, because you'd have more money, even after paying the (lower) income taxes on what you take out.
There are other factors to consider when choosing between the two types of IRA. (There's a nice rundown here and here.) But they are all secondary to the tax rate issue and some of them are pretty esoteric. In the big picture, what matters are tax rates now and when retired. And for many, if not most, people that means that an old-school traditional IRA is a better choice, even if it lacks hipness and the frugal appeal of paying more now for a benefit far in the future.
Saturday, February 21, 2009
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Great post, but I think you missed a major benefit (indeed, the major benefit) of the Roth IRA and it's puzzling that you did since your example highlights it really obviously. Let's imagine that both Tom and Robbie have more than enough money to max out their respective investments. I.e. they both can cap out and still want to invest. Tom puts the full legal maximum of $5000 into his IRA and so does Robbie. Now, Robbie doesn't have the problem of only putting in $2250 (after taxes) compared to Tom's $3000 before taxes. In other words, the Roth allows you to shelter more money in tax-protected accounts.
ReplyDeleteStill, it's always nice to see someone who isn't afraid to question the conventional wisdom.
That's a good point, and it is indeed something in the Roth's favor that I failed to mention. I also failed to touch on a few other factors worth pondering, including some non-obvious estate planning issues and the option of converting a traditional to Roth in the future.
ReplyDeleteBut I really believe that for most people, the tax rate issue dominates all these concerns. If the tax rates are 25% now and 15% in retirement, then Tom is probably still better off putting what he can in the traditional and his additional savings elsewhere in a taxable account.
As you say, the point was to question conventional wisdom, something I do compulsively. Conventional wisdom seems to discuss only Roths. And yet, there are cases where a traditional IRA is the smarter move, something that I don't think gets mentioned anywhere near enough.
Thanks for the comment.
I do agree with you that the tax rate issue dominates all others. For young money-conscious professionals, especially those just starting out, I think the Roth IRA is easily the best move for a couple of reasons. 1) They are very likely to be in a higher tax bracket in retirement than they are at the start of their career. 2) They will likely become ineligible for the Roth at some point and thus investing in a Roth early provides them with tax-diversification (since they'll be putting money into traditional plans of some sort, probably, for the bulk of their careers).
ReplyDeleteI would guess that a very large number of personal finance bloggers fall into this category so it's not surprising that the Roth IRA has taken the personal finance blogging world by storm. But, of course, you're quite right that anyone who is in their peak earning years should consider very carefully before putting money into a Roth rather than a traditional IRA.
This is really interesting. I am in my mid 20s (as is the hubby) and we both have 401Ks with some matching by employers. I am no longer in the work force, so we were considering either IRAs or trying to get my currently tiny 401K rolled into his 401K. But this makes IRAs less intimidating. Thanks!
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