Roth IRAs in Perspective

 

There’s a growing interest in Roth IRA accounts.  The benefits are well-known, access to contributions, no required minimum distributions, and of course, tax-exempt earnings which is the main attraction for many.  However, a Roth IRA may provide less financial benefit than expected.  In this article, we’ll review some key points on why you may want to think twice before funding that Roth IRA.

 

But first, let’s clarify the perspective.  The decision to use a Roth IRA is not made in a vacuum.  Often it comes down to the choice of making a Roth or Traditional IRA contribution, each having different but interrelated considerations.  So, we’ll look at things from that perspective -- someone who qualifies for both Roth and Traditional IRA contributions, while all else is equal. We won’t get into qualification details, but you can find the rules at the IRS website.

 

For those who don't qualify for Roth IRA contributions and are considering Roth 401(k)s or IRA conversions,  the logic used here can still apply.

 

To Roth or Not

 

The most popular argument for using a Roth IRA is the earnings may be tax-exempt upon qualified withdrawal.  In other words, money made inside the IRA may be totally tax-free!  That point alone convinces many to favor Roth IRAs over their Traditional counterparts.  But when it comes to taxes, nothing is really free.  Here are some additional points to consider when thinking about that Roth IRA.

 

Tax Deduction

Roth IRA contributions are not tax-deductible.  In other words, Roth contributions do not receive the upfront tax benefit Traditional IRA contributions get.  Of course, Roth IRAs do provide tax-exemption for qualified withdrawals in the future. But those looking for immediate tax breaks will not get them with Roth IRAs.  In addition, deductible contributions cannot be recovered, they are “use them or lose them” every year.

 

Value of Tax Benefits

We don’t know what tax rates will be in the future, but it’s reasonable to assume most people make more money and are in higher tax brackets while working than in retirement.  In that case, an upfront tax deduction may be more valuable than a future exemption.  Put another way, are tax breaks worth more when income is higher or lower?   

 

Control Over Taxation

Tax-deductible contributions provide some control over taxation.  For example,  Traditional IRA contributions help us avoid taxes now and allow us to chose when to pay them later, like years with low income.  But since Roth IRA contributions are non-deductible, all the taxes are paid upfront.  Again, this is counterproductive when income and tax rates are higher now than later.

 

After-Tax Dollars

A second-order consequence of non-deductibility is a Roth IRA contribution requires more dollars than a commensurate deductible contribution.  For example, assuming a 25% tax burden, a $1 after-tax Roth contribution requires $1.33 (because $1.33 minus 25% tax equals $1).  In contrast, a $1 before-tax Traditional IRA contribution would only require $1 (because $1 minus no tax = $1).

 

Seeing is Believing

 

Those are only a few considerations, and there are more. However, after everything is considered, a Roth and Traditional IRA could end up with the same results!  Seeing is believing and the chart below shows how this could happen.   It compares the value of a Roth IRA versus a Traditional IRA over 30 years using the following assumptions.

 

• Roth IRA starts with $750 after-tax dollars (taxed at beginning)

• Traditional IRA starts with $1,000 before-tax dollars (taxed at end)

• Both accounts are subject to a tax rate of 25%

• Both accounts earn 7% interest per year (you wish!)

• Both accounts are fully withdrawn at end 

 

Roth vs Traditional Over Time