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Why Roth IRAs Are Bad

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This is a Devil's Advocate post.

When you get both sides of something, you know, at the very least, that there are some smart people looking at it and you can try to piece together a full picture and form your own opinion on something. When was the last time someone said that investing in a Roth IRA is a bad idea?

Yeah, I haven’t met anyone who has told me that a Roth IRA was a bad idea either and almost everyone I’ve met has said that the Roth IRA is fantastic, wonderful, a must for everyone; so… who’s giving the other side? Well, in this Devil’s Advocate post, I’m going to try to provide this other side and here are the reasons why I think Roth IRAs are a bad idea!

You Can’t Assume The Tax Structure Will Remain The Same

In the last few years we’ve already seen people suggesting alternate means of taxation to do away with the monstrosity of income tax and the Internal Revenue Service, to go with a flat tax, or a value added tax, or some other form of non-income related tax. What if we did go to something like that? Well, the benefit of a Roth IRA is that you pay the income taxes now so you don’t pay them on disbursement and if there was no income tax then you lose that benefit. If let’s say we instead instituted an automatic 20% national sales tax and abolish the income tax, then your Roth IRA would in essence be double taxed. Now, if we were to make a change, I’m sure there would be some grandfather clause so that no one was penalized but maybe not!

Roth IRA’s Are Not Incredibly Better Than Traditional IRA’s

Often times when you hear someone talk about Roth IRA’s, they talk about how they’re ridiculously better than Traditional IRA’s, except they’re not. With traditional IRA’s, you have a bigger piece of pie to invest now with the spectre of taxation in the future; with Roth IRA’s, you have a smaller piece of pie to invest now but without taxation hovering over your earnings. While it sounds nice to not pay taxes on your earnings, it really works out to be approximately the same if your rate of taxation remains the same. The reason this is so is because what you pay now in taxes on your Roth IRA contribution would be otherwise invested and make up for the amount in taxes you’re skipping out on by prepaying. Hopefully that made sense…

You Can Withdraw Your Contributions Without Penalty

If you withdraw early from your 401K, you face a 10% penalty on top of your regular income tax. If you want to withdraw your contributions from a Roth IRA, they let you without penalty as long as you follow a few simple rules. This is great, except if you are the type that can’t resist taking out the money (once it leaves, you can’t put it back in), then this is a bad thing since there aren’t any obviously negative effects (such as 10% off). Sure, this is a weak argument against Roth IRAs (and often touted as a benefit) but the fact remains some savers like the idea of a penalty so that they aren’t tempted to withdraw the money.

As you can see, Roth IRAs aren’t the holy grail of retirement investing and the tax free growth isn’t as miraculous as it may seem. Personally, I’ve put as much as I can into my Roth IRA (which really isn’t all that much anyway, it’s certainly not the $15k limit of 401Ks) each year so even if you were to go full tilt on Roth IRAs, you aren’t really in a bad shape if things turn out badly. It’s just useful to know that while a Roth IRA is a very important piece of your retirement savings puzzle, don’t let all the talk of its awesomeness overshadow the fact that its use as a retirement vehicle does have risks involved and hopefully in this Devil’s Advocate post I’ve laid some of them out for you.

If you know of any that I’ve missed, please do share and I’ll try to integrate them with the post. (I do admit that making this argument was difficult past the first reason, so keep that in mind!)

{ 33 comments, please add your thoughts now! }

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33 Responses to “Why Roth IRAs Are Bad”

  1. RootAnn says:

    Actually, there is an investment firm (fee-based) in the Midwest who openly discourages people from investing in Roth IRAs in their radio commercials. While they say that under “some circumstances” it makes sense, they much prefer you put money in a Traditional IRA and definitely put in the maximum in your 401k/403b/etc at work before you even contribute to a Trad IRA. They are vehemently against Roth 401ks.

    One of their reasons is the tax structure one, but another (if I remember correctly) is that if you are in the 25% tax bracket, you are in essence going to get $1000 back in the form of a tax break/credit and you should use that money to invest in a non-retirement account. Thus, you are investing 25% more than you would in a Roth IRA.

    I am sure they have more arguments PRO Trad IRA and CON Roth IRA, but I don’t know what they are. They have other non-traditional opinions like you should never pay off your mortgage and you don’t have to change your investment allocations based on your age or how close you are to retirement (“Your money doesn’t know how old you are.”).

    • Marion says:

      You might want to refer to my comments to Jim regarding net account value resulting from equivalent contributions to Roth and deductible IRAs. An additional point to consider is that (pre-contribution) taxes on income are typically at your marginal tax rate (e.g., 25% in your comment), while gains from your non-retirement account may be at a lower (dividend or capital gains) tax rate. However, those gains are taxed as realized, and the rate is at risk to increases in the future.

  2. jim says:

    I suppose they’re trying to make a name for themselves by being contrarian but that sort of advice is dangerous because you take some good common sense points and you can convince anyone of anything.

    Take for example the “asset allocation by age” (or proximity to retirement age), certainly your money doesn’t know how old you are but you do and your ability to weather downturns is significantly less the older you get. If you’re 20 and your investments drop 40%, you have 40 years to recover. If you’re 60 and your investments drop 40%, you’re in deep trouble.

  3. Jesse says:

    Even if the tax law doesn’t change, you have an unknown on what your tax rate will actually be at retirement. Maybe it will be lower for very common, feasible reasons (not the abolishment of the tax code). That likelihood is there. I woudn’t wish that on anyone though ;)

  4. EMF says:

    The 2nd point about there being no difference between Roth and Traditional IRAs should the tax rates be the same now as in retirement is absolutely correct.

    But that argument is only important if you are not able to contribute more to your retirement than the maximum of a Traditional IRA or a lower amount to a Roth after taxes are paid. All other things being equal, if you contribute the maximum to a Roth you will have more money in retirement than if you contribute the maximum to a Traditional IRA. The Roth effectively allows you to contribute more to tax advantaged retirement savings.

  5. I’m not buying the argument, but I give you and A for effort. The reason I’m not buying it is that you kind of have to assume that the tax structure is going to remain the same. You can’t plan for an unknown other than to assume all possibilities and put some eggs in each basket. One of those possibilities though would be today’s current tax structure which would make the Roth IRA a good thing.

  6. jim says:

    Hahaha Thanks Lazy Man, I agree with you on how you have to assume the tax structure will remain the same but that’s also why you should contribute to a 401K and a Roth, you should diversify your tax profile just as you diversify the assets you’re in. Don’t bet it all on black!

  7. cindy says:

    THANK YOU for a devil’s advocate post. It’s great to hear things from the other side, especially how Roth is not greatly better than the traditional, which I think it’s a great misconception that everyone has, including me.

    Cheers,

    Cindy

  8. Debt Hater says:

    The strongest argument does seem to be the second one about the traditional and Roth not being wildly different, but I can see it was a stretch to make this post! Still good point though

  9. jpsfranks says:

    I’m much more inclined to believe that changes to the tax structure would be to the benefit of the Roth rather than work against it. Which is a more likely reform: something huge change like a VAT/national sales tax, or something relatively easy like an adjustment to the marginal rates? And I think they more likely to go up than down. As you pointed out in a previous post, top rates were much higher not so long ago.

    The only thing wrong with my Roth is that I can only put $4k/year in it!

  10. Foobarista says:

    Actually, I’m putting my money on various sorts of Pigovian taxes. Not that I think they’re good, but they are clearly where the “policy zeitgeist” is going these days. A “Pigovian tax program”, which is basically a bunch of sales taxes, would hurt Roth IRAs and favor 401Ks.

  11. empyrean says:

    Hey Jim

    appreciate all your articles – especially the ‘Devils Advocate’s… just wanted to drop a line to keep the great work up!

  12. I don’t see it as particularly likely that the method of taxation will change in the near future, much as I’d prefer to see a consumption based system. I’m sticking to my Roth, while also investing in the tradtional…

  13. KMC says:

    My opinion is that clearly the federal tax structure must change. I don’t know what form it will take (be it VAT, flat tax, increase in margin rates in current structure) but I firmly believe they must go up. That thinking alone makes Roths superior. And the idea that anyone reading this site will have a lower rate at retirement is highly unlikely. We’re all savers and thinking about this stuff.

  14. NewGirl says:

    I’m a huge fan of your Devil’s Advocate posts, but I have to say that for me, a Roth IRA is the right thing by a huge margin. I make much less money now than I plan to at any later stage of my life, so assuming that I will stay in the same tax bracket is a terrible one for me to make. Also, because I’m young and not at all financially established yet, it’s psychologically much easier to contribute to a Roth IRA knowing that if my circumstances change, I can get that money back. I have no intention of doing it, but I have found that it makes my friends much more open to the idea of saving for retirement to know that they aren’t completely locked into giving up their money for the next 40 years if they need it. In addition, my employer doesn’t have any kind of retirement plan I can contribute to, so I am pretty much left out of the higher limits on 401(k)s and such as far as I know. The only point you’ve made which does apply to me is if the tax structure changes drastically I could be double taxed on this money. Even in the worst case scenario, where these accounts aren’t grandfathered in, the relative ease of removing contributions for things like buying a home means that I should have enough time to take out all of my initial investment and put it towards a house or education before those things are taxed under the new system. In that case, all I could be double taxed on is the gains I’ve made between now and then.

  15. Pete says:

    Three things left off:

    1) State taxes – if you are in a high income tax state now and plan to retire in Florida or some other low income tax state, it may be better to defer the income until retirement to avoid higher state income taxes

    2) Graduated tax structure – if you are in the 25% or 28% tax bracket, the amount you put into a regular IRA or 401(k) saves you based on the tax rate you are in (because the income is taken off the top when taxed). When you receive the money in retirement some of the money received is taxed at the lower tax brackets (10% & 15% in addition to the upper tax brackets). For example, if you are married earning $70,000 and save $5,000 in a 401(k), you will save taxes of 25% on the $5,000. When you receive it in retirement, you may get taxed on a $40,000 distribution at a combination of 15% and 25% rates. So, even if tax rates go up 10%, being taxed at different income rates may be beter off (17% and 28%).

    3) People say that tax rates will go up (with sales, VAT or income) to pay for the baby boomers. Yet, some younger people may see the tax rates come back down as the baby boomer blimp disappears before they retire.

    We want to say it is best to do a Roth or 401(k), yet everyone needs to see where they are at and what they feel will happen with taxes.

    • Steve says:

      Excellent points. On the graduated tax structure, the lowest bracket is actually 0 percent up to the personal exemption + standard/itemized deductions.

  16. mbhunter says:

    The money in our Roth IRAs, 401(k)s, and traditional IRAs will be used to try to fill in the Social Security shortfall. Just wait and see. Buy lots of land in the mountains and hoard ammo. ;)

    That’s probably too far to one side, but tax-advantaged accounts have a lot more oversight, penalties, and restrictions associated with them than unqualified accounts. And present rules governing these accounts can, and probably will, change, as needs arise. Guess whose needs. I certainly don’t expect less oversight, fewer penalties, or fewer restrictions attached to on these accounts.

    I’d keep an ear to the ground and pull out if it looks like things are turning sour. Penalties or not.

  17. FIRE Finance says:

    Thanks for this great post. We have listed you as one of our favorites in our Carnival round up for the week.

  18. How do you know you will be in a higher bracket? What if now you are already not eligible for a Roth? Then you are in a very high bracket and likely to be lower in retirement. I hadn’t thought about state taxes, but that’s a great point.

  19. JohnR says:

    I see your point on some things, but have to disagree on point #2. Lets assume all things are equal, including your tax brakets being the same in retirement. So, whether you pay it now or later, you are paying the same percent. Then, with a Roth you are investing $5333 pretax dollars vs $4000 with traditional. So, if your already maxing out your other tax advantaged accounts (401k), a ROTH is essentially enabling a higher contribution limit.

    One additional point. Say you plan to get the same income at retirement. Now, you probably have a lot more deductions (kids, home, etc.) that you wont have later. If you are contributing to a standard 401k, its good to do a ROTH to diversify your taxation exposure… just like you diversify your investments.

  20. Moneywise says:

    I read the post and comments and I am more confused now. I am currently struggling with traditional/roth pros & cons situation myself. After much thinking I think the better approach will be to invest my 4k in traditional IRA and my wife’s 4k into a Roth IRA. Why choose one? What if you choose wrong? I will invest in both.

    • jim says:

      Do you have a 401K? If so, that’s tax deferred savings ($15,500 max instead of $4,000 max) so if you are contributing to that then you may not want to contribute to the Traditional.

      Let’s say you contribute $4K a year to your 401K, that means by your plan you are now putting in $8K tax deferred (traditional + 401k) and $4k tax free (roth), which isn’t necessarily a bad mix. Just remember you have more tax deferred options than you do tax free options (Roth and Roth 401k, if your employer offers it).

  21. Josephine says:

    I think that the best argument for investing money in a ROTH-type of vehicle (either 401k, or IRA) is that you are hedging against future taxes. I would not recommend doing only one or the other, but if you can afford it, a mix of both is a good bet.

    Imagine you need to make a large purchase, or have a large bill in one single year of your retirement (e.g., house renovation, medical bill, helping pay for grandkid’s college…) that cannot be financed over multiple years. You may need to withdraw a large amount from your retirement funds in addition to the money you are living on. If you only have tax-deferred accounts, you will have to pay taxes on top of that large withdrawal and the large withdrawal may change your tax bracket to a higher tax bracket. If you have a tax-free retirement account (such as a ROTH), you will not have to pay increased taxes on that extra withdrawal and will not risk increasing your tax bracket (if those are still around).

    Nobody knows what the future holds, and hedging your bets against tax changes could be a smart move.

  22. Marion says:

    Here’s another (potential) reason to emphasize taxable vs. tax-deferred (or tax “free) accounts:

    http://www.carolinajournal.com/exclusives/dems-target-private-retirement-accounts.html

  23. barbara says:

    My question is: When I convert from a traditional IRA to a Roth IRA, that conversion amount must be counted as income for income tax purposes. This added income means that less of my social security benefits are tax free. So considering that I would now be paying income tax on 85% of my social security benefits vs. 10%, would this cancel any benefit that I may receive from converting to a Roth?

  24. Marion says:

    Jim -

    Ric Edelman makes many of the same points as presented in your post in his article at

    http://www.ricedelman.com/cs/education/article?articleId=704

    One point overlooked in the “net after tax” comparison is that you can contribute as much AFTER TAX to the Roth as you can PRETAX to the Traditional IRA, resulting in a HIGHER after tax amount in a Roth account.

    Modifying Edelman’s table as presented in his article to reflect an increase in the invested amount in the Roth would result in the following:

    ROTH DEDUCTIBLE IRA
    EARNINGS 143 100
    TAXES @ 30% 43 0
    LEFT OVER (TO INVEST) 100 100
    INVESTMENT DOUBLES TO 200 200
    TAXES ON WITHDRAWAL 0 86
    NET VALUE AFTER TAXES 200 114

    Although I made the table similar to Edelman’s example, the real advantage comes when you maximuze your contributions ($5000 for 2009 — so multiply table amounts by 50).

    Note that you would pay $13 in taxes on the extra $43 in either case, as it is not tax-deferred in the Deductible IRA case (staying with my assumption that the AFTER tax Roth contribution is the same as the PRE tax Deductible IRA). The result is that you would have 43% more “tax free” money in your Roth account than in a traditional IRA.

    Two additional points:
    1) Income taxes are likely to go up in the future (deficit reduction, anyone?)
    2) A consumption tax is also a possibility (see http://www.fairtax.org/)*

    * The fairness of the “Fair Tax” plan is also debatable, and does not currently address allowance for prior Roth contributions. As presented, you COULD be effectively taxed twice on your Roth.

    • Bob says:

      I think your math is wrong as you apply tax rates to all of the account value. That is not correct — the marginal rate only applies to part of the withdrawals. If you limit withdrawals you can create 0% tax liability on all traditional IRA funds. Imagine you own the house outright and need almost no income at retirement but for food, utilities, and property taxes. In fact, move to a state without property taxes and all one needs is food and utilities.

      A wise planner and spender has no income tax liability at retirement. You need to be very rich at retirement for the roth to pay off.

  25. cfiz says:

    Roth IRAs are great if you’re young, just entered the workforce, and aren’t making much money compared to what you’ll probably be making later. Pay 15% on the money now and then pay no taxes later? Hell yes! Assuming that the tax structure doesn’t change to tax withdrawals later, it’s a great deal.

    I really don’t buy the argument of penalty free withdrawals being a downside. It’s a benefit, because it’s one less fee to pay. If your credit credit company increased fees, it would be silly to argue that that’s a benefit because it urges people to rack up less credit card debt. If people can’t exercise self control, that’s their problem. If you have that much trouble with self control, then make a bet with your spouse/family/friends to give them 10% of the money if you withdraw it early, or do something similar.


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