A client took the quiz in last week’s newsletter (related to retirement savings accounts) and had a question regarding one of the answers. The question was an “all of the above” answers are true related to Roth vs traditional IRA accounts. Here was the statement he was questioning

“Workers who want to contribute the maximum to a retirement savings account can accrue more wealth with a Roth than a traditional account.” 

His question was – if tax rates are the same before and after retirement, don’t both account types accrue the same amount of wealth? He even went so far as to “show his work” – quoted below (understood that the example is above contribution limits – it’s just an example!)

A future retiree has $100,000 and is deciding whether to put it in a Roth or Traditional IRA.  The overall tax rate is 30% at the time they put the funds in AND when they withdraw the funds in 10 years.  The yield is 5% annually compounded monthly:

I.               Roth: The person pays $30,000 in tax and puts $70,000 in an account and withdraws it in 10 years and pays no taxes on what is left in 10 years:

a.     Amount in 10 years would be (70,000)(1+.05/12)¹²⁰ =$115,291

II.             Traditional: The person puts $100,000 in the account but has to pay 30% to IRS when money is withdrawn in 10 years: 

a.     Amount in 10 years would be [(100,000)(1+.05/12)¹²⁰}X70%=$115,291

     Is my thinking off here or is the Roth only advantageous if the tax rate at withdrawal is more than the tax rate initially? In that case, a  Roth  IRA is better as they get taxed at the beginning?

I thought this was an excellent – and well-thought out question – and rather funny it was raised as I too believed that answer in the quiz needed more caveats when I read it as well.

It is true that if tax rates are exactly the same before/after – and growth is the same within each account during the specific time period – you end up in the same place.

However, that is a very big “contingency “if” and one that often doesn’t pan out – especially in the case of younger works. Typically, in the early years of your working life (which can start as early as you have earned wages) funding a Roth makes complete sense as it is very likely future income – and therefore future income tax rates – will be meaningfully higher.

Yet once you get further along in your career, the tax rate difference argument needs to be more carefully evaluated. And to make it even more complicated, you’re going to have to bank on some future estimates and predictions on a topic that is very hard to predict (given the immense political influence).

It’s important to remember there are other very reasonable reasons for opting for savings within a Roth wrapper. The main reason I find that having some level of Roth savings as being beneficial is the optionality it provides in how to obtain cash flow in retirement.   Quite a few items are tied to income levels on tax returns beyond the marginal tax brackets – such as ACA health care subsidies before Medicare years, Medicare Part B premiums, long-term cap gain rate, and certain tax provisions (under current law – the added senior deduction and the new charitable 0.5% of AGI limit).  Having Roth funds allows one to better control income levels if need be.

Roth funds also help negate “tax bracket creep” in later years that can arise as one stacks hefty RMDs (required only in pre-tax retirement accounts) on top of pensions, social security, investment income, etc..

Other individuals prefer to have mostly Roth funds for estate planning purposes. Traditional IRAs can pass down the income tax burden to heirs, especially now that most non-spouse beneficiaries have to fully distribute the accounts within ten years of inheritance. Converting pre-tax accounts to Roth while you are still alive (especially during a market downturn you view to be temporary in nature) can allow you to pay the taxes for your heirs in advance and negate this issue for future generations.

All this to say, saving within a Roth account structure (or converting to such a structure at a later date) can and often does make a lot of sense for many individuals. But as with most investment questions, the answer will vary greatly from one investor to the next, so be sure to work thru your specific situation with your advisor.