Roth Mania
Why more young people should reconsider Roth IRAs
Ask any internet forum regarding personal finance strategies, and scores of knowledgeable individuals will inundate you with recommendations about a Roth IRA. The allure is understandable. No taxes on your withdrawals at retirement. What’s not to like?
Actually, there are a few things which get lost in the hype : Opportunity Cost, Compounding, Time Value of Money and Effective Tax as a retiree.
Opportunity Cost
What so many overlook, is that for many, electing to choose a Roth means saving less money. Most individuals can not afford to maximize both their 401(k) with company match and their IRA contributions. This fact is often overlooked in these theoretical discussions.
Assuming that your employer offers you a 401(k), then a traditional IRA can offer an effective Federal income tax benefit of up to ~16% depending on your tax bracket. In a state like California you could tack on another 5% benefit on state income taxes. For simplicity sakes we will just use 20%. This means that for every $1,000 you contribute to a Roth, you could have put around $200 extra more in a traditional IRA.
Compounding and the Time Value of Money
Another factor not included in these calculations is the time value of money and the magic of compound interest. Money now is worth more than money later. Taxes saved now are worth more than taxes saved later. How much more? This depends on the rate at which you compound those excess tax savings.
Let’s assume at age 25, we generate a $200 benefit by using an IRA ($1200) versus a Roth IRA ($1000). We compound that until age 72 at a rate of 6.5% per year. The math says $200 will nearly 20x to $3,859. If use the same rate of return for the original $1000…the traditional IRA will be worth 40% more than the Roth. Of course as each year passes the compounding effect lowers. Contrary to popular wisdom, the time to consider a Roth might be towards the middle of your career, not the earlier part. You may not receive a tax benefit at this part of your career and you’ll also be more likely to be able to max both the IRA and your 401(k).
Taxes in Retirement
The final point that’s often overlooked in the conversation is taxes in retirement. Most individuals pay substantially less taxes in retirement than they do when they are working. This is because they can live off less income (house is paid off or they use a reverse mortgage), and some of that income is tax advantaged (Social Security).
Assuming you need 50k to live off as a retiree per year. Average Social Security per year is $29,800. This means you would need $20,200 in retirement income per year. At these levels only 50% of your social security would be taxable income (higher income can lead to 85% of your SS being taxable income). Your effective tax rate would be somewhere around 7.8% for Federal, and depending on where you live, 0% for state.
Going back to our original example.
At age 25 you realized a $200 tax savings by using a traditional IRA. You compounded that into $3,859 by age 72.
Using the same rate of return for the $1000 base in both the Roth and traditional…your Roth would be worth 19,294.40. Your traditional would be worth 23,153.28
Applying our 7.8% effective tax rate to the traditional IRA, you would pay $1,805.96 in taxes. This would leave the traditional IRA with 21,347.32 in post tax distributions. In this scenario it beats the Roth by over 10%.
Conclusions
The objective of this post isn’t to argue that the Traditional will always beat the Roth. It won’t. However some people may be leaving money on the table by opting for a Roth without thinking the whole equation through. If you can’t max out your contributions AND you realize a tax benefit from a Traditional IRA, you need to weigh those factors. Simple framework:
What rate of return can I generate?
How long can I compound these contributions for?
What is the extra tax benefit generated?
How much extra money does that allow me to save?
What style of life do I expect to lead in retirement?