The ROTH Myth

"Roth IRA's are tax-free and all of the earning are tax-free, so it must be better than a traditional IRA or 401(k)"

That's the sales pitch. Here's the reality:

From a purely mathematical perspective (what else is there that matters?), a Roth IRA is advantageous ONLY to those who are in a lower tax bracket NOW as opposed to the bracket they are in when they plan on withdrawing the money. When you invest in a Roth IRA, you lock in your tax rate on all of your investment and your returns now. Forever. If you are always in the same tax bracket, it doesn't make a difference.

Example: You pay 25% total in state and federal income tax now and in retirement. If you put $3000 into a Roth IRA, it actually cost you $4000 in earnings to make $3000 after taxes. If you compound that investment of $3000 over 20 years at 8%, you would have $13,982.87 left to spend.

If you placed the $4000 "pre-tax" into a traditional IRA or 401(k), and compounded that investment over 20 years at 8%, you would have $18,643.83 in your account.

If you apply a 25% income tax to $18,643.83, you end up with $13,982.87 left to spend! A Roth IRA has no mathematical advantage if you are always in the same tax bracket.

Variables:

1. Your income. If your income drops when you retire, chances are your tax rate will be lower. If your income goes up in your retirement years, your tax rate may be higher.
2. Tax rates. We can't predict the future... will taxes go up or down?
a. If your tax rates go up, you would have wanted more money invested in a Roth IRA
b. If a flat-tax is adopted, you may have wanted more money invested in tax-deferred vehicles.
3. Location. If you move to a state with no income tax, you total taxes may be lower.


Other considerations:

1. A Roth IRA does not have a required distribution at age 70 1/2, if that's important to you.
2. You can withdraw principal from your Roth after 5 years with no 10% penalty.
3. Each person's (or couple's) situation is different.
4. Diversification among pre-tax and after-tax investments may be a solution.

Don't be scammed by someone saying, "All of the interest is compounded tax-free." They aren't looking at the math behind their statement. Please examine your own personal situation, goals and plans, tax rates and income before making an investment decision.

The Federal Government didn't come up with the Roth IRA to let you get out of paying taxes. They came up with the Roth IRA to get you to pay income taxes on your retirement account NOW, instead of later. They don't care what your tax rates are in the future... they can't spend your tax money unless they can get their hands on it.

P.S. I have a Roth IRA. And a 401(k). And my wife has a traditional IRA. I don't know what tax rates will be when I retire, but I know how each of them works.