Why You Don’t Need A ROTH IRA
I don’t know how many of the bloggers will agree with Jeff about ROTH IRAs. I suspect that most of them will. It is my desire to give you another view of the story.
First, Why Do Roth IRAs Even Exist?
There will be many other posts that talk about what a ROTH IRA is and how it works, I won’t repeat the details here. But do you know why it even exists? When Jeff mentioned that the young people didn’t know what it was, I was not surprised. This is not a slight on the young people, their education or background. It gets to the sensibilities of typical young people. A cynic might point out that young people aren’t interested in retirement savings (that is probably true) but I think there is another issue: it doesn’t make any sense.
Young people are idealistic, full of energy and optimistic. Their instincts wouldn’t tell them that they need a special government sponsored account to save money. If you want to save your money, well damn, then just save it!
So why do these accounts exist? It’s because grown ups can’t decide how to structure a tax system that is simple and fair. On the one side, you have demagogues who champion a progressive tax system to raise revenue. Then, on the other side, you have people who lobby for special treatment because they need “help” to save because tax rates are too high , or there are those who feel people aren’t taking care of their future and government should do something about it.
In the end, we have a tax system that is ultimately flawed beyond belief. It’s a circus of conflicting policy both trying to raise revenue through taxation and reduce revenue through breaks. You may think you are getting a break from taxes with the ROTH IRA, but did you consider what other consequences will result? What will happen if revenues are not high enough to pay for government spending? They will have to find the money from somewhere else! So, even if you think that this program will actually save you taxes (it most likely won’t – see below), the government is still gonna raise the money it needs.
Well meaning CFPs like Jeff Rose make their living providing financial assistance to people and that may include contributing to these accounts. Before you decide you need to also think of the back end — you’re gonna need a CFP at the back end to figure out how to pull all that money out of your ROTH IRA, plus pensions, 401(k)s,Cash Balance accounts plus I can’t forget Social Security.
There is no free lunch here — to get your tax free money you will need to have serious planning to figure out all the government rules, how they interact and how they apply to you. This is assuming that you get any tax benefit at all.
Nothing is simpler than earning your money, paying your taxes, then saving it as you wish.
Is It Even Better Anyway?
Let’s assume that you still want to use the account because your CFP sold you on it. The next question to ask, is it any better than other retirement accounts, or no account at all?
I could throw out a lot of math to explain this, but it isn’t really that hard to understand using a few simple arguments. When you put money in a ROTH IRA today, what you are betting is that your tax rate you pay will be higher when you withdraw the money then the tax rate you paid when you contributed to it. If your tax rate is higher when withdrawing the money, you get a “free lunch” because you save the difference between the two rates.
If you had saved the money in a tax deferred account, you potentially would pay the higher tax rate on your contributions as well as your earnings. So, the thinking goes, the ROTH IRA helps you to pay less in taxes.
But, lets consider what people actually pay and what their tax rates will likely be. There are a few scenarios where your tax rate might be higher. What will the potential benefits be?
Scenario 1: Tax rates will be higher when you retire.
There is a huge long term structural deficit in the budget for the Federal Government. The tax revenue growth is starting to improve but the levels are not keeping up with the growth in the budget. About two thirds of the Federal budget is so-called non-discretionary spending which means that it automatically changes according to program rules and eligibility. And it has no where to go but up due to the aging of the population, increasing retirements, and new health benefit programs that were added in the last 10 years (e.g., Medicare Part D).
One might logically conclude that this would result in higher tax brackets in the future. But, politically it does not seems very unlikely. Republicans lowered taxes rates for everyone when they were in power, and Democrats certainly don’t want to raise them for middle class people either. So, who is it that will want to raise your tax rates?
If you are lucky enough to be in a top tax bracket, you can’t contribute to a ROTH IRA anyway!
Scenario 2: My own tax rate will be higher due to my ROTH IRA account growth.
Very unlikely. The limits for ROTH IRA contributions are only $6,000. When you consider the average family income of $50,000, this is only 12%, and it’s a smaller percentage when you earn more. The math doesn’t work for this percentage of income saved to earn enough money to put you into the next higher income tax bracket. Perhaps if you saved 50% of your income, but this savings won’t be in your ROTH IRA because the contribution limits are too low.
Conceptually, the idea of the ROTH IRA sounds great, but in actuality you can’t put enough money into it to make a significant difference in your retirement such it’s worth the hassle. Look, if you save $6,000, that’s great you should do it. You don’t need this account to do that.
Scenario 3: My tax rate will go up because I will earn more as my career develops.
When you work, it’s inevitable that your responsibility and pay will increase causing your marginal tax rate to increase. The likely scenario is something like the following:
Start working, age 22: 15% tax bracket.
Career Height, age 55: 25% tax bracket.
Retirement, age 65: 15% tax bracket.
The reason that this is likely is that in retirement you will need less income to survive than when you were working (you are not adding to savings, lower commuter costs, lower or no child care, etc). Even if you have a nice nest egg, you probably won’t want to withdraw as much because you don’t need to. The ROTH IRA benefit comes in if your tax rate increases to one greater than your working tax bracket. In this case, that is the 28% bracket, which for married people comes out to over 140K (for 2012). Actually you would need to withdrawal much higher than this level to start getting the tax benefit, but let’s just assume it’s 150K. This withdrawal rate requires a nest egg of almost 4 million dollars, assuming a 4% withdrawal rate.
But ask yourself, if you saved that much, what would change such that you would spend more than what you were earning during your working years? It’s possible, you might want to if you have the ability to increase your lifestyle. But, the ability to spend that much isn’t really going to be possible just because you contributed to a ROTH IRA. It’s predicated on your other savings, assets, or wealth building you did throughout your working years. The ROTH IRA itself isn’t going to get it done.
Scenario 4: My tax bracket will be higher because I will be otherwise rich from my business/inheritance/fill in here.
This is certainly possible. But this demonstrates my point that your retirement security isn’t going to be predicated on this ‘magical’ ROTH IRA account. The ROTH IRA itself doesn’t create anymore retirement security for you simply because you put the money in the account versus elsewhere. It’s your total asset and wealth picture that will do it for you. If you got so much else going on, you probably can’t contribute anyway due to income limits because ROTH IRA’s weren’t designed for you!
Let’s face it, when you talk to a CFP, they are going to ‘sell’ you on all these great programs, accounts, credits, etc. that will ‘improve’ your finances. Be skeptical. And don’t fall for the Kool Aid that these programs offer some magical benefit that you can’t otherwise get with other retirement accounts or simply just saving your money.
Here’s a simple concept: save your money! No special account or CFP required! No extensive analysis of tax tables, tax brackets or credits required!
The worst thing you could do is to assume that these accounts will provide you with extra retirement security simply because you use them. They don’t.