Why Roth IRAs are Overhyped

Most sources heap lots of praise on Roth IRAs, usually by hyper-focusing on the appealing idea of not paying taxes when you withdraw your money in the future. I'll play devil's advocate and bring down the hype so we can look at the benefits of the Roth IRA objectively.

Note: this article was originally published at the end of 2016. It has been updated for the 2018 tax law.

IS A ROTH IRA REALLY ALWAYS BEST?

Since Roth IRAs came out in 1997, they've generally been touted as the go-to retirement planning account. Articles and blogs galore put Roth IRAs up on a magical pedestal that no other retirement accounts can touch, usually by hyper-focusing on the appealing idea of not paying taxes when you withdraw your money in the future.

There is no such thing as a one-size-fits-all, "best" retirement vehicle. And yet, the Roth IRA is treated like the holy grail of personal finance. It can do no wrong.

Because of how it's usually presented, far too many people make Roth IRA contributions as a rule of thumb - forgetting that a rule of thumb, by definition, is what you follow when you don't know what's the best choice to make.

Please don't mistake me for an anti-Roth IRA guy. They're awesome. They have a lot of flexibility and advantages that must be considered carefully. They are appropriate for a lot of situations, and very may well be the best option for you.

But here, I'll play devil's advocate and bring down the hype so we can look at the benefits of the Roth IRA objectively. Let me go over a few reasons why Roth IRAs are often an overstated as a rule of thumb in the media, which is what most people rely on for their personal financial planning rather than a fiduciary financial advisor (someone who is legally bound to act in your best interest at all times - which is not all advisors).

A QUICK ROUNDUP OF THE TRADITIONAL vs. ROTH DISCUSSION

If you're not clear on the general difference between Traditional and Roth IRAs, I'd recommend you get familiar with it as soon as possible (here's a good primer). I'm not going into the details here, and will assume that you know the basic differences between them, as well as the difference between gross income, AGI, and taxable income.

The general analysis for the Traditional vs. Roth debate starts with the following ideology:

• If you think your tax rate will be lower in retirement than it is during your working years, then contribute to a Traditional IRA. You won't get taxed on your contributions now when rates are higher, and you'll get to pay taxes at a lower rate when you withdraw money in the future.
  

• If you think your tax rate will be higher in retirement than it is during your working years, contribute to a Roth IRA. You will pay taxes now at a lower tax rate, and won't have to pay taxes later when rates are higher.

What affects your tax rate in retirement? Your income level, your tax filing status, your standard of living, and future tax law. You have control over the first three factors, and there is some degree of predictability there. The last one, future tax law, not so much.

In a perfect world, the marginal tax rate system we have now would stay the same permanently. This would make it easy to inflation-adjust all our planning assumptions each year and figure out what our tax rates will be in retirement, based on our desired standard of living. But alas, the future of tax law is uncertain.

YOU COULD END UP WITH MORE MONEY IN A TRADITIONAL IRA, EVEN AFTER YOU PAY TAXES

The big problem in self-diagnosing the decision to make pre-tax (Traditional) or post-tax (Roth) contributions is that most people don't really have a great understanding of how to assess these factors correctly for themselves. So, they read advice or information promoting Roth IRAs without recognizing that the support for doing so may not apply to them.

Here's how most people mess up their reasoning with mental shortcuts. They read something that says "if you are in a lower tax bracket, like 10% or 12%, you should do a Roth IRA, because the probability of paying lower taxes in the future is minimal."

I present my rebuttal: who cares if you pay more taxes in the future then you would now, if you still end up with a higher amount of money after taxes?

Here's a very simplified example to get my point across.

Let's take two different people, Adam and Ben. Each plans to contribute $300/month toward retirement. We'll look at a 35-year timeline and assume they get a 7% portfolio return. They are both in the 12% marginal tax bracket.

• Adam chooses the Roth IRA. He gets no income tax deduction for contributions, but after 35 years has amassed $540,316. Not too shabby. He doesn't have to worry about being taxed on any of that amount.

• Ben chooses the Traditional IRA. His $3,600 annual contribution saves him $432 on taxes ($3,600 x 12% marginal tax rate) each year, so starting in Year 2, he adds that tax savings to his contributions. His final portfolio value? $595,724.

Ben has $55,408 more after 35 years (for only $14,688 more in contributions - $432 every year for 34 years).

If both of them need to withdraw $30,000 per year, Adam can just draw that amount out tax free, while Ben has to pull out more than that so he can pay taxes and still have $30,000 left over.

Here's where math gets misapplied. Most people forecast the 12% tax bracket and think, "that means Ben has to withdraw an extra $3,600 to pay federal income taxes!" ($30,000 x 12% marginal rate).

Oopsy. That's erroneous thinking. How so?

When you are contributing to a pre-tax retirement account, you are saving on taxes at your marginal rate - the highest tax rate applied to part of your money. But when you withdraw in retirement, you are paying taxes at your effective rate - your total taxes paid divided by the income withdrawn. Part of your income is NOT taxed because of above-the-line deductions and your standard/itemized deductions, and then part of it is only taxed at 10%, and only then do you pay 12% taxes on a portion of your income.

If Ben is married, the first $24,000 of income withdrawn from his Traditional IRA is not taxed, because of the standard deduction. The remaining $6,000 is only going to be taxed at 10%, or $600. So he only has to withdraw $30,600.

Adam had to withdraw 5.55% of his portfolio to get $30,000, while Ben only had to withdraw 5.04% of his portfolio. Additionally, after Year 1 in retirement Ben still has $585,380 left in his portfolio to still get some growth, while Adam only has $510,316.

Whose money do you think is going to last longer?

Obviously, this is an extremely simplified situation that isolated Traditional vs. Roth contributions and factored out Social Security, withdrawals from other retirement accounts, and a bunch of other factors too.

The idea I'm trying to uncover for you, though, is that if you are smart enough to actually invest the tax savings you get from making pre-tax contributions, you can supercharge your retirement savings. So much, in fact, that even after taxes, you could end up with more money than if you just did a Roth IRA.

Even if you didn't invest the tax savings you got each year from pre-tax contributions, a pre-tax account could still leave you with more money due to this difference in marginal vs. effective tax rates.

In summary, I think the number one reason that Roth IRAs are overhyped is that people attempt to DIY their current vs. future tax situation - which is the most important consideration in the Traditional vs. Roth decision -  but do so inaccurately, and draw the wrong conclusion.

I guess if being left with more money is secondary in importance to paying less taxes, this idea might not jive with you. But if your primary goal is to have more money, 

Here are a couple other ways benefits of the Roth IRA get exaggerated in .

THE MASS MEDIA CAN BE SKEWED TOWARD HIGH-INCOME PEOPLE

First off, the financial media is heavily influenced by input from financial advisors, who work mostly with high-income people. And when you're higher income, the benefits of a Roth IRA are more straightforward.

Here's how Roth IRAs get overhyped to the general public through media. Most journalists and writers at well-known publications aren't actually financial experts. However, they're sharp people who are adept at binge-researching a topic over a week and spitting out a well-organized article that is super simple. Because they're not experts, they rely heavily on interviews and media requests from financial advisors to get the meat of their content written. 

Most financial advisors work with the highest 25% net worth and income-earning households in society, and thus, their off-the-cuff advice can tend to lean toward strategies that are appropriate for those they serve. Inadvertently, the mass media often publishes this advice without an awareness of the caveats that apply to the mass middle-income part of society. 

If you are high income, this is how the Traditional vs. Roth decision becomes different for you (these are 2021 figures):

• If you are single, you start losing your ability to deduct Traditional IRA contributions once your AGI hits $66,000. But you can still contribute the max to a Roth IRA as long as your modified AGI is below $125,000.
  

• If you are married filing jointly, you may start losing your ability to deduct Traditional IRA contributions once your AGI hits $105,000, if you have a retirement plan offered through your employer (if you don’t have a retirement plan offered through your employer, you don’t start losing your ability to deduct Traditional IRA contributions until your AGI hits $198,000). But you can still contribute the max to a Roth IRA as long as your modified AGI is below $198,000.

As you can see, if you’re a high-income earner it’s possible that you lose the benefit of deducting pre-tax contributions to a Traditional IRA anyway, so a Roth IRA may be the only way to go after 401(k) contributions.

The higher your income level, the more concerned you are about reducing taxes because you start paying taxes out the nose.

In fact, just the thought of tax rates going even higher in the future really concerns high-income people, especially if they plan on living in retirement with an equally high standard of living. From this perspective, a Roth IRA sounds great because you never have to worry again about paying taxes on the back-end.

THE FINANCIAL SERVICES INDUSTRY HAS OTHER INCENTIVES TO PROMOTE ROTH IRAs

The other incentive financial advisors have to promote Roth IRAs is that most of them make their money via Assets Under Management (AUM). This means that their fee is paid by a percentage of the investments they manage for you.

The industry norm is 1%, and in many cases, higher. This means if they manage $100,000 for you, they take $1,000 in fees annually. As your managed assets grow, so does their fee, almost always without a cap limit.

Oh, and if it's an advisor that also takes commissions, he/she may be taking a 5-6% slice of your money off the top just to open the account.

It seems that most people I talk to who have met with a "financial advisor", have, unfortunately, been told with absolute certainty that the best thing for them to do after contributing to a 401(k) for full employer match is to make any further retirement savings in a Roth IRA...provided by the advisor, of course.

But in many cases, the best thing for them personally would have been to continue additional 401(k) contributions, especially if they're eligible for the Earned Income Credit or have good reasons to want to lower their AGI.

For more information on the difference between most advisors and fee-only financial planners, see this FAQ page.

FEAR OF HIGHER TAXES

When describing this current vs. future tax rates discussion, some good old-fashioned fear-mongering is often thrown in by financial services professionals to make the Roth IRA sound like a no-brainer. 

It frequently sounds like this: "The federal government is surely going to have to raise income taxes due to the national debt. You might as well contribute to a Roth IRA and pay taxes now, so you don't have to pay taxes in the future when rates will have skyrocketed."

I give it as my opinion that if Congress feels the need to tax us higher on our retirement accounts in the future to increase revenue, there's nothing stopping them from making Roth IRA withdrawals partially taxable too.

Most likely, if a law making Roth IRA withdrawals taxable was passed, it would do so by treating a part of the distribution as a return of capital and tax your earnings or growth only (this is how certain annuities are taxed).

In addition to that, any large-scale changes in our tax system are either going to be tiered in over time or we'll given enough advance notice that if you are doing a good job with your financial planning, there will be ways to adjust for the upcoming effect. This can be done with systematic Roth conversions or changing the proportion of future contributions made to different investment accounts. 

AHH SO WHAT SHOULD I DO?

I hope that I've brought a more balanced and thoughtful discussion to whether a Roth IRA is really best for you. At the very least, you should be more aware of why the benefits of a Roth IRA can be overstated.

You'll hear me say again and again that the best financial decisions for you cannot be found by following rules of thumb or general advice. You've got to be able to run information through the filters of your goals, your life circumstances, your current and future income level and tax rates, your savings rate, your risk tolerance, and a bunch of other things to determine what's best for you.

Take every piece of advice with a grain of salt if you don't know how to assess whether it applies to you.

Like I've shown, the seemingly small decisions you make with regards to your investments and retirement (Traditional vs. Roth) have a dramatic effect on your long-term outcome. If you think you'd like a comprehensive investment and retirement planning meeting, don't hesitate to reach out! As a sworn fiduciary, I pledge and am legally obligated to always act in your best interest.