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The Oxford Oracle
Are Roth IRAs Really the Best?
This the final blog in a three series blog looking at whether or not Roth IRAs are the "best" vehicle for retirement savings.
Aren't Roth IRAs Best?
The financial press is quick to point to the major perceived benefit of Roth IRAs; namely, withdrawals from these accounts are tax-free. That is true, but it walks past the important fact that Roth IRAs can only be funded with after-tax contributions. Traditional IRAs/401(k)s, on the other hand, are funded with before-tax dollars. In the year you contribute to a 401(k), your taxable income is lowered by the amount of the contribution. That makes 401(k) contributions a fully tax-deductible item. Not many of those left in the tax code any more.
For the rest of this blog we will ignore traditional IRAs due to their low contribution limits and limited eligibility for tax deductions. Instead we will focus on traditional 401(k)s which are taxed similarly but with higher contribution limits, and make up a far greater proportion of retirement savings wealth in the United States.
Math Is Your Friend
As an illustration, assume you are deciding between funding your retirement with a Roth IRA or a traditional 401(k):
You plan to save $6,000/year into some sort of retirement vehicle (we'll assume you are eligible for this analysis)
Your current working years average tax rate is 25%
Your expected average tax rate in retirement is 25%
Your investments will earn 7% per year
The money will be invested for 20 years
At the end of 20 years, your 401(k) will have grown to $245,973. All of your contributions and earnings have grown with zero tax over these 20 years, and now the IRS will come to collect its share. Each dollar you withdraw will incur a 25% tax. If you were to withdraw the entire account, you would be left with $184,480 after taxes.
Now let's compare to a Roth strategy instead. Keep in mind, Roth IRAs are funded with after-tax dollars. So, in order to keep things apples to apples with the 401(k) approach, we must pay the taxes upfront. Redirecting $6,000 of your before tax salary into a Roth will leave you with only $4,500 to invest after paying 25% taxes on the income you earned.
At the end of 20 years, your Roth IRA balance will be...$184,480. That is EXACTLY the same value as the 401(k) approach.
How can this be you ask? Aren't Roth IRAs better because they're tax-free? No, they are not. We just proved it with the math. We share this with people all the time and it blows them away. Tax-free sounds good on the surface, but you have to dig deeper.
So if the math works out exactly the same, what should you do?
Traditional 401(k) Advantages
Traditional 401(k)s make up the vast majority of retirement savings in this country. They offer several important advantages:
Convenient. These plans are offered by many employers and are administered via payroll deduction. You simply sign up and choose how much you want to save.
Free money. Many employers offer matching contributions on the amounts you contribute. Good luck finding anyone to match your Roth IRA contributions.
Build good habits. This is the secret power of 401(k) plans. The money is automatically deducted from your paycheck along with other employee benefit costs, leaving you free to spend whatever is left over. People are good at living within their means on whatever shows up in their net paycheck. People are less successful at investing when they must make an extra choice every two weeks about where to spend/invest their pay.
Higher contribution limits. For 2021 employees under 50 may contribute $19,500 into a 401(k), but are limited to only $6,000 in a Roth IRA. Said differently, you can save more than THREE TIMES as much in a 401(k). As we already demonstrated, 20 years of max savings into a Roth IRA only gets you $184,480 which isn't very much to retire on these days. Even after paying taxes, a 20 year plan of investing $19,500 annually into a traditional 401(k) will net you $599,559.
Available to higher income earners. For 2021 couples earning more than $198,000 are not allowed to make Roth IRA contributions, yet they still are eligible to contribute to 401(k)s. These income limits do rise over time, but not as quickly as some salaries. You could find yourself ineligible for Roth IRAs by your mid-career.
Roth IRA Advantages
Despite the eligibility and contribution limits of Roth IRAs (click on this blog for more details), Roth IRAs have some interesting advantages:
Tax-free withdrawals. This can be a powerful tool should future tax rates rise.
No Required Minimum Distributions at age 72. Unlike traditional IRAs, there are no Required Minimum Distributions at age 72. Assuming you have a sizable enough Roth IRA, this allows you to control the timing and amount of taxes you incur when making account withdrawals during retirement.
So What Should You Do? It Depends
One of the biggest drivers in this decision is knowing exactly what future tax rates will be. If taxes are higher in the future than they are today, then Roth IRAs represent a powerful way to avoid future taxation.
While it's popular to say that "taxes have nowhere to go but up", the reality is that individual taxes have generally fallen since the 1980's. Many of our retired clients have found their tax rates in retirement have been far LOWER than they were during their working years. That made traditional IRAs/401(k)s a better choice for them because they were able to lower their taxable income during their high income working years, and pay a lower rate in retirement.
We often stress the benefits of "investment diversification", but perhaps another virtue is the benefit of "tax diversification". By choosing a mix of tax-deferred (i.e. traditional 401(k)/IRA) and tax-free vehicles (i.e. Roth IRA) one can build a portfolio of assets with different tax characteristics. When it comes time to take retirement withdrawals, you can look at tax laws at that time and decide which vehicle to withdraw from. The end goal is maximizing after-tax income.
Still Confused? We're Here to Help
We've been helping clients prepare for, and thrive in retirement for over three decades. Our clients' continued financial success is exceeded only by their success at the game of life.
When we build retiree portfolios at Oxford, we seek a balance between Stability and Growth following the principles outlined in our proprietary Power of 5 Investing system. Our goal is to help clients achieve inflation-beating growth in their wealth, while managing through market downturns, ultimately helping clients leave a legacy to the people and places they love. Our system has been battle tested in 25+ years of market ups and downs and is ready for whatever the market can throw at it.
If you'd like to discuss your retirement vehicle options, click on the link below to schedule a free Get Acquainted meeting.