Corrected Version – Thanks to the help of a few of my readers I have corrected a mathematical error which overstated the benefits of the Traditional IRA. However, I still strongly favor the Traditional IRA over the Roth IRA as described below. Cheers!
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You know the wonderful Roth IRA or the Roth 401K contributions everyone has been raving about? Well, it might not be so shiny and wonderful after all. In fact, these Roth investment accounts might just be another government tax and “money grab” scheme targeting middle-income earners. But then again, the government never institutes policies that would increase the tax burden on the middle class (what’s left of it), sure, right….
Why does everyone say Roth IRA and 401k contributions are so great?
A Roth IRA allows you contribute up to $5,000 per year of 2012 after-tax savings ($6,000/year for those age 50 and up) into an investment account that grows tax-free and is also not taxed upon withdrawal as long as you are at least 59 1/2 years old.
In a Roth 401k plan, employees can contribute up to $17,000 per year of 2012 after-tax savings into a qualifying employer’s 401k plan. Again, the Roth 401k plan grows tax-free and withdrawals are tax-free at retirement subject to similar age restrictions. Sounds great right! Everyone likes to hear the words “tax-free”…
But here is the down side:
The Federal income tax brackets for 2012 is listed below. Take a look at the 25% bracket for those Married Filing Jointly. Let’s review a simplified example: Assume you are hard-working couple and you and your wife each earn an annual pre-tax income of $40,000 for a total combined gross income of $80,000. According to the chart below you will be in the 25% Federal income tax bracket in 2012 (assuming no other deductions for simplicity). Which means that if each of you contribute $5,000 to a Roth IRA for a total of $10,000 per year you will pay a 25 % tax on $9,300 of that lump sum in the tax year you made the contribution. ($80,000 – $77,700 = $9,300).
| Tax Bracket | Married Filing Jointly | Single |
|---|---|---|
| 10% Bracket | $0 – $17,400 | $0 – $8,700 |
| 15% Bracket | $17,400 – $70,700 | $8,700 – $35,350 |
| 25% Bracket | $70,700 – $142,700 | $35,350 – $85,650 |
| 28% Bracket | $142,700 – $217,450 | $85,650 – $178,650 |
| 33% Bracket | $217,450 – $388,350 | $178,650 – $388,350 |
| 35% Bracket | Over $388,350 | Over $388,350 |
Now, if you had instead contributed that $10,000 to a tax-deductable Roth IRA your annual gross income would have declined to $70,000 and you would have moved into the lower, 15% Tax Bracket. You would have paid approximately $2,430 less in taxes in that same tax year and every year you contribute to the Traditional IRA, assuming your income remains constant and tax laws are not changed. This means that each you are paying an extra $2,430 in Federal taxes just because you happen to be on the border of the 25% and 15% tax bracket. Why would anyone in their right mind want to pay extra in taxes now in exchange for the promise that when you retire you will not owe any taxes in the future? Finance 101: “Money now” is always worth more than “money later”, see the Time Value of Money concept…
It gets worse…
If we assume that for the next 30 years you and your wife make annual $10,000 contributions and earn annual rate of return of 7% each year, you are sure to have a smaller amount of after-tax savings in a Roth IRA relative to your combined Traditional IRA and your Taxable Brokerage! If you were to contribute the same amount to a Traditional IRA and then invested $2,430 in tax savings into a Taxable Brokerage account earning the same 7% return you would have approximately 6% more in your combined Traditional IRA account and Taxable Brokerage than a Roth IRA on an after-tax basis in 30 years.
Why? Because you paid an extra $2,430 in taxes, upfront. And since you just spent the last 30 years living on only 87.5% of your gross income (you saved 10,000 or 12.5% of your combined gross income in your IRA; remember that?) you are sure to be in the 15% tax bracket in retirement.
This also means you paid 10% in extra taxes per year on your $9,300 in income over the $70,700 threshold of the 15% tax bracket into an Roth IRA to avoid paying a 25% tax in retirement. But, the whole time everyone already knew that if you were able to save $10,000 a year and live on $67,500 gross income you would already be in the 15% bracket on this $9,300 if you continued to live the same lifestyle in retirement anyway. Congrats, you now have less money and the Government has increased their tax revenue off the backs of the middle class once again.
How do you like them apples? Does anyone disagree or think I am missing something?
Here are my calculations:
| Working Years | Traditional IRA | Roth IRA |
| Pre-tax Income | $ 80,000.00 | $ 80,000.00 |
| Income Adjustment | $ (10,000.00) | $ - |
| Adjusted pre-tax income | $ 70,000.00 | $ 80,000.00 |
| Federal Taxes | $ (10,500.00) | $ (12,060.00) |
| Income net of Federal Tax | $ 60,370.00 | $ 67,940.00 |
| Extra Tax Bill due to Roth (savings for IRA) | $ (2,430.00) | $ - |
| Account Values at Retirement | ||
| Lump Sum Amount at Retirement | $ 802,916.68 | $ 944,607.86 |
| Lump Sum of Tax Savings (taxed at higher-bracket) | $ 195,108.75 | $ - |
| Total available in future dollars | $ 998,025.44 | $ 944,607.86 |
| Assumptions & Inputs | ||
| Pre-tax income | $ 80,000 | |
| contribution | $ 10,000 | |
| 401k contributions % of income | 12.5% | |
| Investment Return | 7.0% | |
| Working years remaining | 30 | |
| Marrital Status | Married Filing Jointly | |
| Traditional IRA - Maximum tax bracket | ||
| Working Years Federal Tax Rate | 15% | |
| Retirement Federal Tax Rate | 15% | |
| Roth IRA - Maximum tax bracket | ||
| Working Years Federal Tax Rate | 25% | |
| Retirement Federal Tax Rate | 15% | |
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Your scenario is correct but there are lots of people it doesn’t apply to. Since our family is in the 47% that have no tax liability there is no current benefit to investing in a traditional IRA so I have a Roth IRA. Since our income should go up quite a bit this year I will check again next year to see which IRA works better for us.
How is your family in a zero tax bracket? And if so, how do you have extra money to put into an IRA?
I will definitely be starting with Roth accounts when I graduate this spring because I fully expect my income to go up a lot between then and when I retire. I think between the difference in tax rates and the piece of mind of knowing I don’t have to pay taxes (on the principal) when I don’t have a guaranteed income stream there is enough incentive there. In a few years I may change my mind and go traditional, or I may do a combination. My employer offers both traditional and roth 401k’s, and I can get matching on both so I’m definitely not losing money either way.
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Every time I see a post like this I’m always surprised by the numbers arguing for a Roth. I’ve seen several tax geeks knock out the numbers every year. It always ends with a Roth IRA only being beneficial if you’re already in the lowest tax bracket.
Unfortunately the biggest flaw in most peoples thinking is that they’ll be in a higher tax bracket when they retire, which doesn’t happen too often. Similar arguments can be made about the Roth conversions.
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At the end of the day, everybody has to make their own decision. I picked a Roth IRA when I was in college because of the same reasons mentioned by pKamp3. I was in the 10% bracket when I added most of the funds in my account, and am still only in the 15% which I foresee staying that way for at least a few more years yet. My wife is at the top of her payscale in her retail position and, realistically, my income won’t be going anywhere without going back for my masters.
Fair point. I think the 25% and 28% tax brackets are likely to take the biggest tax hit on Roth contributions. The jump from 15% to 25%/28% is substantial. If you are on-the-border, would be very wise to consider the Traditional over the Roth. Also I view the 25%/28% tax brackets as the middle class. See this post regarding the whole “what makes a person ‘rich’ discussion”: http://networthprotect.com/money/americans-150000-year-rich/
Actually, there is a lot of room for growth before we hit the next bracket. But if it does happen, I’ll open up a traditional IRA, because I certainly won’t be in that high of a bracket when I retire. We are planning on about $25-30k income in today’s value.
I think that a lot of the populist anger found in the OWS movement isn’t so much by the 99% upset from the 1% but really, the lower middle class, making <=$50k upset by the upper middle class who claim they are "poor" because they can't afford to live on twice that much.
Even in your response to my comment on the Roth post, you claim that you need to be in the 25% tax bracket to be middle class. That's basically calling everyone who makes under $70k poor. In reality, $50k in the median household income. According to HHS guidelines, for an income of $79k to be poverty level, your household size would have to be 16. Unless you are the Duggers, that is more than enough money.
Edward, I often look through my NY City lens, which certainly views cost-of-living much higher than many parts of the U.S. So, I hear your point regarding averages. I should crunch some numbers to see if I can come up with a cost-of-living adjusted median by state or region so we can compare apples to apples. In my neck of the woods (or cement-jungle) less than $70k would be very tough to raise a family of any size, so that is where I am coming from. Here monthly rents start at $2,000 – $2,500 for a studio or small 1-bedroom apartment so less than $70k is going to be very tough.
My point is mainly that being in those middle tax brackets 25%/28% and making Roth contributions is really leaving money on the table today even though people in those tax brackets will likely drop to 15% in retirement. And I don’t like the idea of giving the government any more money than I have to.
To your OWS comment; That is an interesting point that I didn’t think of until you mentioned it. But it really makes sense, that is why a cost-of-living adjusted framework needs to be utilized. $100k in NYC is probably like making $50K in middle America, so these two seemly different income levels have interests that are aligned more than you may think. (I need to check into the exact math here, but I think my statement holds water…)
In an ideal world these accounts wouldn’t be needed. So much of tax policy is bolted on piecemeal over time by different factions, so that there is a fair amount of uncertainty in any policy or program. However, the ROTH IRA has a benefit that you can pull out your contributions at anytime. This is the most flexible of the accounts. However , if you are starting out, the deductible plans can make sense since they accelerate the amount you can save.
That is a good point, access to your initial investment capital without a penalty is certainly an advantage of the Roth IRA. And I also agree that these tax-advantaged accounts were created in a vacuum by several administrations so the framework of the greater tax system is fundamental flawed in that regard.
Yep, all the intelligent things that PKamp3 said.
For me, a Roth is a good idea right now because I fully expect my income (and therefore my tax liability) to increase between now and retirement. And I’d much rather take my chances now than try to predict what crazy ass tax code changes may happen in the future.
I hear your point, but I also don’t trust the government, therefore I want my tax savings now and not later. The Roth promises you a savings later and there is no guarantee that this will not be taken away in the future.
Sure, the government could raise taxes in the future, but I know that I will be in a lower tax bracket in 30 years on relative basis, unless the world really goes sideways.
My main point, I want to taxes savings today and I am not waiting for it tomorrow. If I was inclined to leave a massive estate to my kids then a Roth IRA would probably be ideal, but unfortunately I am not in that situation.
Point taken – but you’re conflating marginal rate with effective rate. Only the $9,300 you earned in excess of the $70,700 would be taxed at the 25% rate. The money earned below the $70,700 would still be taxed at the 15% rate.
One of the other reasons to go for the Roth is the threat of future tax increases – but I’m convinced we’re just as likely to see those in the form of consumption taxes, in which case traditional is the way to go. If income rates get jacked up you might be better off with a Roth. You’re also might be better off if you have disappearing deductions (mortgage, for example) or an expectation of future earnings increase – as you might in the early years of a career.
The last advantage is wonky – you can actually save more money in a Roth than a traditional… The Roth can save a true $16,500 or $5,000 a year while a traditional can only save $16,500 or $5,000 MINUS tax… so you shield more funds using the Roth.
Again, it’s wonky. If you don’t have a good idea how your salary will turn out you’re probably better off splitting between the two accounts for tax diversification, haha.
PKamp3 – Thank you for pointing out my error in the tax calculation! What a blooper… I have corrected the calculation to account for the different tax treatment at each level of income which of course reduces the annual tax savings of the Traditional IRA materially, down to ~$2430 vs. my initial $9,000+. I know, I know, Big difference!
However, I stand by my thesis on this one. I would much rather save on taxes now rather than wait for the government’s promise that my Roth IRA will not be taxed later. That government could just as easily chnge that as they could change the tax rates in the future. My view is that more money now that I can invest and control is better than a promise of more money later.