Think Twice About That Roth
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.
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.
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
Notice at Year 30 the Traditional IRA grows to $7,114, versus only $5,336 for the Roth. This is because the Traditional avoided the upfront tax burden that the Roth incurred. Meanwhile, the Traditional must pay taxes at withdrawal while the Roth does not. But in the end, after tax, both accounts end with $5,336 and the only difference is when the tax is paid, now or later.
Of course, this is a very simple example with all kinds of assumptions that may not hold up in reality. Tax rates, for example, are unlikely to be the same. If the tax rate is lower in the future, then the Traditional would end with more money despite not having tax-free treatment, the reverse is also true. Sometimes the consideration may not even be tax-related, but instead focused on access to principal, or deferring distributions, features unique to Roth accounts. The bottom line is despite strong opinions for or against Roth IRAs, there is no clear, absolute answer as to whether a Roth is better or worse than a Traditional.
Which is better really depends on an individual’s circumstances and objectives. The takeaway is don’t jump onto the popular Roth bandwagon because #taxfree is trending. Like with other financial decisions, it pays to think twice and carefully consider whether the decision is right for your own needs and goals. A good place to start is with a big-picture evaluation of all the relevant factors in your life, financial and otherwise.
To that end, Bellwether Capital Management LLC (BCM) can help with a complimentary financial review. Contact BCM to consult a knowledgeable and experienced professional who will answer your questions and get you moving in the right direction. There's no cost for the review, but time and space are limited, so claim yours' now by submitting your info below. A BCM representative will follow up and schedule a time to connect.
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Bellwether Capital Management LLC and its representatives do not provide tax advice. This article is provided for informational purposes only and does not represent advice of any kind. While the information provided is believed to be correct its accuracy is not guaranteed. You should perform your own due diligence and consult with relevant professionals to determine if and how this information can be used. Furthermore, you release Bellwether Capital Management LLC and its representatives from any harm or liabilities connected to your use of this information.