A Behavioral Case for the Roth IRA
Saving money in an Individual Retirement Account (IRA) is a great financial move. An IRA is not tied to an employer, so you don’t have to think about rollovers if you change jobs, you can choose whichever broker/custodian you’d like (I’m biased toward Vanguard), and it’s easy to automate contributions.
Two IRA options are available: traditional and Roth. A traditional IRA provides tax savings in the year you contribute, but taxes future withdrawals. A Roth IRA does not provide tax savings in the year of contribution, but future withdrawals are tax free.
Traditional IRA example: $100,000 income for the year, and a $6,000 IRA contribution: Your taxable income is $94,000, so you’ll have a lower tax liability than with a Roth. Thirty years from now, withdrawals from the account will be taxed at marginal tax rates in place at that time. Another way to think about this: if you’re in the 22% bracket and make a $6,000 traditional contribution, you’ll save $1,320 in tax. [$6,000 x 0.22 = $1,320]
Roth IRA example: $100,000 income for the year, and a $6,000 Roth contribution: Taxable income is $100,000, since Roth contributions provide no current tax benefit, so you’ll have a higher tax liability versus a traditional. Thirty years from now, however, the withdrawal from the account will be tax free. Another way to think about this: if you’re in the 22% bracket, to make a $6,000 Roth contribution, you’ll pay $1,692 more in taxes compared to a traditional contribution. [($6,000+$1,692) x (1-0.22) = $6,000]
IRA contributions have limits. In 2020, the maximum is $6,000 (add another $1,000 if you’re over 50), and at high income levels, Roth contributions aren’t allowed. (Post-2020 readers: do an Internet search for contribution limits and/or income limits if interested.)
Both IRA options are good. Both provide tax savings and tax-free growth. One option can be better than another, depending on circumstances (and who knows what tax brackets will look like in the future). But the discussion here is not about the optimal mathematical choice.
When considering human behavior, the Roth is better for many.
If you really want to find the strategy that’s more likely to yield the best after-tax results, read something like this. Or this. (And talk to your financial advisor if you have one.) If you open those links and your eyes immediately glaze over, you cringe, and you start to sweat a bit, the Roth might be best.
Why? Because any comparison between a Roth and a traditional IRA yields a better result for the traditional IRA only if we assume that traditional IRA tax savings are invested. Indeed, any comparison between the two options will always have this caveat, otherwise the Roth will win every time.
That’s not hyperbole, that’s math. Take two savers who each contribute $5,000 per year to an IRA over 20 years, one to a traditional IRA, the other to a Roth. Assuming they both earn 6% per year, each will end up with about $184,000. The traditional IRA saver will pay tax at marginal rates for every withdrawal. The Roth saver will pay zero tax on withdrawals.
In the original example, a $6,000 traditional IRA contribution in the 22% marginal tax bracket yielded $1,320 in current tax savings. Again, to have a chance at a higher after-tax account balance compared to a Roth in the future, all of the tax savings must be invested.
Many won’t take this step, for various reasons:
-If you make the maximum traditional IRA contribution, the tax savings need to be invested in another investment account. That could be your 401(k) or 403(b) through your employer, as the contribution limits on those are higher ($19,500 in 2020). But you would need to go to your HR or payroll person and change your contribution via payroll withholding - an extra step many do not want to take. Health savings accounts are an option too if they offer mutual funds. (Taxable investment accounts should be the last option.)
-If you do not get a tax refund, investing the traditional IRA tax savings might be more difficult. Sure, some people have a plan, figure out their tax savings (keep that $1,320 in mind if you’d like), and make the extra contributions via payroll deductions throughout the year. That’s a good idea! But if you like to allocate a portion of tax refunds to saving and investing, and don’t get a refund, scrounging up an extra $1,320 might be difficult when you’re already sending tax due to the IRS and/or state tax agencies, or you just have other, more immediate cash needs.
-Even if you don’t make the maximum IRA contribution, the person making a traditional contribution still needs to take the extra step of doing the math and making an extra contribution. For example, if you want to contribute $1,000 for the year to a traditional IRA, in the 22% tax bracket, you’ll need to invest another $220 to potentially yield more favorable results than the Roth in the future. That’s not easy to do for those with tighter budgets. (I get it, the trade-off with a Roth is a higher tax bill now, which is also not easy on the budget, but tax filing is the same number of steps regardless, and the mental accounting is different. Taking the extra step is the behavioral issue with traditional IRAs.)
-Many simply don’t consider the difference between the traditional and Roth options, and aren’t concerned about optimizing, so they’re not likely to invest traditional IRA tax savings anyway. This is the key. If you fall into this category, nothing is wrong with you - you probably have other priorities and better ways to spend your time than trying to optimize taxes and investments. For those trying to save, simple human inertia will prevent many from making the extra effort.
So if you’re going to contribute or budget a specific amount towards an IRA, the Roth will always come out ahead in the end if you’re not likely to invest traditional IRA tax savings.
The best financial plans are those we actually stick with. Many don’t want to take extra steps to optimize tax or investment strategies. If that’s you, a Roth is the way to go.
Note:
-If your employer offers a Roth 401(k) or Roth 403(b), the tax/investing/behavioral implications work the same way.
-Roth contributions have practical benefits as well: (1) Contributions (not investment earnings) can be withdrawn penalty-free with a Roth. It’s not recommended, but it’s nice to have penalty and tax-free withdrawal options in a pinch. (2) Traditional IRAs have required minimum distributions starting at age 72, while Roths do not.
-Those just starting out on the low end of the salary scale, who are likely to be in higher tax brackets in the future, should generally use a Roth anyway, as future withdrawals will occur tax-free when they’re in those higher brackets. A point in favor of the traditional IRA is that people are often in lower tax brackets during retirement. However, this circumstance still requires investing the tax savings for the duration of the time one is contributing to the traditional IRA.
-For further reading: NerdWallet
-Update: This study found that contribution rates to Roths and traditional accounts did not differ, a phenomenon which favors the Roth for the reasons mentioned above.
