Are Roth IRAs Overrated?

I wrote the following in Everything You Need to Know About Saving For Retirement about the decision between utilizing a Roth or traditional tax-deferred IRA or 401(k) for retirement savings:

This is the type of decision where you shouldn’t overthink things. No one has a clue what future tax rates will look like so trying to make a spreadsheet answer to the traditional vs. Roth dilemma is difficult to quantify, especially the further away from retirement you are. If you want to nerd out on tax codes you could probably come up with an optimized strategy to make your decision.

For those who would like to keep things simple, I like the idea of diversifying your tax exposure. So maybe you utilize a traditional 401(k) through your employer but also have a Roth IRA that you make contributions to as well. Or you could use a traditional and Roth 401(k) plan in concert with one another if your employer has both options. That way you earn some tax breaks now and save some tax breaks for future you.

My feeling is you can get lost in the minutia on a decision like this. Yes, it can make a difference but don’t let the details get in the way of taking action.

However, there are people who get to the point where it makes sense to understand the best tax-deferral strategy for their retirement savings.

On a recent podcast Michael and I discussed an article from Brett Arends at MarketWatch. Here are the highlights:

According to IRS data, at the end of 2017 there were more than twice as many traditional IRAs as Roths, and they held about nine times as much money: $8 trillion in total, compared with $841 billion in Roths.

Four-fifths of households in retirement will pay an effective tax rate of 0%, or nearly zero, write Boston College researchers Anqi Chen and Alicia Munnell (the director of the Center for Retirement Research, and a MarketWatch contributor) in a new paper. That includes federal and state income taxes.

Only those in the top fifth of retired households by income pay significant taxes, and even then the average rate for that group is only 11.3%, they calculate.

In the top 1% by income the average is 22.7%, they add.

“Regardless of the drawdown strategy, households in the bottom three [income] quintiles most likely pay zero taxes in retirement,” write Chen and Munnell. “This percentage rises to only 2 to 3 percent for the fourth quintile. In terms of financial security in retirement, this finding is good news—most households are not dramatically underestimating their retirement resources by not considering taxes.”

Michael and I wondered aloud whether some of the benefits of contributing to a Roth had previously been overstated.

The listener response to this one was strong-to-quite strong. This is one of those topics much like the individual bonds versus bond funds debate that has some surprisingly strong opinions.

We had so much feedback come in that we decided to bring our personal tax expert, Bill Sweet, on to share his thoughts and answer some questions.

Not to bury the lede here, but after our chat with Bill, I immediately made the switch from a traditional to Roth 401(k). I have assets in Roth IRAs, traditional IRAs, taxable accounts and a traditional 401(k), so it made sense to me to continue diversifying my retirement tax base.

Diversification in all things is a guiding principle for my finances so I like the idea of having different options when it comes to tax exposure in retirement.

We discuss:

  • Diversification between tax sources for retirement savings
  • It doesn’t have to be all or nothing with these decisions
  • The compounding benefits of a Roth
  • If you’re at the point of optimizing you’ve probably already won
  • Does a Roth make your retirement planning simpler?
  • What if you don’t get a tax break on your traditional IRA contribution?
  • What’s the tipping point to go from Roth to traditional contributions?
  • What does Bill do with his own assets?

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