Roth IRAs

John and I were talking about Roth IRAs a few weeks ago and I thought everyone might benefit from the discussion. Proponents of the Roth IRA are quick to point out that your account grows tax-free which creates huge tax savings. Right? Well, yes and no. Although you will definitely pay less overall tax to the IRS, your net distribution at retirement will be the same whether you choose a Roth IRA or your employer's 401k.

A quick example to illustrate this point will help. Let's assume you have $1,000 to invest this year at 10% interest and you are (and will be in the future) in the 25% tax bracket.

As you can see, you did pay $4,709 more in taxes but the amount you would be left with at the end of the 30 years is iiiiidentical (think My Cousin Vinny). The government has only convinced you to pay your tax now instead of later which effectively has cost the government revenues in the future. But don't think for a moment that the congress of 2038 can't change their minds and say "Hey, those idiots 30 years ago took our tax revenues and we need to fix this!" The government is NEVER under any obligation to allow a tax benefit to remain from one year to the next.

So, IF you think your tax rates will go up in the future AND you think that the government won't strike §408A(d)(1) from the Internal Revenue Code (sorry for geeking out on you there) then a Roth might not be a bad idea. However, proper tax planning should result in you being in the same or lower tax bracket at retirement. And if the law does change, you would have been better off just putting your money in a brokerage account (instead of a Roth) because at least you could have avoided the 10% early withdrawal penalty if you needed your money before retirement. Even if all things were equal, you would still get a higher return on investment if your money was in your 401k since your employer is picking up the account management fees.

The point is, you are not necessarily worse off with a Roth IRA, but you likely aren't better off either.