Author Topic: So what if Roth IRA allows tax-free growth?  (Read 7568 times)

bikebum

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So what if Roth IRA allows tax-free growth?
« on: April 04, 2014, 06:20:35 PM »
Sorry if this has already been done, but I searched the forum and did not see this.

Many articles, like this one: http://www.fool.com/money/allaboutiras/allaboutiras03.htm, state that tax-free growth is an advantage of a Roth vs. a Traditional IRA.

Here's a quote:

"In other words, the Roth offers tax-exempt rather than simply tax-deferred savings. One word makes a big difference. While both allow you to accumulate wealth without paying taxes along the way on your profits, the traditional IRA ultimately sticks you with a tax bill for those profits (plus your initial contributions if those were deducted when made). The Roth doesn't. As long as you follow the rules, you never pay taxes on your gains. So paying the piper now before contributing to the Roth may work out to be better for you than paying him later on your investment profits."

My questions is: Is this really an advantage over a Traditional IRA?

Say you have $100 of income to invest for 20 years, your effective tax rate is 25%, rate of return is 7%.

If you choose Roth:
Your $100 becomes $75 after you pay taxes.
$75 x (1.07)^20 = $290.
No tax to withdraw.

If you choose Traditional:
No tax on the $100 up front.
$100 x (1.07)^20 = $387.
Your $387 becomes $290 after taxes upon withdrawal.

Seems the case that the tax-free growth allowed by the Roth IRA is an advantage ignores the opportunity cost of paying taxes up front and having less money to invest.

I see this claim all over the internet. Am I missing something?

2527

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Re: So what if Roth IRA allows tax-free growth?
« Reply #1 on: April 04, 2014, 06:31:40 PM »
If you are going to max out both in dollar terms, the Roth is better.

The Roth is better if you intend to leave any of the IRA to your children.
« Last Edit: April 04, 2014, 06:44:08 PM by 2527 »

seattlecyclone

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Re: So what if Roth IRA allows tax-free growth?
« Reply #2 on: April 04, 2014, 06:32:02 PM »
Your analysis is correct if the money you're putting in an IRA is all you have available to invest. If you can afford to max out your IRA (whichever type you choose), a Roth IRA can potentially allow you to put more into a tax-advantaged account. Here's how: if you put $5,500 in a Roth IRA this year and it grows to $20k when you take it out in a few decades, you'll get to keep the whole $20k.

If you put $5,500 in a traditional IRA, on the other hand, you'll have to pay tax on your $20k when you withdraw it. You might be left with $17k if you're in the 15% bracket when you retire. You will be able to save some money on your taxes this year, and invest that in a taxable account. This money will compound alongside your IRA, but you will be paying taxes on any dividends and other transactions in the meantime. For a lot of us Mustachians who plan to dramatically decrease our incomes (and thus tax rates) when we retire, we will likely come out ahead this way anyway because our tax rate is much higher now than we plan for it to be in retirement. But if you have a low tax rate now and can afford to max out your accounts, you may find that a Roth will give you a better overall retirement income.

MDM

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Re: So what if Roth IRA allows tax-free growth?
« Reply #3 on: April 04, 2014, 07:17:36 PM »
For more details, go to https://forum.mrmoneymustache.com/investor-alley/401(k)-vs-roth-ira-vs-taxable-accounts.

The whole thread is worth reading, but you can search within the thread for "associative" to find the particularly germane posts.

The key word in the OP is highlighted: "So paying the piper now before contributing to the Roth may work out to be better for you than paying him later on your investment profits."  Conclusions will depend on assumptions.
« Last Edit: April 04, 2014, 08:09:00 PM by MDM »

bikebum

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Re: So what if Roth IRA allows tax-free growth?
« Reply #4 on: April 04, 2014, 08:05:39 PM »
I think I get what you guys are saying. In a way, the Roth max contribution can be "higher" than with the traditional, because putting $5,500 in a Roth would be equivalent to $7,333 in a Traditional (which is not allowed), assuming the tax rate is 25% now and later. So if there were no maximum limits the Roth would not have this advantage, correct?

The wording in the article just threw me off, mainly "the traditional IRA ultimately sticks you with a tax bill for those profits." This doesn't seem applicable.

aj_yooper

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Re: So what if Roth IRA allows tax-free growth?
« Reply #5 on: April 05, 2014, 01:29:24 AM »
My understanding is:

If you retire to a lower income tax rate, the tax advantaged is beneficial; you transport or beam your money to a lower tax rate.  If you retire to the same tax rate, however, the Roth accounts are better (IMO) as you can place more money in them, but of course you pay more taxes up front, but not on the anticipated accumulated appreciation, dividends, or interest.

At the same tax rate in retirement and working, the commutative principle applies:

Savings * (1-tax rate) [tax advantaged option sequence}= (1-tax rate) * Savings [Roth option sequence]

At a higher tax rate in retirement (could happen!), then a tax advantaged is not helpful as it increases your tax bill; it beams the $ to a higher rate.   A Roth is also beneficial then too as all taxes are done, forever, no required minimum distribution, unlike the tax advantaged accounts. 

kpd905

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Re: So what if Roth IRA allows tax-free growth?
« Reply #6 on: April 05, 2014, 11:09:38 AM »
The probably with your calculations is the flat 25% tax.  This is one reason a traditional IRA might be favored in many cases.

Put money into a traditional IRA or 401k and save your marginal tax rate (maybe 25% + state tax), then when you withdraw you fill up the brackets from the lowest up.  So the first ~$10k is tax free, then $10k at 10%, then 15%.

In order to pay 25% federal tax on IRA withdrawals, you'd have to withdraw about $240,000 in a year.

phred

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Re: So what if Roth IRA allows tax-free growth?
« Reply #7 on: April 05, 2014, 11:32:31 AM »
As with most questions - it all depends.  If your paycheck is on the small side, you can barely contribute the max yearly, you're putting it into bank CDs or not so hot mutual funds, and your retirement income is going to stay in the lower tax bracket, then a regular IRA is better due to the deduction up front.

On the other hand, if you have several IRAs including SEP or SIMPLE, are an experienced investor, and plan to use the IRA to buy a good-sized apartment house (through a trustee), then the ROTH is the way to go.

Should financial skills improve later on, once you are 59 1/2 you can withdraw small bits at a time from your regular IRA (small bits so as not to bump you into a higher tax bracket) and put it into a ROTH.

bikebum

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Re: So what if Roth IRA allows tax-free growth?
« Reply #8 on: April 05, 2014, 12:35:19 PM »
Thanks for the responses guys, but some of you are answering a different question than what my post is about. The question is whether the tax-free growth of the Roth IRA is advantageous over the Traditional IRA, not which account is better in general. The 25% flat tax is a simplification to make the calcs easy to follow.

Many articles say the tax-free growth of the Roth is a very special thing. I think it is not so special, it is similar to putting pre-tax dollars into a Traditional, since you can get more of your money in earlier. Unless you are going to hit the max contributions, which others have pointed out that in this case the Roth could allow you to end up with more money in the account. If the Roth IRA did not offer tax-free growth, the Traditional IRA would obviously be the better option, so the tax-free growth of the Roth is not special.

Cheddar Stacker

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Re: So what if Roth IRA allows tax-free growth?
« Reply #9 on: April 05, 2014, 12:45:55 PM »
The tax free growth is not really an advantage the Roth has over the TIRA. There are a few major difference in the accounts as others have commented on, but as your simple calculation in the first post clearly shows, given an identical tax rate they both effectively have "tax-free growth".

ender

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Re: So what if Roth IRA allows tax-free growth?
« Reply #10 on: April 05, 2014, 12:48:37 PM »
You might be interested in this thread I posted today.

The implications of those calculations directly help answer your question.

MDM

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Re: So what if Roth IRA allows tax-free growth?
« Reply #11 on: April 05, 2014, 12:59:34 PM »
The probably with your calculations is the flat 25% tax.  This is one reason a traditional IRA might be favored in many cases.

Put money into a traditional IRA or 401k and save your marginal tax rate (maybe 25% + state tax), then when you withdraw you fill up the brackets from the lowest up.  So the first ~$10k is tax free, then $10k at 10%, then 15%.

In order to pay 25% federal tax on IRA withdrawals, you'd have to withdraw about $240,000 in a year.
kpd905, it appears you are assuming that when time comes for withdrawals, the only income is the IRA and the taxes are for a single person.  Is that correct?  Not disagreeing, just trying to ensure I understand the assumptions.

bikebum, re "The question is whether the tax-free growth of the Roth IRA is advantageous over the Traditional IRA" I see it the same as you describe. 

bikebum

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Re: So what if Roth IRA allows tax-free growth?
« Reply #12 on: April 08, 2014, 06:04:43 PM »
Your analysis is correct if the money you're putting in an IRA is all you have available to invest. If you can afford to max out your IRA (whichever type you choose), a Roth IRA can potentially allow you to put more into a tax-advantaged account. Here's how: if you put $5,500 in a Roth IRA this year and it grows to $20k when you take it out in a few decades, you'll get to keep the whole $20k.

If you put $5,500 in a traditional IRA, on the other hand, you'll have to pay tax on your $20k when you withdraw it. You might be left with $17k if you're in the 15% bracket when you retire. You will be able to save some money on your taxes this year, and invest that in a taxable account. This money will compound alongside your IRA, but you will be paying taxes on any dividends and other transactions in the meantime. For a lot of us Mustachians who plan to dramatically decrease our incomes (and thus tax rates) when we retire, we will likely come out ahead this way anyway because our tax rate is much higher now than we plan for it to be in retirement. But if you have a low tax rate now and can afford to max out your accounts, you may find that a Roth will give you a better overall retirement income.

If you are going to max out both in dollar terms, the Roth is better.

The Roth is better if you intend to leave any of the IRA to your children.

You guys want to help me convince some people on the City-Data forum that this is correct? I brought back an old post where someone was explaining how the Roth has a higher effective contribution limit. The other posters didn't believe it, so I created an account to pick-up where it was left off. I can't seem to convince them either. Here's the link:

http://www.city-data.com/forum/personal-finance/2068494-roth-ira-401-k-has-higher.html

If you're not into it that's cool. I think it's kinda fun.

simonsez

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Re: So what if Roth IRA allows tax-free growth?
« Reply #13 on: April 09, 2014, 09:27:27 AM »
If you choose Roth:
Your $100 becomes $75 after you pay taxes.
$75 x (1.07)^20 = $290.
No tax to withdraw.
Although seattlecyclone et al have touched on it, your Roth IRA table should look like:
Your $100 contribution stays $100 in the Roth IRA and you pay $25 in taxes using other dollars.  Effectively you contribute more and also need more as you would need $125 total to be able to have $100 in the Roth IRA in your example.  Dollars are fungible.



CorpRaider

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Re: So what if Roth IRA allows tax-free growth?
« Reply #14 on: April 09, 2014, 09:36:47 AM »
You're not missing anything.  "Transitive property".  If your rates are the same the there's no difference if the haircut comes off the top or the bottom.  The tax savings are still part of your net worth if you make traditional contributions, if you take the tax savings and blow them on rapidly depreciating consumer assets then some of the arguments many made in this thread in favor of the roth are relevant.  But if you put the money in BRK, TPRE, MKL or even SPY you're getting tax deferred compounding as well (or hell put it in munibonds).  Most people will have lower rates in retirement (esp in the early form).  Also, all of these articles completely ignore state taxes and the ability chose the time and amount of recognition.  Move from california to florida; that's material.
« Last Edit: April 09, 2014, 09:41:26 AM by CorpRaider »

Cheddar Stacker

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Re: So what if Roth IRA allows tax-free growth?
« Reply #15 on: April 09, 2014, 11:01:15 AM »
The tax free growth is not really an advantage the Roth has over the TIRA. There are a few major difference in the accounts as others have commented on, but as your simple calculation in the first post clearly shows, given an identical tax rate they both effectively have "tax-free growth".

From what I can see, one of the bigger advantages of a Roth is that if you are going to leave your kids an inheritance, they'd inherit a Roth tax free, IIRC.

Yep. That's one of the major differences. No RMD's and can pass on to heirs within the ROTH.

bikebum

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Re: So what if Roth IRA allows tax-free growth?
« Reply #16 on: April 09, 2014, 06:05:38 PM »
If you choose Roth:
Your $100 becomes $75 after you pay taxes.
$75 x (1.07)^20 = $290.
No tax to withdraw.
Although seattlecyclone et al have touched on it, your Roth IRA table should look like:
Your $100 contribution stays $100 in the Roth IRA and you pay $25 in taxes using other dollars.  Effectively you contribute more and also need more as you would need $125 total to be able to have $100 in the Roth IRA in your example.  Dollars are fungible.

You could do it that way too. I started with $100 pre-tax for both on purpose, because it is easier than starting with different amounts to make the contribution the same and then deciding what to do with the tax savings of the Trad IRA. Think of it like you have $100 pre-tax income and you want to decide where to put it. Anyway, my question was answered.

bikebum

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Re: So what if Roth IRA allows tax-free growth?
« Reply #17 on: April 09, 2014, 06:13:51 PM »
Your analysis is correct if the money you're putting in an IRA is all you have available to invest. If you can afford to max out your IRA (whichever type you choose), a Roth IRA can potentially allow you to put more into a tax-advantaged account. Here's how: if you put $5,500 in a Roth IRA this year and it grows to $20k when you take it out in a few decades, you'll get to keep the whole $20k.

If you put $5,500 in a traditional IRA, on the other hand, you'll have to pay tax on your $20k when you withdraw it. You might be left with $17k if you're in the 15% bracket when you retire. You will be able to save some money on your taxes this year, and invest that in a taxable account. This money will compound alongside your IRA, but you will be paying taxes on any dividends and other transactions in the meantime. For a lot of us Mustachians who plan to dramatically decrease our incomes (and thus tax rates) when we retire, we will likely come out ahead this way anyway because our tax rate is much higher now than we plan for it to be in retirement. But if you have a low tax rate now and can afford to max out your accounts, you may find that a Roth will give you a better overall retirement income.

If you are going to max out both in dollar terms, the Roth is better.

The Roth is better if you intend to leave any of the IRA to your children.

You guys want to help me convince some people on the City-Data forum that this is correct? I brought back an old post where someone was explaining how the Roth has a higher effective contribution limit. The other posters didn't believe it, so I created an account to pick-up where it was left off. I can't seem to convince them either. Here's the link:

http://www.city-data.com/forum/personal-finance/2068494-roth-ira-401-k-has-higher.html

If you're not into it that's cool. I think it's kinda fun.

I should have been more clear about this. The OP at City-Data claims that the Roth IRA allows for a higher "effective" contribution limit, which is what seattlecyclone and 2527 pointed out to me on this post. The people who responded didn't believe it, well at first they sort of did and then later denied it. So I was asking if anyone wants to join me in trying to convince the fools that the Roth has a higher effective contribution limit; in other words, it allows you to get more money in a tax-advantaged account. The post has since fizzled down though.