Why are Roth IRAs so Confusing?

This blog is primarily about bad advice, that is, the recommendation of unwise money choices. But I also have a nice sideline going in misinformation, statements about personal finance that are not merely foolish, but are flat-out objectively wrong.

A recurring topic in that area, you might call it a running gag, is the lack of tax saving advantages of Roth IRAs over traditional ones. When I started this blog a few months ago I assumed that most of the people who published misinformation about Roths knew better but had some motive, be it sinister or well-meaning, to mislead. Now I understand that they just don’t understand what they are talking about.

The latest infuriating instance of this is a blog post on Mint.com written by Michael B. Rubin, author of the book and blog Beyond Paycheck to Paycheck and "President of Total Candor, a financial planning education company." It was linked to by the Wall Street Journal’s Wallet blog.

The gist of the post is that converting your traditional to a Roth IRA is a good idea because it will make you more money.

At a very high level, a regular IRA provides for tax-deferred growth whereas a Roth IRA gives you tax-free growth. All else equal, we’d all prefer tax-free growth, of course.

No. Wrong. All else equal there is no reason to prefer one type of IRA over the other.

Why is this so hard to understand? I honestly don’t get why people don’t get this. Let me try explaining it in a few different ways.

By Example: Let’s say you’ve got $1000 in income you want to salt away for retirement. You can put it into a traditional IRA, which means you will not pay taxes on it now but will pay taxes on it when you withdraw the money. Or you can put it in a Roth, which means you will pay taxes on it now, but not when you withdraw it. Assume that you are, and will be, in the 25% tax bracket and that between now and when you withdraw the money in retirement your investments will earn 200% return.

For the traditional, you would deposit $1000 now, it would grow to $3000, and when you withdrew it you would have $2250 after taxes. For the Roth, you pay $250 in taxes now, deposit $750, and it grows to $2250, which you can withdraw without paying taxes. So you see, you wind up with the same amount of money either way.

Algebraically: Let

$X = the pre-tax money to be saved

T = the marginal tax rate

r = the compounded return between deposit in the IRA and withdrawal

For the traditional, the after-tax value at withdrawal is:

($Xr)(1 – T) = $Xr – $XrT

For the Roth it is:

($X(1 – T))r = ($X- $XT)r = $Xr – $XrT

Thus, the after-tax values of the two accounts are identical.

Allegorically: Once upon a time there were two farmers named Joe and Bob who lived in the Kingdom of Ira. The King of Ira said to Joe and Bob that they must pay one fourth part of their grain as a tax. But, being a kind and wise king, he gave them a choice. They could pay a fourth of their seed in the spring or a fourth of their harvest in the fall.

Joe chose to pay a fourth of his seed and so could sow only three fields, but kept all that he reaped. Bob decided to keep all his seed, and planted four fields, but had to give the bounty of one of those fields to the king. Both farmers had three fields worth of grain to feed their families and so lived happily ever after.

Cynically: The traditional was around for rather a while before the government invented the Roth. You think they would have enacted something that seriously reduced tax revenues?

There are reasonable and well-informed reasons to prefer a Roth, all of which, in my opinion, violate "all else equal." Chief amongst these is the view that the marginal tax rate will be higher in retirement. I don’t happen to agree with this as a general statement, but a person who believes this still gets a gold star for actually understanding the issue.

And there are some implementation details around how much you can contribute, and if you can contribute at all, to each type. And the estate planning implications of choosing between the two types give me a headache every time I read about them.

But differing tax rates and estate planning don’t show up very often in the blogs, newspapers, books, and radio shows that tell folks to choose Roth. No, these experts just don’t understand IRAs. And I just don’t understand that.

Investing, Media, PF Blogs, Taxes | Frank Curmudgeon | August 10, 2009 11:59 am

70 Comments

By Kosmo @ The Casual Observer, August 10, 2009 @ 12:06 pm

I have broken down some scenarios here
http://www.observingcasually.com/roth-vs-401k/

You are correct that if everything else if equal, Roth vs. 401(k) is a wash. My article breaks down some situations where the “everything else” is not equal.

I have posted this link before, so if you experience deja vu, do not be concerned

I also find it frustrating (and a bit odd) that some many advisors blindly assume that Roth is better for their clients. In reality, it’s foolish to assue that Roth or Traditional is ALWAYS better than the other.
By Ian, August 10, 2009 @ 12:57 pm

When you withdraw your traditional 401k/IRA money at retirement, it’s taxed as normal income, right? So only some of it will be taxed at the marginal rate, and the rest will be in lower tax brackets – which means that a traditional 401k/IRA is better all else being equal.

Am I missing something?
By Amanda, August 10, 2009 @ 2:09 pm

I still don’t get it. If I’m going to put $1,000 into either a Roth or a traditional, then that’s how much I’m going to put in regardless, and if it goes into a Roth then I just pay a little more taxes this year than I would if it went into a Traditional. But then I’ve got all those years of tax free growth ahead of me. I don’t see how this is equal.
By Brandon, August 10, 2009 @ 2:17 pm

Things like the marginal rate at retirement are an unknowable risk (and some would argue you should have both pre-tax and post-tax investments to hedge this risk), but there is one important factor in the difference in these calculations that is knowable now and that has to do with contribution limits.

Let us take your example and change a few numbers.

Let’s say you’ve got $6666.67 in income you want to salt away for retirement. You can put it into a traditional IRA, which means you will not pay taxes on it now but will pay taxes on it when you withdraw the money. Or you can put it in a Roth, which means you will pay taxes on it now, but not when you withdraw it. Assume that you are, and will be, in the 25% tax bracket (and 15% long term capital gains bracket) and that between now and when you withdraw the money in retirement your investments will earn 200% return.

The catch is that there is a $5000 contribution limit for an IRA. Therefore, for the traditional, you would deposit $5000 now, it would grow to $15000, and when you withdrew it you would have $11250 after taxes. Assume no other tax preferred method is available to you, you would pay taxes on the remaining $1666.66 giving $1250, which would add an additional $3375 to the total money after long term capital gains taxes on the gains (15%) for a total of $14625 (assuming you bought and held so that you never cashed out at any other point and had to pay capital gains or harvest capital losses)

For the Roth, you pay $1666.67 in taxes now, deposit $5000, and it grows to $15000, which you can withdraw without paying taxes.

You are $375 ahead by doing the Roth in this case.

I keep wanting to write more, but it from there it all goes into issues that probably are not knowable in advance. The core thesis though is that with the Roth IRA, you can effectively contribute more money each year by virtue of the total contribution limit being off of after-tax rather than pre-tax funds.
By Wm Tanksley, August 10, 2009 @ 2:37 pm

Amanda, if you’ve got $1,000 set aside for retirement, then putting it all into a conventional IRA means that you automatically receive some money back (from taxes you’d otherwise pay). What are you going to do with that money? If your answer is “spend it!” then a Roth is a better investment. If your answer is “put it into the IRA”, the two are equal.
By Wm Tanksley, August 10, 2009 @ 2:42 pm

Note: I feel kinda bad about using the term “better investment” above. If you “spend” the tax refund on something of lasting value that you couldn’t have gotten otherwise, then good for you; the conventional IRA _was_ a good investment, and it paid off right now. The actual value of its entire payoffs (including the tax return) is higher than the present value of the far-future Roth payments, for you.
By Ron, August 10, 2009 @ 2:58 pm

Just the same, I think I’d rather get it tax free in the future. Governments aren’t exactly notorious for reducing taxes.

Just watch though, they’ll pass some law taxing Roth benefits at some point in the future!
By Wm Tanksley, August 10, 2009 @ 2:58 pm

In response to the “cynical” response: “You think they would have enacted something that seriously reduced tax revenues?”

My more cynical response: if there’s some kind of real advantage to the Roth, it would reduce tax revenues in the far future, in return for higher revenues right now. What do YOU think politicians will care more about — the far future, or RIGHT NOW?

Personally, my approach is that the two are useful as diversification. Put some in Roths when you think you’re more likely to see higher taxes in the future; put some in conventionals when you think lower taxes are more likely. I don’t like to make all-or-nothing bets.

And it should be noted that most people do make all-or-nothing bets; it’s much easier to fund a conventional 401(k) than it is to put ANY money into a Roth IRA. Therefore, I’d expect to see more advice given to increase one’s contribution to a Roth — most people desperately need that advice.

-Wm
By Jim, August 10, 2009 @ 3:19 pm

Good article. Nice allegory.

I’m personally particularly annoyed by all the advice about converting traditional IRA’s to Roths. It seems that people take it for granted that doing a conversion is automatically a good idea based on their love of Roths.
By Neil, August 10, 2009 @ 3:25 pm

I believe Amanda has nailed on the head why the Roth is, in general, the superior choice. Most people set aside a fixed amount of money – that they currently have in their bank account – for retirement savings. They’ll put in $1000 into either vehicle. Then, if they opt for traditional, they’ll spend their tax refund on something nice.

The two are only equal for people who actually factor in the tax refund in determining how much to contribute to the traditional. Since for most people, this either means waiting longer to make part of the contribution (after they get the refund for the first chunk), or borrowing some money to be repaid when their refund is received, there is extra cost to the traditional.
By Mike Piper, August 10, 2009 @ 3:39 pm

Haha. I’m glad you used the allegory you came up with previously. I quite like it.

That darned commutative property of multiplication. Gets us every time!
By SJ, August 10, 2009 @ 4:12 pm

Wm Tanksley: I enjoy your more cynical response =)
The Roth IRA is just either foregoing future taxes… i.e. being really stupidly short-sighted… Or maybe it’s the govt. hedging their bets lol

Good ole math…
By bex, August 10, 2009 @ 4:23 pm

There’s one other sinister plot…

If I have a traditional IRA, I take the tax deduction *now*, and (in theory) have more $$$ to put into retirement.

If I have a Roth IRA, I take the tax hit now… and I hope and pray they don’t change the rules in the future!

Don’t trust me? Social security benefits used to be non-taxable income. Then Regan decided to tax 50% of the recipients. Clinton ratched it up to 85% of recipients.

Also… since these IRAs are meant for the “common man,” how many of them will be in a HIGHER tax bracket when they retire? Just plain silly…
By bex, August 10, 2009 @ 4:40 pm

Although… you’re numbers don’t quite add up if you have the cash to “max out” a Roth IRA.

Assume you had $6250 income, so it either needs to go to taxes or investments. Also assume your 25% tax bracket, and 200% return. The comparisons are closer:

Roth IRA:
$5000 invested
$1250 taxes
turns to $15,000 tax-free

Traditional IRA:
$5000 invested
turns to $15,000 taxable
Total: $11,250

The traditional is $3750 less… although arguably, you could take the $1250 tax break, and invest that as well, to make them closer.

However, if you’re in the 25% tax bracket, you’d need to turn that $1250 tax break into $4333 in order to make them even. That’s a 250% return while your tax-deferred one was only making 200%.

Even if you took the $1250 tax break for the traditional IRA and invested it in a tax-managed fund, you’d need nearly a 400% return on investment for that to make them even again.
By fern, August 10, 2009 @ 4:46 pm

Since I cannot know for sure if i’ll be in a higher tax bracket than i am now (though I rather doubt it) i am hedging my bets by having both traditional and Roth IRAs. I haven’t converted any of my traditionals, but since they introduced roths, I’ve been only contributing to my Roth.
By Atticus, August 10, 2009 @ 5:13 pm

All of this makes sense. But a Roth actually allows you to shield more retirement money from taxes than a traditional IRA or 401(K), correct?

For example, you can contribute a maximum of $16,500 to a 401(K) this year–whether you choose a Roth or a traditional 401(K). With a Roth, you contribute $16,500 after-tax dollars. With a traditional, you contribute $16,500 pre-tax dollars. After-tax dollars are more valuable than pre-tax dollars, so you are actually setting aside more for retirement with the Roth. Of course, you’re also paying a lot more in taxes up front–but assuming you set aside the max every year, you’ll end up with far more at retirement if you max out a Roth than if you max out a traditional account.
By Atticus, August 10, 2009 @ 5:14 pm

Should have read the comments before I posted. Two others made the same point.
By Dangerman, August 10, 2009 @ 5:37 pm

I’m gonna have to say Frank is pretty wrong here, because he’s ignoring at least two major aspects of this analysis:

1. taxation of Social Security benefits – withdrawals from traditional IRAs/401ks are not only themselves taxable income, but ALSO make a larger portion of most people’s social security benefits taxable. In other words, the money you withdraw from your tIRA is NOT ONLY taxed at your marginal rate – but it also causes money that was not taxed at all to suddenly become taxed. This is how many retirees will end up having a marginal tax rate of over 50%.

2. Roth IRAs have no Required Minimum Distributions. The ability to NOT withdraw, and therefore not pay taxes when you don’t want to, is HUGE for tax planning and estate planning.

Gotta look at the big picture.
By Mark Wolfinger, August 10, 2009 @ 6:17 pm

There is a psychological edge to the Roth.
When it comes time to take the cash, you’ll be happy not to have to pay taxes. There may not be a dollar difference, but you will feel better. That’s worth something, even if it’s not worth money!
By Frank Curmudgeon, August 10, 2009 @ 6:49 pm

As usual, lots of great comments.

For those who pointed out the advantage to Roths becuase of the de facto higher contribution limits, a) that’s a good point b) I alluded to it in the 2nd to last para of the post c) it’s an argument for Roths that I can only remember seeing here in BMA comments and d) the blog post that got my dander up this morning was about conversions.

Wm Tanksley: You make a good point that the attraction to politicians of Roths (and I imagine why they got enacted) is that they increase short-term tax revenues. And of course the government would only be made whole if they invested the extra Roth revenues at the same rate of return that the IRAs get. Not likely.

Dangerman: The high effective marginal rates for retirees on the SS taxation bubble is yet another perfectly reasonable argument for Roths that only seems to appear here. But I think that for people fairly distant from retirement (say 10+ years) planning on this being a problem and on the rules not changing in the meantime is a bit much.
By Dave C., August 10, 2009 @ 8:59 pm

Your post was actually quite informative Frank, thank you! Like you said, I suppose it mainly comes down to whether or not you think the tax rate is going to be higher in the future.
By Kelly Miller, August 11, 2009 @ 12:00 am

There is another reason to prefer the Roth — flexibility in case of emergency. Principle can be withdrawn from a Roth without penalty, while 401K’s and the like get a hefty 10% penalty if money needs to be withdrawn.

Withdrawing retirement savings early is a bad idea if you can avoid it, but calamity may strike and a time may arise when you can’t avoid it. A Roth is a better super-duper emergency fund than a 401K, because it isn’t nearly as costly.
By TFB, August 11, 2009 @ 12:17 am

For most people with a 401k and enough income to contribute to an IRA in addition to contributing to a 401k, contributions to a traditional IRA are not deductible. For people with low enough income to make them deductible, they are not paying much tax to begin with. Therefore for contributions, we can say Roth IRA is probably better for more people than it’s not.

Conversion is a different matter. Your King of Ira story is great!

My first time here. I also write about these myths in the media, like “missing the 10 best days”, “401k loan double taxation”, etc. Looks like I found good company. Added your feed to my reader.
By Tzen, August 11, 2009 @ 4:37 am

Question. What about death tax? Say you accumulated $5 million dollars in your Roth. On your death, your beneficiaries receive your Roth IRA tax-free. Is that correct?
By Wm Tanksley, August 11, 2009 @ 1:23 pm

“If I have a Roth IRA, I take the tax hit now… and I hope and pray they don’t change the rules in the future!”

Why would they want to change the rules in the future? If they did that there’d be a huge political kickback, and they wouldn’t get a penny from it right now (well, unless they just TOOK the money, but that’s a risk with ANY money).

I could see them forcing ALL traditionals to convert to Roth, but not the other way.

-Wm
By My Journey, August 11, 2009 @ 1:57 pm

Tzen,

Roths are part of your taxable estate and then are stretched (hopefully if your beneficiary is smart) over the bene’s lifetime.
By Wm Tanksley, August 11, 2009 @ 2:19 pm

Tzen, no — you get the same inheritance taxes with a Roth as with a conventional (and with any inherited money). The Roth continues to grow and make distributions tax-free, so if there’s any further growth you’re not taxed on it (while with the conventional you are). I suspect there’s little advantage to bequeathing a conventional IRA rather than just cash; there’s a decent advantage to bequeathing a Roth instead of cash (and the recipient will benefit from keeping it in its Roth form).
By Wm Tanksley, August 11, 2009 @ 2:21 pm

Oh, here’s a very good article: http://www.fairmark.com/rothira/inherit.htm
By Seth, August 11, 2009 @ 3:40 pm

What about for those who make too much to normally qualify for a Roth IRA and are converting IRA of after-tax dollars?
By mljhouse, August 11, 2009 @ 4:21 pm

Any chance that the govt will start taxing rich people’s roth ira distributions in the future? Will the govt have enough self control not to try and grab some of that money they see accumulating decades from now?
By Wm Tanksley, August 12, 2009 @ 6:46 pm

mljhouse, like we said, there’s always a CHANCE, but the gov’t would have to pass a law to change existing tax law, and they’d get a HUGE protest for that particular one. It’d be much easier to nudge other tax rates up. Anyhow, they can’t just “start taxing” or “try and grab” it, they have to pass a law that repeals the current law and replaces it with something else.
By ron, August 13, 2009 @ 9:31 pm

you are too simplistic and haven’t scratched the surface, so don’t try and make an issue of something that requires more information.
By Patrick, September 3, 2009 @ 11:27 am

in Canada we have RRSP (tax-deferred) and TFSA (tax-free). Same deal. The question comes down to your marginal tax rate now, versus the tax you expect to pay when you withdraw the money. In your examples, these are equal, so yes, there’s no real difference.
By Bryan, April 10, 2012 @ 4:40 pm

I love the allegory. It’s a very helpful way to visualize the change. However, should the money put into the Roth grow substantially between the time one puts it in and one pulls it out, surely the investor will come out ahead (compared to having to pay taxes on the full amount + gains when money is taken from a traditional IRA)?
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