Why I prefer traditional IRAs to Roths (part 2)

June 5, 2014

Last time I explained the difference between pre-tax and after-tax contributions to retirement accounts. (These accounts are often called traditional IRAs and 401ks for pre-tax accounts, and Roth IRAs/401ks for after-tax accounts.) I also explained that if you’ve got a fixed amount of money to invest, and it’s less than the maximum amount you can contribute to your retirement account, then you’re typically going to be better off putting more money into a pre-tax account than an after-tax account. (If you’re not already fairly familiar with pre-tax and after-tax retirement accounts, as well as the concept of marginal tax rate vs. effective tax rate, it may be good to go back and read the first post.)

This time I want to look at the situation where the amount you’ve earned and have available to put in a retirement account exceeds the limits of what you’re allowed to contribute by law. For example, 401k’s limit most people to about $18,000 each year (adjusts for inflation annually) in contributions – but to make the math easy we’ll say the limit is $20,000. So what if you have $25,000 more income than you need and want to invest it?

In this case, the comparison isn’t as clear cut. If you put $20,000 into a pre-tax account, then you don’t pay tax on that $20,000, but you will pay tax on the other $5,000. For simplicity, let’s assume a marginal tax rate of 20%, meaning you pay $1,000 in tax and have $4,000 left to invest outside of any type of retirement account. We’ll call this Scenario 1.

If you instead put $20,000 into an after-tax account, then you pay tax on the full $25,000. Assuming the same 20% marginal tax rate, that means the remaining $5,000 all went to taxes. So you’ve got $20,000 in an after-tax account, and everything else went to taxes. We’ll call this Scenario 2.

So let’s follow what happens over the next 30 years if we assume your portfolio grows to 10 times its original value, and then everything is liquidated.

Scenario 1: You start with $20,000 in a retirement account and $4,000 in an ordinary investment account with no tax advantages. Over 30 years, the $20,000 becomes $200,000. The $4,000 becomes…well, that’s where things get tricky. Because taxes might have eaten away at some of the returns, you probably won’t get the same return on investment as you did with the money in the retirement account. So you’ve got $200,000 in a retirement account that you’ll have to pay tax on when you withdraw it. You also have whatever the $4,000 outside the retirement grew to after accounting for taxes paid along the way, or any growth you gave up for more tax-favored assets. (Some assets, most notably municipal bonds, provide largely tax-free earnings…but you typically pay for that tax status with lower yields on the investment.)

Summary: At the end of 30 years, you have $200,000 minus the tax you pay to withdraw the $200,000, plus $40,000 minus anything you lost along the way to either taxes or foregone gain in tax-favored investments.

Scenario 2: You start with $20,000 in a retirement account. It grows to $200,000. There’s no tax to withdraw it, so you have $200,000 at the end of 30 years.

Summary: At the end of 30 years, you have $200,000.

Note that I’ve assumed a particular rate of return…but the comparison doesn’t change if the actual rate of return is different. As long as your choice of investments in your portfolio is unaffected by whether your money is in a traditional or Roth account (which seems logical that would be the case), then we can take the rate of return as a given that has no affect on the comparison of which is better.

So…which scenario actually makes you better off?? Well, notice that Scenario 1 has two unknowns. The first is how much you’ll pay in tax when you withdraw the money from your retirement account. The second is how much you’ll lose on the money that’s outside of a tax-favored retirement account.

Well, let’s say for simplicity that your tax rate in retirement is still 20% on all income, so when you withdraw the $200,000, you’re left with only $160,000 after taxes. The remaining $4,000 almost certainly didn’t grow to $40,000, because you were paying taxes – or foregoing maximum growth in order to avoid taxes – along the way, so you wind up with less than $200,000. Since Scenario 2 leaves you with $200,000 in the end, you’re better off with Scenario 2, the after-tax contribution scenario. This is the argument people make when they advocate for contributing to after-tax Roth accounts.

But wait a minute! As I showed last time, the tax rate you’ll pay on the distributions is nearly always going to be much closer to your marginal rate than your effective rate. (For a complete explanation, see the last post.) So you’re going to be paying lower taxes on the distribution…probably significantly lower. So let’s run the math on a tax rate of 10% on the distributions. (In my experience as a tax professional, an effective tax rate of roughly half your marginal rate is quite common.)

In this case, the $200,000 you have to pay tax on in Scenario 1 only reduces what you have left to $180,000 (not $160,000). This means the $4,000 outside of a retirement account only had to grow to $20,000, rather than $40,000, to get to break even. Well, I’m not a financial advisor, but I can tell you there are ways to invest for the long haul that actually involve very little tax bite. The easiest way to do this is you could invest in stocks that provide primarily price growth (which doesn’t get taxed until sold) with little to no dividends paid (since the dividends get taxed whenever paid) – so at the end of 30 years you might have close to $40,000, of which you’ll have to pay tax only on the gain over the original $4,000. Since the tax rate on long-term gains has been better than the ordinary tax rate through-out most of the 100-year history of income tax in this country…and your ordinary rate will already likely be lower when you sell the stock later…then it’s a good bet that the original $4,000 could be worth over $30,000 even after accounting for taxes. So now that we’ve added some real-world facts to this situation – most notably that you’ll probably pay a much lower tax rate on the distribution than the contribution – we see that Scenario 1, the pre-tax contribution, results in more money left at the end after everything is accounted for…over $210,000 compared to $200,000 in Scenario 2.

(Here’s an alternate possibility for the money outside the retirement account: You could invest in municipal bonds on which you pay no tax. You generally give up some yield when investing in safe, tax-favored investments like muni bonds. However, just about any financial advisor will tell you that some safe muni bond investments should be a part of any balanced portfolio. So if you’re going to hold some safe government bonds anyway, then you could hold them in a non-retirement account, where it will make little difference that you’re not receiving any special tax treatment.)

Of course, this has all involved predicting 30 years into the future, and nobody has a crystal ball. Some people will quibble with various assumptions I’ve made, and that’s certainly to be expected. If we’re going to compare, then we have to make some kind of assumption for the unknowns. And my reasonable assumptions may be somebody else’s fool’s beliefs. Only time will tell.

But to me this uncertainty is yet another argument for recognizing most tax savings now, when it’s a certainty, rather than waiting for much later when the benefit is only an educated guess at this point. I’ll never argue with a balanced approach to pre-tax and after-tax retirement account contributions, but in my mind the vast majority of the time that balance should be tilted strongly in favor of pre-tax accounts that provide an up-front tax benefit.

A caveat: Sometimes I have clients who owe no income tax at all. Far from being the free-loading 47% you may have heard about, they’re typically hard-working people, often with educations and good middle class incomes, who have a lot of deductions (usually a few kids). Or they’re self-employed and had a bad income year, or they went through a long period of unemployment. For a variety of reasons, large numbers of people wind up owing no federal income tax, but they still have some savings available and would like to set aside some money for retirement in a tax-favored account. (Usually they know this no-tax status won’t last for long.) In this case, a Roth contribution is definitely the way to go, hands down. Taking a deduction for a traditional IRA account provides no benefit in this case, and you now might be shifting income from a year where it won’t be taxed to a year where it could be. Bad move. Every time. If there are no tax savings from putting money in a Traditional IRA, then use a Roth.

Second caveat/personal note: My personal mix is about 80% of my retirement savings is in traditional IRAs and 401ks, with the remaining ~20% in a Roth IRA. I would probably put even more in a traditional IRA, but Roth IRAs do have one really nice benefit that’s not available with Traditional IRAs. I can withdraw the money I’ve contributed to a Roth at any time, penalty-free. If I withdraw the earnings, I get penalized, but there’s no penalty for withdrawing up to what I’ve contributed. So I put my low-risk, liquid investments in my Roth account, and my Roth effectively functions as an emergency savings account. If I unexpectedly needed to access a reserve of cash beyond my ordinary savings, I could liquidate the low-risk assets in my Roth and withdraw most of the money in my Roth without penalty. Just thought I’d throw those tips in there in favor of Roths since I’ve spent most of the last two posts beating up on Roths.