If there’s one tool that financial experts seem to unanimously love, it’s the Roth IRA. It’s often touted as the hands-down best way to save for retirement, even inspiring a full-blown movement to encourage more people to contribute.
Is this retirement account really the slam-dunk experts make it out to be? Not exactly.
But first, what is a Roth IRA?
An individual retirement account, or IRA, is a tax-advantaged savings account for retirement funds. When you contribute to a traditional IRA, your contributions are made pre-tax, meaning your money goes straight into your account without having any income taxes taken out. Then, once you’re ready to use the funds in retirement, you pay taxes on the withdrawals.
A Roth IRA, on the other hand, taxes your contributions up front. Then you can withdraw the principal and earnings tax-free. The biggest benefit to this is that you can pay fewer taxes on your retirement savings now if you expect your income to increase over time (and thus, put you in a higher tax bracket at retirement).
There are some other pretty great benefits to the Roth IRA, such as the ability to withdraw funds before retirement penalty-free and to make contributions past age 70½. And we’re certainly not here to discount those benefits. But if you examine some of the less-discussed downsides, you might think twice before putting your retirement savings in one.
In fact, Miguel Gomez, a certified financial planner at Lauterbach Financial Advisors in El Paso, recently advised one of his clients against making Roth contributions after running the numbers. Though every person’s situation is different, here are the major reasons he said it might not make sense for someone to contribute to a Roth IRA rather than another type of retirement account.
1. You have to contribute more income upfront.
Since your Roth IRA contributions are made with after-tax money, you actually have to contribute more income than what ends up in your account.
Take this example: In order to max out your contribution for the year in a traditional IRA ― which is currently $5,500 for individuals under the age of 50 ― you need to save $5,500. But let’s say you contribute to a Roth IRA instead and your effective tax rate is 15 percent. You’d actually have to contribute $6,325 to save that same amount.
Obviously, the trade-off is that your withdrawals are going to be tax-free. But not everyone has a ton of extra money lying around to save for retirement. In fact, new data from Northwestern Mutual found that a third of Americans have less than $5,000 saved for retirement, while one in five hasn’t saved a dime.
Instead of paying those taxes upfront, you could have an extra $825 every month to spend on other priorities. For example, if you have student loan or credit card debt with interest rates that are higher than what you’re earning in your IRA, you’re effectively losing money at the end of the day. But by paying taxes at retirement rather than right now, you could pay off that high-interest debt, save for a home or contribute to your child’s college savings in the meantime.
And if you do have the financial bandwidth to take that extra savings and invest it somewhere else, “you’re able to invest money that otherwise would’ve gone to Uncle Sam. And I think that’s a very sweet deal,” Gomez said.
2. The tax savings probably won’t be that big.
As mentioned, one of the biggest reasons to contribute to a Roth IRA is to save on taxes in retirement. The assumption is that you will earn a lot more income by the end of your career than you do right now.
But how large will those savings be? Maybe not as much as you think. That’s because we follow what is known as a progressive tax system.
Rather than having all your income taxed at a certain rate, it’s taxed in tiers according to our tax brackets. Here are the 2018 brackets for a single filer:
$0 - $9,525: 10 percent
$9,526 - $38,700: 12 percent
$38,701 - $82,500: 22 percent
$82,501 - $157,500: 24 percent
$157,501 - $200,000: 32 percent
$200,001 - $500,000: 35 percent
$500,001 or more: 37 percent
Let’s say you earn $40,000 per year. Though you fall into the 22 percent bracket, most of your income isn’t taxed at that rate. The first $9,525 is taxed at 10 percent, then the next $29,175 is taxed at 12 percent. The remaining $1,300 is what’s taxed at 22 percent, giving you an effective tax rate of just under 12 percent.
So you can see, whether you earn $40,000 or $80,000, you’ll fall into that same bracket and your income would be taxed at the same rates. Even if your income jumped to $100,000, only $17,500 would be taxed at the slightly higher rate of 24 percent ― the difference tacking on an extra $350.
It is possible to save on taxes by contributing to a Roth IRA. However, the tax savings will be minimal unless you earn significantly less today than you will at retirement age ― and you have a lot of time between now and then.
3. It’s impossible to predict the future.
Many of the benefits of a Roth IRA depend on your ability to predict what life will be like in the future. If you’re fairly young, it can be especially difficult to guess what your priorities and goals will be in 20, 30, even 40 years.
For instance, what if you decide you want to move from a high-income tax state like California or New York and spend your golden years sitting along the banks of the Rio Grande or swimming in the Florida Gulf? Your fellow retirees in these income tax-free states will only have to worry about paying federal taxes on their retirement withdrawals. You, on the other hand? Well, you already paid the state taxes decades ago.
Then there’s the bigger picture. Just look at Social Security ― when the program was established, no one predicted that a wave of retiring baby boomers would use up the funds faster than younger generations could replenish them. Many predict that the Social Security trust fund will run dry by 2034, after which retirees would receive diminished benefits that would rely largely on payroll and income taxes.
Finally, there’s the question of what our tax system will look like as a nation by the time you retire. Are you certain the rules won’t change by then? Even the most recent tax reform that went into effect this year ended up lowering taxable income for many Americans. Those who previously contributed after-tax dollars to a Roth locked in the higher rates.
“We know today’s tax rules,” said Gomez. “Who knows if/when the government decides to, for example, make Roth accounts taxable in some way. Personally, I’d rather take the certainty of the deduction today over hoping I’m able to make tax-free withdrawals in 30-plus years.” He noted that this isn’t necessarily the case for all his clients; so much depends on when a person plans to retire.
Hedge your bets.
Like all things in personal finance, there’s never a cookie-cutter solution that works for everyone. So if you’re told there is, it’s worth poking around and questioning whether that’s really true.
For the saver who opts for a Roth IRA due to the potential tax benefits, there’s really only one scenario in which it works in their favor. “It could be a good idea for someone who is not making a lot of money right now ... but when they get older and make more money, they could end up in a higher tax bracket,” Gomez said. For example, a young person who is just starting out but ends up hitting it big as a successful attorney or engineer.
However, he noted that unless the income gap is significant, the tax benefit is really not that big. “So you’re giving up that little tax difference for the hope or promise that you will not have to pay taxes on those funds in the future,” Gomez said.
There’s so much uncertainty about what our economy will be like in the future, it’s hard to say for sure what the best option is. That’s why Gomez recommends that you hedge your bets and divide your retirement savings among different types of contributions. “We call it tax diversification. You want to have money in pre-tax accounts, in after-tax accounts and you want to have money in traditional brokerage accounts.”
The only thing that is certain? You need to save, period.
“The most important thing is to do it,” Gomez said.