Can somebody explain why people are crazy for Roth IRAs?

[KrazyHorse]

As I understand it, the situation is as follows:

In a traditional IRA, contributions up to your annual limit are tax-exempt (assuming you are not covered by an employer's retirement plan). When you withdraw monies from the IRA in retirement you pay tax on those monies as though they were earned income.

In a Roth IRA you receive no up-front tax benefit from contributions. When, however, you withdraw monies from the Roth IRA during retirement, these monies are tax-exempt.

Let's say that somebody has an extremely steady job (pay raises keep up with inflation and no more) while miraculously the politicians don't keep changing the tax rates (brackets get tied to inflation as well). Let's also assume that this person pays a marginal federal tax rate of 27.5% and has an effective federal tax rate of 20%. Let's also say that this person wants to retire with a similar income level (inflation adjusted) that he enjoyed while working.

The person can afford to lose, say, 3000$ of his after-tax salary the first year (adjusted for inflation each following year).

If the person chooses the Roth IRA he will therefore have a first-year contribution of 3000$ (no tax benefit). With a traditional IRA his contribution would have been 3000$/(1 - 0.275) = 4138$

At retirement, the traditional IRA therefore yields an account balance 1.38 times larger than the Roth IRA. The effective tax rate the traditional IRA would have had to deal with is 20%, so the traditional IRA would have had to diminish its balance 25% faster (1/0.8) to maintain the same net income. However, it has a 38% larger balance, so it can more than deal with it.

In other words, using this analysis, if we call your current marginal tax rate Mc and your expected effective tax rate during retirement Ee, for a Roth IRA to make sense we require that Ee > Mc

If you plan to increase the cost of your lifestyle during retirement (compared to the current year) then the Roth IRA makes sense most of the time. If you are ineligible for the tax exemption on your traditional IRA contributions then a Roth IRA makes obvious sense. If, however, you are eligible for the tax exemption and you plan to have a similar (or cheaper) lifestyle during retirement as you do during the current year, then contributions to a Roth IRA and a traditional IRA are very similar in terms of net benefit. The Roth IRA certainly doesn't obviously outperform the traditional IRA as is claimed on most reference sites.

Or is there some subtlety I'm missing?

EDIT: Mistake found. Makes my point even stronger. Sorry for the ****up folks.

[Arrian]

I think the Roth is more flexible pre-retirement.

-Arrian

[KrazyHorse]

It certainly has some flexibility gains over traditional IRAs (both prior to and after retirement)

But most of the sites I've seen cream themselves claiming that virtually everybody gets many more benefits from the Roth than the traditional, which I'm not seeing. In fact, it looks as though many (if not most) people would need to pay a small premium for that flexibility...

[Aabraxan]

I'm not an accountant or a tax guy, so take that into account in the following:

The way I think of it is not in terms of tax exemption, but in terms of pre- or post-tax dollars. It's not a question of whether you pay taxes on the money, it's when. Your contribution to a traditional IRA is made with pre-tax dollars. IIUC, you pay taxes on both the initial contribution and any growth at the time of withdrawal. With a Roth IRA, your contribution is made with post-tax dollars. So it actually costs you more on the front end to make the same contribution, in terms of "actual dollar value," for lack of a better term. But when you retire, the principal and the growth are tax exempt. Part of your analysis assumes that politicians won't keep changing the tax brackets. Even if this holds true, the tax bracket of a particular taxpayer may change. As a hypothetical, let's assume that a 20-year old opens a Roth IRA and contributes his maximum allowable amount every year. He finishes college, works a couple of years, decides to get his MBA, does so and goes back to work. Assuming that his earnings increase substantially after the MBA, so will his tax bracket. What he's betting on is that tax rates, or at least his tax rate will increase, and he's sheltering some of his money against that.

[KrazyHorse]

IIUC, you pay taxes on both the initial contribution and any growth at the time of withdrawal. With a Roth IRA, your contribution is made with post-tax dollars. So it actually costs you more on the front end to make the same contribution, in terms of "actual dollar value," for lack of a better term. But when you retire, the principal and the growth are tax exempt.

Yes, but another factor you need to take into consideration is all the growth on the "free" part of the investment which is provided by the tax exemption for traditional IRA investments.

Because you can contribute more for the same up front cost, the traditional IRA allows you to "borrow" money interest free from the government for 20 or 30 years.

I agree that anybody who's in the situation of anticipating major growth in their income should look into a Roth IRA, as should anybody who's not eligible for the tax exemption. The relevant quantities are your current marginal tax rate (assuming exemption applies) and your anticipated effective tax rate, as I mentioned before.

For 20 somethings roth IRAs make sense. For 30, 40 and 50 somethings, probably not so much. In fact, most people are able to live on significantly less in their 60s than in their 40s (no kids), so the Roth IRA makes much less sense...

[Arrian]

Well, my wife and I have Roths (although I haven't put anything into mine in quite a while. I'm good about my 401(k), though).

-Arrian

[Dinner]

In traditional IRAs you would pay income tax on the whole amount you withdraw while in a Roth IRA you only pay taxs on the amount you put in. Since an IRA is a retirement vehicle where people put money and invest it for decades (a 25 year old would keep the money in the IRA until 65; a period of 40 years) so the idea of the Roth is that the amount of money people are taking out 40 years down the line is much larger then the amount going in. Thus it is better to pay taxes now on the small amount and get the big amount tax free instead of vis versa.

[KrazyHorse]

401k's are similar to traditonal IRAs in their tax effects. They're better than that, of course, because of employer matching.

I have a friend who works at a company where they match 200%

Crazy.

[KrazyHorse]

Originally posted by Oerdin
In traditional IRAs you would pay income tax on the whole amount you withdraw while in a Roth IRA you only pay taxs on the amount you put in. Since an IRA is a retirement vehicle where people put money and invest it for decades (a 25 year old would keep the money in the IRA until 65; a period of 40 years) so the idea of the Roth is that the amount of money people are taking out 40 years down the line is much larger then the amount going in. Thus it is better to pay taxes now on the small amount and get the big amount tax free instead of vis versa.

That's an overly simplified analysis, as I've already mentioned.

A smaller tax benefit now is worth as much as a bigger tax benefit later because of the growth of your contributions.

[Ogie Oglethorpe]

Funny every financial advisor I have ever dealt with says the same things. Max your 401K, or conventional IRA then look to Roths.

Roth's suck by the way as the salary/income cap is too low to be of use. I use the 529's in order to sock away funds for kids education instead.

[KrazyHorse]

If you want to be crazy about saving for retirement, however, the Roth IRA provides an effectively higher ceiling for IRA contributions. If the ceiling is 4000$ and I am willing to part with 3800$ after-tax income then contributing to a traditional IRA would leave me out in the cold for 662$ (I would have to put this much in a non-IRA account and suffer the tax consequences). A Roth IRA would take the whole amount.

[KrazyHorse]

401k is definitely the way to go (assuming your employer does any sort of reasonable matching). That's just free money...

[DanS]

The Roth IRA is very good for me, in part because of the diversification of retirement options. I don't know what I want with retirement yet (or whether I will retire).

I have a 401(k), which acts like a traditional IRA. I max that out. I also max out my Roth. (I'm an extreme saver.) So that gives me the flexibility to make what I want when I want to make it.

The Roth IRA's flexibility is valuable. It's sheltered from bankruptcy, f.e. It has a low minimum retirement age. It also gives me an excuse when poor relatives ask to borrow.

As far as OP goes, I agree that there are a lot of considerations for which program to choose. It's a law that guarantees full employment for investment advisors.

[KrazyHorse]

a) How is the Roth IRA's bankruptcy shelter any different than a traditional IRA's?

b) I certainly don't think that Roth IRAs are a ridiculous waste of money. But every website I read seems to fall over itself singing its praises. They make simplistic statements about the Roth IRA being better for almost everybody

[Japher]

401k's are similar to traditonal IRAs in their tax effects. They're better than that, of course, because of employer matching.

They're also better in that they have a $14k limit where an IRA only has a $4k limit.

I contribute to my 401k, my cheapass employeer doesn't match but at least I have a savings there, and I have a Roth IRA. I figure if I want up front tax savings I contribute more to the 401k and if I want back end savings I contribute to my IRA.

One thing to consider is that when you retire and start pulling from these accounts, you tax basis will most likeyl be lower than it is now.