If you read other personal finance blogs, you probably noticed that yesterday was the Roth IRA Movement — a day where many personal finance bloggers got together (at the suggestion of Jeff Rose from Good Financial Cents) to promote the Roth IRA to young investors.
Most of the articles I saw were well-written, and I think it’s great to encourage investors to save via tax-advantaged accounts.
That said, I also ran across a few poorly-reasoned arguments in favor of the Roth as compared to tax-deferred savings vehicles, such as a 401(k) or traditional IRA. (I’m not naming names, because my desire is not to pick on anyone but rather to challenge ideas.)
I thought it might be beneficial to sort through some of the good reasons to contribute to a Roth and some of the poor reasons to contribute to a Roth.
Good Reasons to Contribute to a Roth IRA
In many cases, a Roth IRA is the right choice. For example, Roth IRA contributions are likely preferable to saving via tax-deferred accounts if:
- You think there’s a meaningful chance that you’ll have to spend the money in the not-so-distant future. (Remember, Roth IRA contributions can be withdrawn free from tax and free from penalty at any time.)
- You think your marginal tax rate will be higher in retirement than it is now.
- You think your marginal tax rate will be approximately the same in retirement as it is now, and you want to take advantage of the fact that Roth IRAs do not have required minimum distributions (RMDs).
- You have no idea how your tax bracket in retirement will compare to your current tax bracket, so you’re “tax diversifying” by using some Roth savings and some tax-deferred savings.
- You’ve maxed out your 401(k) and you earn too much to be able to make deductible contributions to a traditional IRA.
- The investment options in your 401(k) are terrible, and you’ve already contributed enough to get the maximum employer match.
Not-So-Good Reasons to Contribute to a Roth IRA
There are also, however, some commonly-cited yet unconvincing arguments for contributing to a Roth IRA, including:
- “Tax-free” is better than “tax-deferred.” It certainly sounds better. But the commutative property of multiplication tells us that paying, for example, a 25% tax now leaves you with the same after-tax amount as paying a 25% tax later. So unless you expect your marginal tax rate to increase between now and retirement, “tax-free” (via a Roth) is no better than “tax-deferred.”
- You’ll pay less tax with a Roth than with tax-deferred savings. This is usually true, but that’s irrelevant. All that matters is how much you have left after paying the tax. And, as explained above, if the tax rate is the same, it doesn’t matter whether you pay it now or later.
- Tax rates will increase in the future. If this is true, it is relevant, but it’s not a sufficient reason to prefer Roth contributions to tax-deferred contributions. Even if legislative tax rates go up, your marginal tax rate could be lower in retirement than it is now if your taxable income goes down dramatically when you retire — as is the case for many people.
Regarding the topic of the commutative property of multiplication and how it applies to the Roth vs. traditional decision, I’ll leave you with an allegorical explanation via one of my favorite blogs (the now dormant Bad Money Advice):
“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.”
Update: Bogleheads author Taylor Larimore wrote in to mention an additional advantage of the traditional IRA:
In a marginal situation, the Traditional may be better. By investing in a traditional IRA the investor gets a tax deduction. She may also be able to later convert to a Roth with little or no tax during the period of low/no income after retiring and before the taxable income from Social Security or IRA RMDs begins. The result is a deductible IRA with tax-free accumulation that is tax-free at withdrawal.