I've been reading a lot about economics and finance lately... Retirement planning gets a lot more complex when you run your own business! In any event, I've learned several things that made me highly skeptical about commonly held advice about retirement savings plans. In particular, I now believe that nobody should ever invest in a Roth IRA. This probably goes against what a lot of financial planners say, but I have my reasons.
Why? First, lets go over the differences:
- Traditional IRA: This is a pretty good deal... these let you purchase mutual funds of stocks and bonds, and take a tax deduction when doing so. Your money grows tax-free while its in the fund. At age 59.5, you can take money out of the fund without penalty, and you pay federal taxes on it as income.
- Roth IRA: This is a relatively new idea... identical to the Traditional IRA, except for two things. First, you cannot take a tax deduction when you put money into it. However, since you paid taxes up-front, you can take money out of the fund, and not pay taxes on it! Wow, sounds pretty good, huh?
For example... let's assume some dude named Bob Lemonjello is 30 years old, and puts in $5,000 per year into a IRA. This is the current maximum Bob can put into his account. We could assume a reasonable 8% growth over the next 30 years, yielding a total of about $610,000 by retirement. If Bob did this as a traditional IRA, that $5000 would be tax-deductible every year... saving him about $50,000 in taxes before he retires. Not bad... but when Bob takes out money from your IRA, it will be taxed... so the government will probably get $150,000 of his nest egg.
If Bob instead did this as a Roth, he wouldn't get a tax deduction, so he'd wind up paying approximately an extra $50,000 in taxes during his working years... but then he has $610,000 of tax-free cash! Woo hoo! The government can't touch a dime of that! Even better, he could have a traditional IRA, then do a rollover immediately before retirement. Sure, he'll have to pay $50,000 in back taxes when doing the roll-over, but for that $50,000 investment, he gets to avoid paying any taxes on his $610,000 nest egg!
Bwa ha ha ha ha!!! Bob is free... FREEEEEEEEEE!!!
I have one question: does anybody actually believe that the future US government would let Bob keep his Roth money, and not make him pay any taxes on it? Does anybody actually believe that the US government will never change the tax laws, and that they will sit idly, and not demand a piece of that easy money?
Reality time: Roth IRAs and Roth 401Ks are amazing tax-free investments, which have become wildly popular amongst people in every tax bracket... which is exactly why future governments will not keep their promises.
Let me remind you... until 1983, Social Security benefits were considered tax-free income... then Ronald Regan signed a law which made half the recipients pay taxes on their benefits! Bill Clinton later boosted it, so that 85% of Social Security recipients pay some kind of income tax. Face facts... When a government wants money, it will find clever ways to tax you. They will be called "Roth Withdrawal Fees," or "Conditional Rollover Fees," or just plain "We got all the guns! Gimme Gimme Gimme!"
The entire benefit of the Roth IRA rests on the belief that the government won't change the tax laws. I for one have zero faith that the government will keep their promises about the Roth. If you want the sure thing, go for a Traditional IRA. This has an immediate tax deduction at exactly the moment when you are in a high tax bracket, along with tax deferred growth. You'll pay taxes when you take money out, but in retirement you'll almost certainly be in a lower tax bracket.
So what do you think? Will the US Government keep it promises? If the tax laws change, will a Roth IRA be worse than a Traditional IRA?