The REAL Roth Story

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There’s a battle underway in the financial realm. Those taking sides are academics, financial planners, personal finance bloggers and reporters as well as do-it-yourself investors. One side is from the country of Roth and the other, Traditionale (please read that with a French accent). At stake are your opinion and the home of your investment dollars. Who will win—the Roth IRA or the Traditional IRA?

You’ve probably heard or read something similar to this next statement regarding your prospective decision to contribute to a Traditional IRA or a Roth IRA:

If you expect to be in a higher tax bracket in retirement than you are today, contribute to a Roth IRA. If, instead, you are likely to be in a lower tax bracket in retirement, contribute to a Traditional IRA.

By this logic alone, if your tax bracket would never change, there’s virtually no difference between the two. But, like many personal finance one-liners and rules-of-thumb, this one falls woefully short of giving you the whole story.

Which is better—a dollar in a Roth IRA or a dollar in a Traditional IRA? As long as you’re expected to pay taxesi  the answer to this question is always – 100% of the time – the dollar in the Roth. This is because the Roth allows you (and your heirs) tax-free growth AND distributions free of taxes. The dollar in the Traditional IRA, on the other hand, is subject to taxation whenever you (or your heirs) remove it. So, if you’re in a 25% tax bracket, your Traditional IRA dollar is actually only worth 75 cents.  The higher your tax bracket, the less your Traditional dollar is worth.

So, what’s all that stuff about the Traditional being better if you’re in a higher tax bracket today than you expect to be in retirement? In order for that logic to work, we must assume you take the extra cash on hand, born from your tax deduction specifically associated with your Traditional IRA contribution, and invest it for your future retirement.  If you make a $5,000 contribution to a Traditional IRA and you’re in a 25% tax bracket, your deduction should be worth $1,250. In order for the Traditional to benefit you more than a Roth, you must not only to be in a lower tax bracket in retirement, you also have to save that additional $1,250 for retirement. But what do most people do with their tax refund? SPEND IT!

What if you use your refund as a down payment on a car or for a vacation? The Traditional edge is eliminated. What if you didn’t receive a refund at all? Unless you write a check to invest the amount you should have received as a deduction for your Traditional IRA contribution after you write Uncle Sam a check, the Roth wins.

One of the great frustrations in financial planning is that most of the planning is based on assumptions of things we can’t actually control or change—annual income, inflation, market returns and, of course, taxes. So, you can contribute to a Traditional IRAii, calculate the proportionate amount of tax deduction and invest itiii —every year—and then hope the $14 Trillion deficit and a wave of increased entitlement spending somehow doesn’t lead to tax increases OR you can take control of one of those factors and pre-pay your taxes using a Roth IRAiv.

Still thinking????

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iThat’s where the Turbo Tax prompter would say, “Most people will fall into this category.” 

iiBy the way, if your company offers a retirement plan (like a 401k) and you make over $66,000 (in 2010 or 2011) as a single individual or $110,00 as a couple, married and filing jointly, you can’t DEDUCT your contribution anyway!  

iiiOf course, if you’ve maxed out your IRA contribution, you also have to invest the tax deduction proceeds somewhere else—likely in an account requiring you to pay taxes on interest, dividends and capital gains as they’re realized.  

ivIt’s quite possible that the most attractive features of a Roth don’t have anything to do with taxes.  Unlike a Traditional IRA or a 401k, a Roth allows you to take back your contributions at any time, at any age, for any reason without paying taxes or penalties.  Furthermore, you’re not required to take Required Minimum Distributions from Roth IRAs—ever.  So, unlike a Traditional IRA which forces you to accept fully taxable income after you reach your 70 ½ birthday, your money continues to grow in a Roth unimpeded.

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10 thoughts on “The REAL Roth Story

  1. I would rather keep my traditional IRA, and NOT pay the taxes in 2011 dollars by converting to Roth IRA. Why? because when I reach 70.5 years old in 2016, and I have to start taking distributions, I am betting I will be paying taxes in greatly-depeciated 2021 dollars.

  2. Excellent point, Mike. But one fundamental problem. The very things that will likely cause the dollar devaluation (which does appear almost certain)will also likely cause higher taxes! Remember too, despite my preference, I don’t see the Roth as the optimal vehicle for EVERYONE… nor do I believe a contribution to a Traditional to be a “mistake.” Thanks for the comment!

  3. “That’s where the Turbo Tax prompter would say, “Most people will fall into this category.” Having just completed my annual weekend-long date with Turbotax, this one had me ROFL!
    I just opened a Roth IRA for the first time in order to sock a little extra money away for my daughter’s college, which starts in two years. Like traditional IRAs, Roths aren’t always considered a parental asset for financial aid purposes, but unlike traditional IRAs, I can use the money for tuition without penalty even though I will not yet be “of retirement age.” Sounds like a big advantage to me.

  4. Converting to Roth is a no brainer on my end thanks to a loss from business that eliminates the tax liability. The bigger concern is the 61.9 trillion deficit (14 trillion PLUS other unfunded liabilities of Gov’t). Sure seems like we’re in for some painful lessons in the near future!

  5. Matt, I believe CONVERTING to a Roth is an entirely different story than CONTRIBUTING… but it definitely seems to make sense in your case. And sadly, I agree that we’re all likely to experience some pain as a result of our government’s inability to follow the simplest of financial lessons–live below your means!

  6. Tim,
    I’m now retired but even while working I exceeded the income limits for Roth; however, I’ve found a way to make it work for me now.
    Deb and I told our 32 year old son that we would no longer give him Christmas or birthday gifts; instead, we fund a Roth each year. The matured IRAs should serve him well when he reaches retirement age. It also demonstrates that my son has become a responsible adult…10 years ago he would have hated the idea.
    As the defined benefit pension plan goes the way of the Studebaker, the next generation is going to need a boost.

  7. Whewww. I guessed right again.Thank you for making it so simple Tim, for the simple, like me. Yet enlightening. Your parenthetical foot notes offer as much meat as the body of the article. Where would we be without parenthesis? ((:
    Wishing you Peace, Love and a back rub in the hot tub…and Happy Easter and Passover.
    Rock

  8. Tim,what a blessing your Roth ingenuity will be for your son… and it’s great to see he also appreciates it.
    And Rock, I’m always appreciative of your feedback. Peace and love to you also this Easter and Passover.

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