Why do people think Roth IRA/401(k) accounts are so great?
October 7, 2019 11:40 AM   Subscribe

Am I crazy to think that most of the articles that promote Roth IRA/401(k) accounts over the traditional alternative are wrong?

As an example, this one on moneyunder30.com compares Roth vs. traditional by showing both the Roth and the 401(k) getting taxed at 20%. But that's wrong. The traditional gets taxed at your overall rate, which is way lower, typically, than your marginal rate. My average rate is almost half my marginal.

Or this calculator at StandardAndPoors.com. It treats the contribution amount as the same for both options. But people save based on the after-tax impact on consumption, right? $19K into the Roth is going to represent over $30K in pre-tax income if you're in a 38% marginal bracket, no? That's the fair comparison, in my my mind. If you assume your rates aren't going to change, the Roth is only better if you're comparing it to an after-tax account with no tax advantages, as the calculator is. But if you had tax savings and weren't maxing your contribution, wouldn't you just use them to fund a bigger tax-deferred contribution?

If you're going to be in a much higher tax bracket in retirement (for personal or political reasons), I totally see why you'd prefer the Roth. Similarly, if you can afford to max out your contribution, you'd obviously prefer to have $19K in the Roth compared with $19K in a traditional. But most of the time (88% of the time, according to Motley Fool) that's not the case. And if you did have a big drop in your income, the traditional would protect you to a certain extent. What am I missing here?
posted by wnissen to Work & Money (16 answers total) 8 users marked this as a favorite
Best answer: As it was explained to me the other day, you're correct that the articles that promote Roth IRAs over the more traditional ones really only apply if you're in a much higher tax bracket, and that for most of us that doesn't apply.

I suspect the people who promote the Roth assume they're going to be in a higher tax bracket and assume you are as well....
posted by EmpressCallipygos at 11:52 AM on October 7, 2019

Best answer: One thing I notice is that $19k is the cap for annual contributions. So, if you were limited in how much you can contribute to a regular 401k and would contribute more except for the cap, this is a way to get more in (though you should account for what else that money would be doing if not invested).

I'm also not sure what you mean by "taxed at your overall rate". I thought withdrawals were just another form of income, so they would be taxed at the marginal rate just like any other income you have at that age in non-retirement investment accounts.

Tl;dr: it probably makes sense if you're rich enough, but may not make sense for people who are actually making tradeoffs with their money rather than just trying to optimize their investment portfolio.
posted by Lady Li at 11:58 AM on October 7, 2019

Best answer: If you max out your tax-deferred contributions, a Roth makes sense. Or if, for whatever reason, you expect your taxes to be higher when you retire. Federal Income Tax is quite low right now. There's a ton of retirement and investing advice, and most of it is designed to sell you something, so you are right to be very wary.
posted by theora55 at 12:00 PM on October 7, 2019

Best answer: We had a question like this but for IRAs last week. The reasons you might go with Roth 401k are similar (although the rules around early distribution directly from a Roth 401ks are less generous than from a Roth IRA if I understand correctly).
posted by caek at 12:08 PM on October 7, 2019 [1 favorite]

Best answer: While I came down pretty hard on Roths in that previous question, for people who are more middle-income, there may be some value in hedging your bets a bit on what future tax rates will look like. (Also, there is an income range where, if you have a retirement plan at work (whether or not you take advantage of it), you can only make nondeductible contributions to a traditional IRA [huge accounting pain, loses key benefit] but you can still contribute to a Roth. Under those circumstances, I'd go for the Roth, b/c the tax treatment is basically the same but the Roth is simpler paperwork and has greater flexibility in other respects. It's about $70K-$110K for a singleton [please don't rely on that being exact].)
posted by praemunire at 12:26 PM on October 7, 2019 [2 favorites]

Best answer: For me, I'm on a Roth 401(k) because I used a loan against my traditional 401(k) to put down a down payment on a house, then got laid off from the job, which meant a huge tax bill, which meant a huge amount of money I suddenly owed (plus my living expenses not being covered by a job at the time I was looking for my next gig), which led to me losing the house, which meant more money owed to a LOT of people, which meant I spent the next 10 years digging myself out of the worst financial situation I've ever been in.

This is also the reason I don't use credit for anything anymore, including cars and won't ever buy another house.

That's kind of intensely personal, but it is a reason. The contributions you make are yours to withdraw (not your employer contributions), which can be at least a bit of an anchor for you for scary financial situations you can't anticipate in the future.
posted by xingcat at 12:32 PM on October 7, 2019 [2 favorites]

Best answer: If I understand it right, I can withdraw my IRA tax-free and penalty free right now. Most people won't need to do that, but I'm planning to drop a large chunk of change on an intense/expensive bootcamp and that might be the capital I need to make it happen right this second. Traditional ones have tax due and a very large penalty % if you withdraw it.
posted by OnTheLastCastle at 12:38 PM on October 7, 2019 [1 favorite]

Best answer: I can withdraw my [Roth] IRA tax-free and penalty free right now

Assuming you're not of retirement age or disabled or using it for a first-time house purchase, only your contributions, not the earnings on those contributions. (Contributions are deemed to be withdrawn first.)
posted by praemunire at 12:49 PM on October 7, 2019

Response by poster: Since everyone pays the same rate of tax on the first, e.g. $9700 in income (10%), the overall, average, or effective (I've seen all three terms) rate is less than the marginal rate paid on the last dollar of income. So a single person making 100,000 is going to be in the 24% bracket, with a 24% marginal rate, but ends up paying only 18% overall in tax. This gets more extreme if you have large deductions.

I'm assuming that the tax-deferred retirement account is your only source of income in retirement, so when you withdraw from it, assuming tax rates and your consumption haven't changed, you'll be paying at your average rate, if that makes sense.
posted by wnissen at 12:54 PM on October 7, 2019

I concur with OP.

Also, a future VAT in the US will effectively be an end run around the tax benefit of the Roth.
posted by LoveHam at 1:13 PM on October 7, 2019 [1 favorite]

Best answer: I'm assuming that the tax-deferred retirement account is your only source of income in retirement

This is essentially the same thing as saying that your taxable income will be lower in retirement, which of course is one of the primary things that any roth vs traditional advice is telling you to take into consideration.

I would argue that not all folks would make the assumption that that's going to be their only source of income - for instance, they may also have taxable investments, or they may expect to still be working in their "retirement" years. That, or they may expect to take bigger distributions in retirement than they have in taxable income today.

None of this means that the retirement income is somehow taxed at your average rate, either. Regardless of how much you have or don't have, each additional dollar you pull out of a traditional account in retirement is being taxed at your marginal rate. You can argue that the marginal rate will be lower, and in some cases that will be true, but still, not in all.
posted by mosst at 1:22 PM on October 7, 2019 [2 favorites]

Best answer: I have a very strange occupation (political campaigns) whereby I basically make money every two years instead of every year. A Roth is handy for me on the off years when I essentially make no money net (I also have a traditional which of course is more important). But yeah my life is weird and what you say makes sense.
posted by Ignatius J. Reilly at 3:07 PM on October 7, 2019

Best answer: You're not wrong/crazy. The only people whose situations will come out extremely in favor of Roth are people who have large pensions or very large traditional 401(k) balances in addition to large IRA balances. And if you end up with too much in Traditional and wish you had put more in Roth, you can always convert some of your Traditional IRA to Roth (not true in reverse). The article that got me rethinking the common wisdom on Roth vs. Traditional IRAs: https://www.gocurrycracker.com/roth-sucks/
posted by matcha action at 3:24 PM on October 7, 2019 [1 favorite]

Best answer: I'm assuming that the tax-deferred retirement account is your only source of income in retirement

Why would you assume that? Most people have income from taxable savings and investment accounts and also collect social security benefits which are also taxable with certain thresholds. Perhaps you will have other income as well in retirement such as rental income. Who knows?

It is very hard to predict what your tax rate will be decades in the future which is why many recommend hedging your bet by putting some into Roth and some into traditional. About all you can safely say is that the higher your current marginal tax rate, the better the odds of taking a current deduction.
posted by JackFlash at 4:39 PM on October 7, 2019 [1 favorite]

Best answer: Reasons to use Roth IRAs (not 401ks)
1) you think your taxes will be higher in the future - either from more income or because you hope sanity will return and marginal rates will be increased from their current historical low points
2) you might need the money before you retire - Roth IRA contributions can be withdrawn at no penalty after 5 years
3) you want to own "tax inefficient" assets like REITs
4) you don't want to have to spend as much effort managing your taxable income in retirement, no Required Minimum Distributions and any money you need you just take out of the Roth without having to worry about the tax implications
5) you want "tax diversification" because you're not sure one way or the other about your future taxable income

Some of those may apply to Roth 401ks as well (I am almost certain #2 does not apply)
posted by Nec_variat_lux_fracta_colorem at 7:51 AM on October 8, 2019

Response by poster: Matcha, that is a very helpful article. There are a ton of factors to consider, and it really depends a lot on individual circumstances. It still seems like most people are better off with traditional, but there are also a lot who should choose the Roth. Thanks, all.
posted by wnissen at 12:46 PM on November 6, 2019

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