Why the Roth IRA is right for me

I recently read an article on Financial Samurai entitled, “Disadvantages Of The ROTH IRA: Not All Is What It Seems.” It really got me thinking because I currently invest in a Roth IRA and have recommended that others invest in them as well. Is a Roth IRA really the correct thing to do to maximize future earnings? Am I doing the right thing and giving good advice?

Here’s a little of what Financial Samurai (FS) says:

1) The government is inefficient: To a certain extent, the government can get into less spending trouble the less amount of money it has to “waste.” By participating in a Roth IRA you are paying taxes up front.

2) The government is smarter than you: The government specifically created the Roth IRA so that more people take advantage of the government’s supposed generosity in future tax liabilities by paying the taxes now. This way the government gets money now that would have been previously locked up in a traditional IRA until retirement. FS says that in reality, the Roth IRA is a great idea for the government, not us.

3) The math is the same whether you pay now or later: Whether you pay taxes now and let the investments grow tax free or you let your pre-tax investments grow and then pay taxes upon retirement, the results are the same.

4) You may never reap the fake rewards: FS says that even if the math wasn’t the same, the government could end up changing the rules down the road and force you to pay taxes again when you withdraw!

5) FS’s final point is this: You never want to give the government more money than you need to.

What do I think of Financial Samurai’s dislike of the Roth IRA?

Well, I do agree with much of what he says. I definitely agree that the government is inefficient and that the scope of the federal government is becoming way too huge and powerful for what the founding father’s intended. There is a huge amount of waste in all aspects of the government. My personal goal should be to keep as much of my money as I can and give as little as possible in taxes.

While I never really thought of it this way, FS is likely entirely correct in that the Roth IRA was devised not as a novel way to help the citizens of the United States invest better for retirement, but more likely as a way to create more immediate tax revenue. Think of the huge increase in revenue that occurred as millions switched into paying taxes now (with a Roth) rather than upon retirement (with a traditional IRA).

I was a little intrigued by the issue that “the math is the same whether you pay now or later.” I didn’t really believe that at first. In all comes down to the fact that with a Roth IRA you are using post-tax money so effectively contributing less.

There’s a very interesting table showing this very calculation on the Non-deductible traditional IRA page at Bogleheads.

It illustrates the growth of a $10,000 investment in various accounts. All capital appreciation and payout of dividends are kept the same and the only difference between the accounts is the treatment of taxes. It ends up showing that the Roth IRA and traditional (deductible) IRA have exactly the same after-tax values.

The reason is that due to paying taxes on the contribution into the Roth IRA up front, you are effectively only able to contribute $7,200 a year in a Roth but will have the full $10,000 working for you in a deductible traditional IRA.

In a follow-up article, Financial Samurai clarifies “the only reasons to ever contribute to a Roth IRA.” One qualifier he mentions is that the Roth would actually be better from a tax standpoint if you are currently in a lower marginal tax bracket and expect to be in a higher tax bracket upon retirement. Conversely, contributing to a traditional deductible IRA makes much more sense if you expect your tax bracket to be lower in retirement than when you are working.

This point, in fact, is one of the main reasons that I decided to contribute to a Roth IRA rather than a traditional. Without going into too much detail, I’m currently in the 25% tax bracket. Once I complete residency/fellowship and find a job, I’ll likely be somewhere in the 33-35% tax bracket. For me, contributing to a Roth (while I still can from an income standpoint) makes the most sense since I’ll be in a significantly higher tax bracket upon retirement than I am now.

There is another interesting aspect to the Roth IRA vs traditional IRA argument that goes unmentioned in Financial Samurai’s articles (though it is addressed in the comments): after a certain income level the contributions to a traditional IRA become non-deductible.

If you contribute to a non-deductible traditional IRA you get the worst of both worlds. Your contributions are not tax-deductible AND you have to pay taxes on future profits. (The investments still do get to grow tax-free in the meantime.)

For someone like myself who won’t be able to deduct traditional IRA contributions, I’m only left with two good choices. I could contribute to a non-deductible traditional IRA and then immediately convert to a Roth (paying taxes upfront) via the “backdoor” approach (discussed more below). Or, I could choose to keep my retirement investing in a taxable brokerage account but invest in tax-advantaged assets. As traditional IRA withdrawals are taxed at the current income tax bracket, the much more favorable long-term capital gains tax rates offered in the taxable account would make more sense.

Since the amount of money you can contribute into a Roth or traditional IRA is currently limited to $5,500 a year, I’ll definitely end up doing a combination of maxing out the IRA contributions and then investing the rest in a taxable brokerage account.

Despite all the “shortcomings” of the Roth IRA mentioned above and in Financial Samurai’s article, why did I still choose to use a Roth? Well, the first reason is that my income tax bracket will be increasing in the future. There is better future tax savings by paying a lower amount of taxes now.

Secondly, doing a backdoor Roth IRA conversion allows high earners to get tax advantages on at least one side of the investment. Otherwise, I’d make too much to get immediate tax deductions AND make too much to contribute to a Roth.

Thirdly, traditional IRAs have required minimum distributions. These force you to take out a certain amount of money each year, which is then taxed as ordinary income. Roth IRAs do not have this requirement. Since I espouse dividend investing, if using a Roth I’d be able to let the capital compound nearly indefinitely, removing the dividend income for expenses completely tax-free. Dividends taken out of a traditional IRA, on the other hand, are taxed as ordinary income and NOT at the usual long-term capital gains rates. By investing in dividend paying stocks in a traditional IRA you are losing many of the advantages of their unique inherit tax-advantaged nature. The IRAs are also a nice way to shield companies, such as REITs, that pay non-qualified dividends.

What do you think? Do you invest in a traditional or Roth IRA?

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5 Responses

  1. Looks like you are on about the same plan as my wife and I. We also can’t take advantage of the deduction for the Traditional IRA, so it obviously make sense to grow our earnings tax free with the Roth also. We deposit the money to the Traditional IRA and then covert right away to a Roth. I am hoping they keep the backdoor to the Roth open. I have always been afraid they would lock this down, but you bring up a good point that they are getting the tax money now, which is probably what they want.
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    • scott says:

      Thanks for commenting, Ryan. Some of the staff at work use the backdoor Roth option as well as it seems to work great for them. Hoping it stays around. I won’t be able to start using for about 2 more years.

      Fortunately, dividends in and of themselves are quite tax-efficient already so investing in taxable brokerage accounts isn’t the end of the world either.

  2. Jeff says:

    Hi Scott,
    Great site !I stumbled across your blog in pursuit of dividend growth investing. Even though this post is from 2014, i’m still hoping you can shine some light into investing for dividends in taxable account.

    A question I have is that by investing in taxable accounts, these dividends would be taxed at a max 20% every April, that means automatically from the get-go, we already lose 20% of the dividends’ values. I don’t know if there’s any way this can be avoided since if one were to max out Roth and traditional IRAs, the only place to park additional money is the taxable account. However, I’d still like to hear your thoughts:

    1. How you prioritize investing in which type of assets in taxable accounts? ie, dividend paying stocks? REITs? Long term capital gain holdings?
    2. How you optimize your portfolio in Taxable account? Do you replicate the same holdings as you do in your Roth IRA, that you buy also dividend paying companies?

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