Is The Roth IRA a Total Con?

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?

ROTH IRAs can be useful

I have to admit that I lean towards your conclusion that the U.S. Government can (and likely will) change the tax law, but have a couple of issues.

1) It'd be nice to see the calculations and assumptions for your estimates (NPV of investment), comparing the ROTH with the traditional IRA. First, you aren't making accurate comparisons -- $5k in a 401k is really equivalent to $5k * .75 (assuming 25% tax rate), which means that you are able to put less per year into your ROTH (post-tax dollars). This actually skews the math towards favoring the traditional.

2) 401k plans have capped contributions. If you're not nearing retirement, there is a limit of how much money you can put into your 401k (limit increases as you approach retirement age). If you max out your 401k, then you need a place to invest your other dollars -- why not try a ROTH? (In fact, most experts recommend this approach: max out your employer-matched contributions, max out your 401k limit, then put the rest of your retirement money into a ROTH IRA).

Your argument really rests on the future actions of the US Gov't not changing ROTH IRA tax laws. However, that same argument can apply to 401ks: what if the US Government decides to tax 401k earnings at a capital gains-like tax rate? (I can just hear the politicians of the future rationalizing it now: "well, only rich people contributed when they were younger. AND THEY DIDN'T PAY TAXES ON THEIR 401K! It's only *fair* that we tax their 401k earnings at 75%!") In that scenario, you're pretty screwed as well.

I like the thinking, but believe you miss that point. ROTH IRAs are really supposed to be a way to contribute towards retirement after you've maxxed out your 401k. They're complimentary, rather than contentious.

Travis Leleu

I'd wager the ROTH laws change first...

True... the future government could change tax laws for traditional IRAs just as easily... but I'd make two observations:

  • The ROTH tax laws would change first, because there's more to tax.
  • They can't rescind my past legal tax deductions.

I totally accept the fact that I have little control over how much the government will tax me in the future... nevertheless, the tax deduction and tax deferred growth are still a great idea that they aren't likely to change.

Look at history, Gov will take

There is no way the Government will ever let us keep our Roth IRA funds tax free. They will take from your Roth IRA as well as the 75%, or more, from traditional IRAs. We are well into the new era. No bad behavior can be rewarded enough, and no good behavior can be punished enough. The future is, "it is unfair that only people who saved money have any money saved".

Income Taxes

Your traditional IRA will be taxed at regular income rates which you assume will be lower in retirement. My opinion would be they would first increase income taxes and disallow future contributions to the Roth rather than make past Roth IRA contributions taxable. The bottom line is nobody knows what tax laws will be in the future so use tax diversification.

This is the only post I can

This is the only post I can agree with. I hate the ridiculous tax code and government policies more than anyone. But how could you think they would go after past contributions. Unjustified paranoia. Split your money between pre and post tax accounts and call it a day.

Roth--will taxes be higher or lower later?

I sell both traditional and Roth IRA's and they each have their place. I agree with the other comments that no matter what it is, the government will try to find a way to tax it. And diversification is vital. The main question I ask is if a person thinks they are paying higher taxes now or will they be paying more later. I'm working with someone right now who is a newly-married small business owner. Right now they are paying almost no taxes b/c of money being invested back into the business, etc. However, at retirement, the expectation is that they will be in a much higher tax bracket, and taking that income tax-free is a bigger benefit. Especially if it's in an annuity that has a guarantee of lifetime income.

Also, where are you expecting to get 8% interest? Consistently?

taxability of Roth conversion

Where are you getting paying $50,000 in "back taxes" if doing a Roth conversion from a traditional? You are assuming that the tax rate is the same at conversion time as it was when he was putting it in. If he converts the $610,000, he increased his taxable income for the year by $610,000.

Re: Roth--will taxes be higher or lower later?

"Also, where are you expecting to get 8% interest? Consistently?"

A S&P 500 index has averaged 10% growth over the last 80 years, but average is not normal. Like you said, diversification is vital. My preference is steady investment in index funds for long term growth, plus a mutual fund of municipal bonds (~5% tax free) to balance the market swings. Its not going to make me a millionaire on the stock market... but a boring, disciplined, principled portfolio is a lot less dangerous that tricking yourself into believing you are a financial genius...

"Where are you getting paying $50,000 in "back taxes" if doing a Roth conversion from a traditional? You are assuming that the tax rate is the same at conversion time as it was when he was putting it in. If he converts the $610,000, he increased his taxable income for the year by $610,000."

My error... I'll update the article. Thanks!

I hadn't considered the

I hadn't considered the government angle, but consider Roth's worse for other reasons.

What I have been noticing is that investment advisors who tout the "advantages" of the Roth over the traditional IRA always neglect to tell you a couple of things. The first thing they neglect to tell you is that you can invest the tax refund you would get from the traditional IRA outside the IRA and grow that money, as well. In the 28% bracket a $5000 IRA contribution is worth $1120, so what you really have is $6120 working on your behalf instead of the $5000 you would have in the Roth. Yes, the proceeds of the $1120 are taxable if you actually realize a profit such as dividends, distributions, royalties, interest or capital gains but if you use a buy and hold strategy and don't actually collect any cash from the investment, you can defer those taxes until you actually sell the investment and realize a gain and hopefully you'll be in a lower tax bracket by then. There is also the possibility of selling these investments at a loss at some point to offset gains elsewhere.

The other big thing I noticed is that almost nobody touting the Roth as a better investment deducts the taxes you paid along the way from your final total at the end. They tell you you'll get your contributions plus the growth back tax free, but don't mention the $1120 you paid every year in taxes on your $5000 contributions if you're in the 28% bracket. If you contribute $5000 x 40 years that's $44,800 ($1120 x 40) in taxes that you have to deduct from the value of your Roth to determine how much money you REALLY saved for retirement.

Then of course, the greedy government angle mentioned in this article comes into play.


They can't rescind my past legal tax deductions.

Being that is the case,it really makes no economic sense for the goverment to go after Roths.Roth IRA/401Ks as of 2009 make up 2% of retirement porfolio in the country,so the amount of work and backlash the goverment would put in and get,for the reward would be so small.The goverment is owed Trillions in traditional retirement accounts,all the goverment has to do with stroke of a pen is raise the income tax rate across the board on everyone,and they just gave themselves "Billlions" in added revenue..The government is going to go after where the money is and its by far not in gonna gonna go after what its still owed and the MUCH larger windfall

Yeah, but the government

Yeah, but the government will go after this money precisely because it is such a small percentage. Parts of the majority 98% will feel entitled to some proportion of the wealth that the 2% (predominately middle class) has accumulated.

I completely agree with you

If your statistics are correct, and remain relatively similar in the future, it would make perfect sense that the Government doesn't attack Roths. My Grandpa made this point to me last night, pretty much stating that the Government will look towards the majority for taxing money. Now I would say, if the number of Roths increased to 40% or more of the country, then we would have to worry, as the Government can make big bucks off taxing the accounts.

I am curious about what the stats really are for retirement savings though. What is the percentage usage of each type of retirement option? This would be between 401k, Roth 401k, IRA, Roth IRA, and company pensions among many others I'm not aware of. Being young and having opened up two retirement accounts(401k and Roth IRA), it shocks me to see how many people actually don't save for retirement.

There's an easy way to

There's an easy way to ensure this doesn't happen... Take the 10% early withdrawal penalty now and invest in a taxable account. Personally, I think they will add a capital gains tax to both the 401k and Roth IRA, hopefully, not at the same amount as income tax. We should go to a national sales tax and be done with income & capital gains taxes anyway!

More Taxes are Coming

With the unfunded liability that the Federal Government has in Social Security, Medicare and Medicaid you can bet that more taxes are coming over the next few decades. The most likely scenario is that taxes will be increased on all forms of retirement accounts and that we will have some sort of Value Added Tax (National Sales Tax) as well. The best way to pay less in taxes is to go with the sure thing now by investing in a traditional IRA or 401k and getting the tax break for sure now. You will most certainly be paying higher taxes in the future.

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