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 Blackboard Lecturing Croptraditional 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.

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