Roth IRAs

The Tax Reform Act of 1998 established a new style individual retirement account (IRA) known as a “Roth IRA.”  Named after Senator Roth, then the Chairman of the United States Senate Finance Committee, its operation contrasted significantly with the long-standing conventional IRA.  The conventional IRA offers an adjustment to income for the money contributed to the account; allows the funds to grow in value without incurring current income taxes; and when the funds are withdrawn, they are subject to income taxation at ordinary tax rates.  In addition, the withdrawal from the account has to start no later than the April 1 following the date when the account owner becomes    70 ½.  The Roth IRA, on the other hand, provides no tax break for contributions; also allows the funds to grow free from current income taxes; but when the funds are withdrawn they are not subject to income taxes.  In addition, there is no mandatory requirement ever to withdraw the funds from a Roth IRA.

There was a great deal of activity in this area when Roth IRAs were established, and the legislation allowed (promoted, really) the conversion of a conventional IRA to a Roth IRA under certain circumstances.  Essentially, if the taxpayer’s adjusted gross income (AGI) was below a certain threshold AND the taxpayer was willing to pay income taxes owed on the conventional IRA, the retirement account could be converted to Roth status.  Articles in the financial press trumpeted that Roth IRAs were superior to conventional IRAs.  Individuals seeking to establish a new IRA were routinely advised to shun the conventional IRA in favor of a Roth IRA.  Many individuals with conventional IRAs were actually advised to “bite the bullet,” and pay income taxes NOW so they could convert a conventional IRA to a Roth IRA and get tax-free income LATER.  Subsequent sessions of the United States Congress even established “Roth 401(k)s” in contrast to conventional 401(k) retirement accounts, and “Roth 403(b)s” for taxpayers eligible for conventional 403(b) retirement accounts.

However, is a retirement account in which the taxpayer does not get an upfront tax break, but can withdraw the funds on an income tax-free basis, really a better deal than a retirement account in which the taxpayer gets an upfront tax break but must pay income taxes at a later date?  If an “advisor” could actually advocate that a taxpayer voluntarily pay taxes in order to get the advantage of the Roth IRA’s income tax free distributions down the road, the Roth IRA has to be a MUCH better deal, doesn’t it?

The reality is that such is rarely the case. Nevertheless, for some taxpayers a Roth IRA is a better choice.  A lot of the hype surrounding the introduction of Roth IRAs was predicated upon either improper analyses, or perhaps just plain bad advice.  For example, the next paragraph asserts a simple arithmetic proposition about conventional IRA versus Roth IRA taxation.   But, I have seen so-called analyses which maintain, over the long term, a Roth style account will yield a greater after tax return than a conventional retirement account.  These arguments rest upon untenable assumptions, such as differing investment performance, or changing tax rates.  Another misleading consideration is the advocacy that because the funds never need to be withdrawn from a Roth IRA, it is somehow a superior investment vehicle.  However, these are accounts enacted to supplement retirement income.  If the account holder is never going to spend the funds in the account during retirement, there are probably better planning options than letting those funds sit forever in a Roth IRA.  

The proper way to answer the question is first to address the conventional IRA’s upfront tax break (which is an adjustment to income) versus the Roth IRA’s lack of an upfront tax incentive.  Whatever is contributed to a Roth IRA is on an after tax basis.  So, if the conventional IRA account holder puts $2,000 into her account, the Roth IRA account holder, assuming a 28 percent tax rate, must earn $2,778 to have $2,000 after taxes to make the same contribution as was made by the conventional IRA account holder.  If it is further assumed that each account enjoys the same investment performance over a given time period (why should anything other than this be assumed?), AND the account holder’s tax bracket in retirement is the same 28 percent, then it does not matter which account is chosen, because the 28 percent to be paid by the conventional IRA account holder upon the withdrawal of the funds negates the upfront tax advantage received and both account holders, after withdrawal and taxes, have exactly the same amount of money.  Stated in another fashion:  If one earns x dollars, pays 28% in income taxes, and then invests the remaining .72x dollars at the same rate of return for a specified term (that is what happens in a Roth IRA), the account value at the end of that term is identical to the value of an account established by investing the entire x at the same return for the same period, but then being forced to pay 28% income tax on the resulting sum (that is what happens in a conventional IRA).

But, what if the taxpayer’s tax rate in retirement is different than when she is contributing to the account?  Is the result different?  Yes, but the typical Roth IRA versus conventional IRA analysis one sees assumes the tax rates remain the same in retirement, or will actually increase.  However, the reality is that very few retirees pay the same rate of taxes in retirement that they did while working.  Furthermore, and more importantly, the data utilized to make most analyses fail to account for the difference between effective tax rates and marginal tax rates.   The difference between the taxpayer’s effective and marginal tax rates boosts the tax benefit obtained when the conventional IRA taxpayer makes her contributions to the account.

Consider a couple we’ll call Dick and Jane, who had $250,000 in taxable income in 2008.  The marginal federal income tax bracket for this level of income on a joint return was 33%.  One might think their federal income tax bill should have been $82,500, as that is 33% of $250.000.  However, the actual amount of federal income taxes this couple owed was $61,229; because the federal tax is graduated, taxing lower incomes at lower percentage rates.  Their $61,229 tax bill was actually "only" 24% of $250,000.  Therefore, their effective rate of taxation was only 24%, while their marginal rate of taxation was 33%.

This marginal vs. effective consideration is critical in the Roth IRA versus conventional IRA analysis, because whenever the effective tax rate on a withdrawal during retirement is lower than the marginal tax rate applied to the contributions made when working, a conventional IRA, or 401(k), or 403(b), will have a superior after-tax result than the corresponding Roth equivalent.  In the real world, Dick and Jane are not likely to pay 33% (their marginal income tax bracket when contributions were made) on distributions from the retirement account.  Hardly any taxpayer in the 33% marginal tax bracket today is going to pay an effective tax rate of 33% upon retiring.   As long as we have a progressive tax system with inflation-adjusted brackets, such is almost impossible.

Reading the above, one might think no one is a candidate for the Roth style retirement accounts.  However, people with very large amounts of taxable income rise further and further into the top marginal bracket of the federal tax system, currently 35%.  When more of a taxpayer’s income is subject to the top marginal rate, the effective rate of taxation begins to converge with the marginal rate.  It actually is possible (although  unlikely) for the taxpayer’s effective rate of taxation in retirement to be greater than the taxpayer’s marginal rate of taxation when the retirement contributions were made.  Such would occur if the taxpayer has significant wealth from other sources and/or a retirement account that grew tremendously in value over a long period.

The wealthy individual in the above paragraph is a candidate for a Roth style retirement account.  So, too, is the 20-year-old wage earner with taxable income less than the standard deduction, because this wage earner is in the zero income tax bracket.  He gets no tax benefit from contributing to a regular IRA, so the Roth style account is obviously the better choice.  Likewise, a 65-year-old who has taxable income less than the standard deduction is also in the zero tax bracket, so she too would favor a Roth style account.  Therefore, age is essentially irrelevant in this discussion; it is only the relationship between the taxpayer’s marginal tax rate when the contributions are made to the taxpayer’s effective tax rate when the funds are withdrawn that matters.  Nevertheless, “analyses” asserting that the age of the taxpayer, or the time period of the investment, are important considerations in the “conventional IRA vs. Roth IRA” debate abound.

Some simple observations for which style of account is better do emerge:

1.  A conventional IRA (or 401(k) or 403(b)) should be favored if the effective tax rate on the retirement distribution will be lower than the taxpayer’s current marginal tax bracket.  Most taxpayers today in the middle range of the marginal brackets (15 to 33 percent) should satisfy the dictates listed above and therefore should favor the conventional accounts.

2.  However, taxpayers well into the top marginal bracket (currently 35 percent) should consider Roth style accounts.

3.  So should individuals who pay no income taxes.  Because there is no upfront tax break to be gained, the Roth style accounts should be used.

4.  Taxpayers living in states with high state income taxes should favor conventional IRAs, as should anyone subject to the Alternative Minimum Tax.  The reason for this is that taxpayers in these states face crushing marginal rates.  If our hypothetical Dick and Jane lived in California in 2008, their marginal rate on $250,000 of taxable income would be 44.3% -- 35% at the federal level and 9.3% at the state level.  Although possible, it is difficult to imagine that their retirement distributions would be effectively taxed at anything close to a 44.3% rate.

5.  Remember, directly contrary to most Roth style retirement account “hype,” the age of the taxpayer and the length of planning horizon are irrelevant.  The only important factor is the expected effective tax rate relative to the current marginal tax rate.