Paul Wonnacott Alan Holmes Professor Middlebury College Middlebury, VT 05753 802-443-5590 email: Paul.Wonnacott@middlebury.edu
With the introduction of the Roth Individual Retirement Account (IRA) this year, the public faces another choice in its important decision to ensure financial security in old age. Unfortunately, financial commentators on radio, TV, and newsletters provide little help when they regularly recommend a switch from traditional IRAs to Roth IRAs on two irrelevant or misleading grounds.1. First, they commonly argue that Roth IRAs have a tax advantage, in that the interest (and dividends and capital gains) accumulated on these accounts escape income taxation altogether -- in contrast to a traditional IRA, which provides only the deferral of taxes on interest, dividends, and capital gains. While technically true, this point turns out to be irrelevant. There is no advantage here for the Roth IRA, as compared to traditional IRA, for reasons explained below.
2. The second common statement is that Roth IRAs have a greater advantage, the longer the time period to retirement. To quote a standard conclusion, "if you have more than 10 years to go to retirement, a Roth beats a regular IRA almost every time." This is misleading. The advantages of a Roth IRA have little to do with the length of time before retirement, except insofar as people of different ages are in different tax brackets.
To explain the problems that arise with these two points, I will focus on the core differences between the traditional IRA and the Roth IRA:
-- Contributions to a traditional IRA are exempt from income tax, while withdrawals (both interest and capital gains) are taxed at normal earned income rates.
-- Contributions to a Roth IRA, in contrast, are taxed in the year the contribution is made, but withdrawals are exempt from tax.
In addition, there are differences in details, what might be spoken of as "bells and whistles" -- most notably, less rigid rules on the timing of withdrawals under the Roth IRA. These bells and whistles can be important, but my main points have to do with the core difference in tax treatment.
I. Escaping Taxes on Interest, Dividends, and Capital Gains.
To see why the first of the above two points is misleading, consider a simple example: an individual who has $2,000 in pre-tax income to contribute to an IRA. Assume, for the moment, that this individual is in a 25% tax bracket now, and will be in a similar bracket after retirement. Again, to make things simple, suppose that the individual will withdraw the IRA in a lump sum in 20 years (an unlikely, but simple, case), and also assume a constant return (interest, dividends, and capital gains) of 7%. At this 7% rate, a sum will approximately double in 10 years in the absence of taxation (by the rule of 70; that is, the sum approximately doubles when the interest rate times the number of years is equal to 70).
Consider the individual who uses a traditional IRA. Since there are no up-front taxes, the whole $2,000 goes into the IRA, which will then double and redouble to $8,000 during the two decades before it is withdrawn. After paying the tax of 25% upon withdrawal, the individual will have $6,000 left.
Now consider another individual, similarly situated, who uses a Roth IRA instead. In this case, the 25% tax must be paid up front, leaving $1,500 in the IRA account. Again, with a 7% return for the 20 years, this sum doubles and redoubles over two decades, to a total of $6,000. This $6,000 can be withdrawn tax-free. In other words, the two individuals have exactly the same $6,000 after taxes at the end of 20 years. The core difference between the two types of IRAs makes absolutely no difference in this simple case.
How can that be? After all, the whole accumulation -- principal plus accumulated interest -- is subject to tax in the first case, while the interest completely escapes taxation in the second, as commonly noted by financial commentators. The answer to this puzzle is that, with a traditional IRA, the individual avoids tax on $500 of the principal at the beginning. With a constant tax rate, the interest on this $500 just covers the tax payments on the interest; thus the two cases come out the same.
II. Differences in Marginal Tax Rates
The two outcomes are the same, of course, only if the tax (25% in our example) is the same after retirement as when contributions are made. If the tax is higher after retirement, the Roth IRA provides an advantage, because the individual avoids the high tax rate after retirement. If, on the other hand, the tax is lower after retirement, the traditional IRA provides the tax advantage.
Incidentally, this touches on misleading financial advice frequently heard some years ago, at the time the original IRA was introduced. The advice at that time was that you gained from an IRA because your tax was deferred and your income tax bracket was likely to be lower after retirement. This was (and is) true; but it is a minor part of the reason for using an IRA. As the above illustrations demonstrate, both types of IRA are advantageous if the tax rate never changes. The major advantage of either type of IRA is that, in effect, taxes are completely escaped on the interest, dividends and capital gains. That is, the possibility of a lower tax rate after retirement is a small part of the overall picture. Note further that the reason frequently given for the original IRA -- that tax rates are likely to be lower after retirement than during one's working life -- would argue for keeping the traditional IRA, and not switching to a Roth IRA, on which the tax is paid at the beginning.
III. The Length of Time to Retirement
Observe also, in the example we have used, that we would have gotten the same result if the period chosen had been 10 years; the two IRAs would have been the same. It likewise would have been the same if the period had been 30 years. The length of time, by itself, does not determine the superiority of one IRA over the other. There is, however, one way in which the time period can be relevant. Those close to retirement are more likely to have high incomes and be in higher tax brackets than the young. This, indeed, makes a case for the regular IRA for those close to retirement and a Roth IRA for the young. In this narrow sense, the longer the time period to retirement, the greater the case for a Roth IRA.
Of course, there are also are other differences between the two IRAs. Both have the same apparent limit -- a contribution of $2,000 per year. But $2,000 per year in a Roth IRA is "more" than $2,000 in a regular IRA because the tax has already been paid. We may see this point by referring back to the first example. For the regular IRA, the $2,000 represents the maximum contribution. But for the individual choosing the Roth IRA, the $1,500 (after tax) is not the maximum. The total may be increased to a pre-tax $2,667; that is, $2,000 after tax. In effect, the maximum with a Roth IRA is one third higher for those in a 25% tax bracket.
If the two types of IRA are so similar, why did Congress introduce the Roth IRA? An obvious explanation was to increase the effective minimum (as explained in the previous paragraph) without seeming to do so. But that, I suspect, was not the primary motive. My guess is that the major objective was to collect taxes up front in the Roth IRA, thus allowing additional tax-preferred retirement saving while minimizing the short-term negative budgetary impact; the loss of tax revenues would come at the end, when withdrawals were made. When Roth IRAs were first considered about a decade ago, this difference might have made some sense, since the government's short-term budgetary situation was grim. The irony is that the Roth IRA has actually been introduced at a time when the short-term budgetary position is strong, while the long-term situation is still a matter of concern. This means that the budgetary effect of switches from regular to Roth IRAs -- resulting in up-front tax collections but lower tax revenues in the future -- may complicate fiscal policies. Of course, because of the long-run tax similarity between the two types, the long-run net budgetary implications are small or negligible. A cynic might suggest that the whole idea of a Roth IRA was driven by the tendency of the government to have a shorter time horizon than the public; the long run in Washington is until the next election. This is a depressing thought, but it may be true; the public may indeed have a longer time horizon than the government.
As a bottom line, I might mention the advice I give to my own children when they ask about their own finances. I lean toward a Roth IRA for them, mainly because of the higher effective maximum contribution and the fact that, being young, they are still quite likely to be in a lower tax bracket than they will be when they retire. But I given them one caution. Even though the tax implications of the two types of IRA are similar, people generally think that the Roth IRA provides greater tax advantages. It is quite possible that congress shares this view, that Roth IRAs provide a tax advantage greater than that of the regular IRA. Does that mean there is a risk? At some time in the future, is it possible the congress will start to tax some of the withdrawals from the Roth IRAs, in order to reduce their perceived advantage?
And that, dear children, is a political risk that I cannot evaluate. You will have to make your own decisions.
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