Part II: What the Government Doesn’t Want You To Know About Roth IRAs
In part one I provided a demonstration of how in a particular example it can be more beneficial to contribute to a traditional IRA rather than a Roth IRA, contrary to the popular advice from some well known personal finance gurus. I think this is a good time to put in a disclaimer. It’s not always the case that a traditional IRA is more advantageous.
For one thing, there are limits to how much you can deduct for a traditional IRA depending on whether your or your spouse’s employer offers a 401k and based on your income level. If you’re not eligible to get the tax deduction for the traditional IRA, then clearly the Roth would be better. Additionally, there are some strategies out there involving rollovers into a Roth IRA that have been extremely successful. That being said, if you can get the up-front deduction for the traditional IRA, my viewpoint is that’s very valuable because of time value of money and is preferable to a Roth IRA.
Now let’s get to the headline of this post, because so far I’ve only focused on the personal finance aspect of the Roth IRA. In the example in part one, an individual ends up better off having contributed to the traditional IRA rather than the Roth IRA. Now let’s consider how the government made out in that example.
If you chose the Roth IRA, then in your working years you’d be paying a bit more tax since you don’t get the deduction — a total of $234,360 by the time you retire at 65. But, since withdrawals from the Roth IRA are not taxable, that’s the only tax you’d ever pay.
In the traditional IRA, you do get the deduction for your contributions, so by the time you reach 65, you’d have paid $186,235. But, that’s where it gets interesting. Since you decided you wanted $80k take home in retirement, you drew down $98,412 per year which results in an annual tax of $18,412! By the time you draw down all the balance from your traditional IRA at the age of 102, you’ll have paid total taxes of $542,565. That’s more than double the amount of taxes paid with the Roth IRA.
For those keeping score at home, the traditional IRA allowed us to still have $888,713 in savings at the age of 102, and the government would’ve collected $308,205 more taxes than the Roth IRA. Seems like the traditional IRA is a win-win!
So then why was the Roth IRA ever created?
Simple — to create a retirement savings account, but also to keep the budget balanced.
According to Forbes “In 1997, then Senator William Roth (R-Del) wanted to restore the traditional IRA which had been repealed in 1986, and the upfront tax deduction that goes with it. Under congressional budget rules, which work within a 10 year window, the revenue cost of giving that tax break to everyone was too high. So his staff limited deductible IRAs to people with very low income, and made Roth IRAs (initially with income limitations) available to others. That slid the revenue cost outside the 10 year window and got the legislation out from under the budget rules.”
So… it seems like in 1997, if Senator Roth had been able to, he would’ve simply restored the traditional IRA. He didn’t have that ability since he needed to balance the budget, so instead he came up with the Roth IRA in the Taxpayer Relief Act of 1997, which I’ve proven to be inferior to the traditional IRA for both the individual and the government. But — at that time, it was the only option.
Then George W. Bush flipped the script.
With the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003, the contribution limit for the traditional IRA is now equal to the contribution limit for the Roth IRA. I used to always just assume that the traditional IRA came first, and the Roth IRA came later and was a better version. In reality, it’s more like this:
So let’s stop pushing Roth IRA’s as a general advice on where to put retirement savings. It’s probably a good recommendation for certain situations, but take the time to think about all the factors at play.
Psst! Feeling lost? Check out part one here.
