What the Government Doesn’t Want You To Know About Roth IRAs
I’m writing this post because of some questionable financial advice that’s being given by some of the most popular personal finance personalities of our time. I think this is especially important, because I highly respect these individuals, and I’ve learned a lot from their books; therefore, I don’t think the average person would question their advice to go with a Roth IRA rather than a Traditional IRA.
The first personal finance book I read was Suze Orman’s Young, Fabulous & Broke. In the book, and again in her blog, Suze spells out four steps to retirement saving. I won’t go into steps three or four, but step one is to contribute to your workplace 401(k) or 403(b) enough to qualify for the maximum matching contribution. That’s solid advice! The second step is to save in a Roth IRA. “Hmmm, why Roth IRA?” you might ask.
Ms. Orman explains that, “ The prospect of having tax-free income in retirement makes a Roth IRA a great deal. There is no upfront tax break that you can sometimes claim if you save in a Traditional IRA, but that’s okay. I want you to focus on the end goal: no tax on withdrawals with the Roth vs. having to pay income tax on every penny that comes out of a Traditional IRA.”
A commendable goal Suze, but is that really the best way to get there?
Another personal finance guru who I follow is Ramit Sethi, author of I Will Teach You To Be Rich. Mr. Sethi recommends a Roth IRA for basically the same reason as Suze Orman. The interesting thing is he goes so far as to make a table to try to prove the benefits of the Roth IRA, but he only compares it to doing nothing or putting your money in a regular, taxable investment account. Why no comparison to a Traditional IRA, Ramit?
All this got me thinking about which option is truly better. There’s currently an IRA contribution limit of $5,500 that can go into either a Roth IRA or a Traditional IRA — or split between the two types… but $5,500 is the maximum of the combined contributions. So, you don’t get to put $5,500 into a Roth and $5,500 into a Traditional. You actually have to figure out which one is a better option. It can’t be as simple as they’re making it sound. Tax now or tax later? That would mean there’s no difference between the two. We pay the tax now or we pay the tax later — either way we still pay the tax, right?
Not quite. There are two factors at play here:
- Progressive tax system — The tax rate we pay increases as the taxable amount increases. So, only if our income remained the same in retirement, i.e., we withdraw from our IRA the same amount, will the tax rates be the same.
- Time value of money — Money today is worth more than money in the future, because you have the ability to invest and earn interest on money you have today.
The financial gurus understand that we have a progressive tax system, and they even mention that you’ll likely have a higher tax rate when you’re older and have a higher income. OK.
They also understand time value of money; it’s pretty much the basis of everything they preach. But — they seem to ignore it when recommending a Roth IRA over a Traditional IRA.
Let me explain in an example:
As I mentioned, the maximum contribution is $5,500. So, let’s say you’re single and make $50,000 per year, and you want to max out your contribution. You take the advice of Suze Orman, because she seems smart and you love blonde highlights and animal print jackets, so you put that $5,500 in a Roth IRA. You get no tax break now, so your income tax will be $6,696.
$50,000 income minus $5,500 to the Roth IRA minus $6,696 to Uncle Sam leaves you with $37,804. In line with the example from Ramit Sethi, we’ll use an 8% annual return on your investments, so if you start at age 30, when you retire at age 65 you will have $947,742. That’s almost $1 million, so it should last a while. Let’s say you take out $80,000 per year to spend how you please and enjoy retirement. Since it’s a Roth IRA, that withdrawal is tax free and you are still earning your 8% return on the balance. You won’t run out of cash until you’re 102 years old. Not bad.
But let’s compare this to a traditional IRA.
$50,000 income. Max out your IRA contribution — so $5,500 to the IRA. You do get a tax break now, so your income tax will only be $5,321.
Ahhhh, this is where the experts are getting tripped up. Your take home with the Roth IRA was $37,804. If you want a good comparison, you have to invest that $1,375 tax savings and assume an 8% return just like you assume for the IRA. Now, you still have $37,804 take home, you still contributed $5,500 to your IRA, but additionally you’ve invested $1,375 in a regular taxable brokerage account. Your IRA balance at age 65 will be the same as the Roth example.
So with the Roth, we saw that you could live all the way until 102 years old, taking out $80,000 each year before you run out of money. The Traditional IRA is different since the withdrawals will be taxed like regular income. That means to get $80,000/yr to spend, you actually need to withdraw $98,412. At that rate, the IRA won’t be able to last all the way until 102 years old like the Roth IRA; you’ll actually run out of money in your IRA at age 84.
Wait, does that mean I just proved the gurus right?
Not even close. Remember that $1,375 tax savings each year that you invested earning 8% until retiring at age 65. Well, when you retire at age 65, it’ll have a balance of $255,890. That continues to grow while you use up your IRA money, and once the IRA money is gone at age 84 the investment account will have grown to $1,022,543!
OK, don’t get too excited. You still have to get the money out of the investment account by selling the investments, and you’ll be taxed on the gains. The good news is that long term capital gains tax rates are more favorable than regular income. To get the $80,000/yr, you just need to sell off $86,088 from the investment account each year. Remember how if you chose the Roth IRA, you would completely run out of money at age 102? Even pulling out $86,088 every year from your investment account — at the age of 102, you would still have $888,713! Take that $888,713 when you turn 102 and use it to help you scratch off each and every item from your bucket list… while the poor Roth IRA investors that followed Suze and Ramit will still have plenty items they can’t afford to scratch off.
Rather than follow the advice of Suze and Ramit, I prefer to subscribe to the teachings of Yo Gotti and Lil Wayne: Women lie, men lie; numbers don’t lie.
I’ve already demonstrated how a Traditional IRA is superior and explained how the financial gurus got a little tripped up in their calculations. Now you’re probably asking yourself — if this Roth IRA crap is such a bad idea then why does it even exist!?!? Why was it written into and remains in the US tax code to this day if it is clearly demonstrated that it is a worse deal than the traditional IRA?
Stay tuned for Part II to find out…
