This week I’m writing all about the good, the bad, and the ugly of a ROTH IRA or ROTH 401k. If you missed Part 1, the good, go here to check it out.
Now you know all about the good parts of a ROTH IRA. You’ve probably been nodding along, thinking how great it all sounds. No wonder you always read all about why getting a ROTH is a no-brainer!
Not so fast, internet friend. ROTH IRA’s have some sneaky downsides that many people don’t ever talk about. It can be confusing to decide whether or not, based on your personal situation, a ROTH or traditional makes more sense for you. So today I’m going to talk all about the bad, non-intuitive parts of choosing a ROTH as an investment vehicle. Stay tuned for Friday where I’ll be talking about the downright ugly parts you need to keep an eye out for.
ROTH – The Bad
So if the ROTH is so awesome, why do I have two more sections to this series about the bad and the ugly? As I mentioned in the introduction, no investment option is perfect for all people all the time.
- It Doesn’t Really Save Taxes (Tax Rates Being Equal) – I once tried to explain this to a friend who had heard Mad Money’s Jim Cramer talking all about how awesome the backdoor ROTH was. I assume he was listening to the show, not reading that article I linked, but somehow he had gotten the impression that putting money into a ROTH was a magical thing that would always save on taxes. Sorry to say, no, it’s not. It all depends on what your tax rate is today, and what your tax rate will be when you withdraw. If the tax rates are the same, you’re financially no better off.
- This is a really hard concept for people to grasp. What they usually do is to compare $5500 put into a traditional, and $5500 into a ROTH (or $18k into a traditional and ROTH 401k). Then they calculate out the growth and see just how much money they’ll save in taxes with the ROTH.
In fact, this is what I get when I used the Bankrate Traditional and ROTH calculators on their website. This was for a $5500 starting balance, contributing $5500 per year starting at 30 and ending at 65. If you just look at the outcome of these calculators, you might think that it’s obvious the ROTH was better. You end up with the same dollar amount, and the ROTH is totally tax free! You’re forgetting, though about the next bullet point.
- People (and online calculators, for that matter) forget that you can’t actually compare equal dollar amounts when it comes to contributions. When you have a traditional IRA/401k, you are putting in pre-tax money. With a ROTH, you pay taxes, and then put in the money. So you have to count the cost of the taxes in your original contributions.
- Why is this important? Because when you’re making financial decisions you need to base it on the math. And in this case, your intuition might lead you to a bad decision if you haven’t done the math.
- A $5500 contribution to a ROTH doesn’t usually cost you $5500. It actually costs you that amount PLUS whatever you paid in taxes. So if you’re in a 25% tax bracket, you actually had to earn $6,875 to contribute that $5,500. The extra $1,875 goes to taxes.
- Contributing $5,500 to a traditional IRA means you only had to earn $5,500, because it’s pre-tax. So a $5,500 traditional IRA contribution is actually equal to a ROTH contribution of $4,125 (if you’re in the 25% tax bracket). You had to earn $5,500 in both cases in order to make that contribution. The exact amount varies depending on your tax rate.
- If your tax rate is unchanged from your contribution time to your withdrawal time, both investment vehicles leave you with the same amount of money at the end.
Check out the same calculator adjusting the amounts to account for taxes. You can clearly see that you will have the exact same amount of money at the end if your tax rates are the same. Now most times your tax rates won’t be the same, but whether you’ll pay higher or lower taxes in retirement depends on how much retirement income you’ll receive, and future tax rates. Many people think tax rates will be higher in the future, but no one knows for sure. That’s why it’s best to hedge your bets and do both a ROTH and a traditional.
- Income Limits – The ROTH isn’t open to everyone all the time. As I mentioned in Part 1, if you’re single, your modified adjusted gross income must be less than $133,000 as of this writing (2017), and contributions are reduced starting at $118,000. If you are married, your MAGI must be less than $196,000, with reductions beginning at $186,000. You can get around this limit by using the “backdoor”, where you contribute to an after-tax IRA and then immediately convert it into a ROTH.
- …after Five Years for earnings – This is a continuation of the “Withdraw Contributions Anytime…” rule. One of the oft-touted benefits of a ROTH is that you can withdraw contributions any time. While true, you can’t withdraw your earnings-and taking out your contributions cuts the ROTH off at its compounding knees. This is actually why it can be hugely beneficial to your kids if you help them open an account as a teen, because it starts the five year clock early on. Check out this post from Schwab for more details and exceptions.
- Low Limits – You can only contribute $5,500 into a ROTH IRA, and $18k into a ROTH 401k. Again you can get around this by using the backdoor strategy right now. I’d keep an eye on this, though, because whenever the media touts a backdoor way for the wealthy or high income to avoid taxes, Congress eventually gets wind of it and closes the loophole. One of the commenters in my last post said they think the lower limit can be a good thing-it’s a lot easier to “max out” the ROTH than it is to max out the 401k.
So am I saying that a ROTH IRA is bad? No, not at all. It can make total sense to invest in a ROTH, and if you’ve already maxed out pre-tax and you’re looking for another tax-deferred investment option, ROTH’s can be a great idea. But you need to do the math, pay attention to the limits, and make sure you really understand the limitations before you decide if it makes sense.
I’m not the only one that doesn’t think the ROTH is always an awesome choice. You can check out this article from Go Curry Cracker with a detailed breakdown of why (and when) a ROTH is a bad option.
Stay tuned for Friday and check out the downright ugly gotchas that a ROTH can throw at you (or if you missed The Good, go here!). In the meantime, let me know in the comments if anything you learned here surprised you, or if you know of other “bad” components of ROTH investing!
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7 thoughts on “ROTH and Backdoor ROTH – The Bad – The Good, The Bad, and The Ugly”
Hello Liz! Love this follow up and I’m looking forward to part 3. I also like when people make true statements like this: “Why is this important? Because when you’re making financial decisions you need to base it on the math” Gets me every time. We honestly have too many feelings tied up in our finances.
Yeah, you have to watch out for emotional decision making. And if you find yourself thinking that an investment option is ALWAYS good or ALWAYS bad, you likely need to do some more research. There is rarely an option that’s great for everyone all the time, or terrible for everyone all the time. Even whole life insurance, as bad as it can be, has a place to do good in some financial plans.
If you take money out of your Roth, you can only pay back that year’s limit. I was house shopping last year, and knew the rule allowed me to use money from my Roth. Once I learned the specifics I decided to pass.
I agree with everything you said, but I think a lot of people look at the ROTH tax free growth as a hedge against future tax increases. Especially with a long investing horizon, our current liabilities and future commitments as a country, taxes are likely to increase over time. I think looking at your investing horizon in addition to considering your current and future tax brackets is a big part of the equation for you to make your decision.
People have been saying that taxes are likely to go up in the future since the ROTH was created in 1997. I believe so far in the past 20 years, they overall have not, at least not according to the research I’ve done (of course it depends on your specific tax situation). It’s a gamble, which is why it can be good to hedge your bets and do both a ROTH and a traditional.
I can’t say 100% for sure either way. I do know that where I live state, local, and sales taxes have increased. As far as I know federal income tax brackets have been adjusted for inflation since the 90’s but not significantly raised or lowered. But I do know that spending and the deficit have continued to rise and we have just continued to kick the can down the road. The pyramid scheme can only go on for so long…
One reason I really like Roth accounts is because there are no required minimum distributions so you can keep the money in their as long as you want until you actually need it. This allows you further take advantage of compound interest. But in general I think it’s a good idea to invest in both ROTH and traditional accounts to give you the best of both worlds.