FYI: In the 1980s, 60% of employees were offered pensions by their employers. Today, that figure is less than 5%. The decline has shifted the responsibility of saving for retirement to workers, many of whom are turning to Roth IRAs. Over one-third of U.S. households owned a Roth IRA in 2016, and if you're thinking of joining them this year, you have until the tax-filing deadline in April to make a contribution for 2017. Investing in a Roth IRA can be smart, but there are drawbacks you should know about beforehand. These three problems with Roth IRAs could make saving for a retirement in a traditional IRA a better option.
Regards,
Ted
http://www.cetusnews.com/business/3-Big-Problems-With-Roth-IRAs.S1-nwcViFz.html
Comments
Problem 1- Roth IRAs have income limits: If your income is too high to contribute to a Roth IRA (a good problem) you have the financial ability to contribute to a taxable retirement account and then orchestrate a "back door" Roth strategy...problem solved.
Source: https://kitces.com/blog/how-to-do-a-backdoor-roth-ira-contribution-while-avoiding-the-ira-aggregation-rule-and-the-step-transaction-doctrine/
Problem 2 - Roth IRA benefits can be limited: Roth death benefits are tax free for the beneficiary. Tax deferred IRAs are taxable upon death to the beneficiary. If you die early...your dead... regardless. I would agree that if your beneficiaries are non - profit organizations, then, by all means, contribute to tax deductible IRAs and pass the entire tax deferred account on the the non-profit tax free.
Problem 3 - The time value of money can be hard to beat:
Time value is the very reason Roth IRAs are such a great long term retirement investment. You pay less "real dollars" in taxes. When you contribute to your Roth IRA you pay taxes in today's dollars. A $5500 contribution at the 15% tax rate would equate to $825 additional income tax...at 20% rate would equate to $1100...at 25% rate would equate to $1375. The 2018 lower brackets look like this:
If you will fall within these lower brackets it make tax sense to contribute to the Roth. It also makes sense to lower yourself into these brackets by deducting income on contributions to tax deferred IRAs. A combination of the two is also a good strategy.
Fast forward to age 60 (30 years of compounding growth @ 7%):
This one Roth contribution ($5500) would have a value of about $39K (tax free) and has no RMD requirements at age 70. At age 70, it will have grown to almost $77K. This money can help you strategically lower your taxable withdrawals from other taxable accounts to further minimize taxes. This can also help you avoid many income based costs (i.e.- income based medicaid premiums) or qualify for income based subsidies (too many to list).
Fidelity article on Strategic Income Withdrawals:
https://fidelity.com/viewpoints/retirement/tax-savvy-withdrawals
Had this contribution grown in a tax deferred IRA, the deferred tax liabilities at age 60 would be - $5850 (@15% rate), $7800 (@20% rate), and $9750 (@25% rate) and about twice that at age 70. Roth locks in the tax rate at the point of contribution...tax deferred is always the differential between what you saved on contributions (your tax deductions) verse what you paid on withdrawals (your tax liability on your withdrawals). RMDs force your income higher so you have less control over income levels.
If you can lock in a low tax rate on a contribution with either or both tax free (Roth) or tax deferred (401K, 403b, 457, etc.) this is a tax bird 'in the hand". The real problem is not knowing what your taxable income will be on your tax deferred withdrawals in retirement... that is the "tax bird in the bush." and not having a mechanism to help strategically live on some tax free income when it is to your advantage. Saving 15% on contributions to then, 30 years later, pay a higher tax rate on withdrawals is a real long term loss of capital (withdrawal tax rate - contribution tax rate) compared to the Roth IRA (contribution tax rate).
I like to think of the taxes paid on a Roth contribution that permanently locks in the cost of taxes. Obviously, there are many other advantages to a Roth IRA such as access to you contributions at any time tax free, no RMDs, and the ability to fine tune your retirement income with regard to tax liabilities by accessing tax free dollars.
1. Roth income limits. Here are some concerns about Kitces backdoor solution, a couple pragmatic and one a matter of principle.
I don't know how many 401(k) plans allow transfers from IRAs. If you can't segregate pre-tax and post-tax IRA money via an IRA to 401(k) transfer, backdoor conversions are often impractical. Too much pre-tax money in the IRA.
Also, even if you can move your pre-tax IRA money to your 401(k), that money will be stuck there, whether the 401(k) is a good plan or not.
The matter of principle is that, as Kitces stated, what makes backdoor conversions illegal is intent. The fact that you won't get caught if you follow his prescription doesn't make it legal. Just in case that matters. Me, I jaywalk daily and twice on Sunday.
3. Time value of Roths. Locking in rates can be good or bad. Would you lock in a 5 year CD at 3% now when you can get 2.5% on an 18 month CD? There is potential value in flexibility - one can contribute to a traditional IRA and convert to a Roth some time in the future when taxes are lower (locking in that lower rate when it materializes).
Whether you want to wait depends on what your crystal ball shows for future tax rates from now until retirement, and perhaps beyond. Personally, I'm betting on higher taxes (and locking in via Roth conversions of past years' contributions), but that's just one individual's opinion.
Someone who has difficulty maxing out IRA contributions is more likely in retirement to draw steadily from an IRA for income. That will limit the growth of the IRA, so that RMDs (and taxes) don't grow out of control. On the other hand, if one can easily max out IRA contributions, the time value of the Roth becomes even more important.
Here's a numeric example showing that even if tax rates are somewhat lower in retirement, contributing to a Roth (if you max out) can be better than contributing to a traditional IRA. It comes out better because when you max out a Roth you're sheltering more dollars (in after tax value) than you would in a traditional IRA.
Say the person is in the 24% bracket, but will be in the 22% bracket at retirement.
Assume there's $5500 in earnings, and $1320 (24% of $5500) in a taxable account. Finally, also assume that the taxable account is 100% tax-efficient (no taxes along the way), and gets taxed 15% (cap gains) at the end.
The investor can either put the $5500 into the Roth, using the $1320 from the taxable account to pay the taxes up front, or can put $5500 into a traditional account, and invest the $1320 in the taxable account.
Even with the higher (24%) taxes up front, the Roth breaks even once the investments have grown 125% (i.e. 2.25 times the original value). From that point on, the Roth pulls ahead. I've shown below what happens at the 125% growth mark, and at the 250% (3.5 times original value) point. That's still a lot less than Bee's growth (600%, to 7 times the original value).