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Study Finds Huge Wealth Gap in Roth IRA Returns

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What You Need to Know

  • A new study found that investors who made less than $200,000 had much lower returns in Roth IRAs than higher income individuals.
  • The spread in traditional IRA returns between the two income groups was much narrower.
  • The findings could have policy implications as Roth IRAs were intended to help middle-class Americans, the authors write.

A recent academic study looking at the performance of IRAs found some “striking and unexpected” results. First, for those who make less than $200,000 (or “low-income”), returns on Roth IRAs were 3.6% from 2004 to 2018, versus 8.5% for those who make more (or “high-income”). Further, the Sharpe ratio for those with lower returns was 50% higher (.49 versus .32).

“At the aggregate level, the risk-adjusted performances of IRA plans are comparable to that of the aggregate equity market,” Lorenzo Bretscher of London Business School, Riccardo Sabbatucci of Stockholm School of Economics and Andrea Tamoni of Rutgers Business School write in their paper, “The Unintended Consequences of Roth IRAs.”

“However,” they write, “high-income individuals substantially outperform low-income ones, and this return differential is almost three times as large in ‘tax-free’ Roth IRAs, suggesting that their introduction, intended to help hard-working, middle-class Americans, greatly benefited high-income individuals and amplified wealth inequality.”

ProPublica’s investigation in 2021 of billionaire Peter Thiel’s $5 billion Roth IRA highlighted the benefits of these accounts to certain investors, like Thiel, who use them to invest in early-stage startups that can later explode in value. As the study notes about that $5 billion, “no tax will ever be due on this amount.”

The study’s authors explored two questions: 1) What is the return performance of aggregate IRA plans, and Roth IRAs in particular, on average? and 2) Are the returns of high-income IRA investors economically different than those obtained by low-income individuals, at the aggregate level and across the different IRA plans?

They found the average return on aggregate Roth IRAs from 2004 to 2018 was 4%, “slightly lower than the 4.9% obtained by traditional IRAs,” the authors state. Also, the Sharpe ratio of Roth IRAs was 0.287, lower than the 0.443 obtained by traditional IRA plans. They noted that the S&P 500 during that period returned 6.7% with a Sharpe ratio of 0.413.

Then they looked at performance among income groups. Those with income $10,000 to $100,000 earned an average of 2%-3% per year on their IRA investments, while higher income investors — those earning $1 million or more — had returns of 10% per year. Sharpe ratios were 0.351 and 0.519, respectively; therefore the risk-taking differential wasn’t significant, the researchers found.

Likewise, those earning $200,000 or more outperformed the low-income individuals by a factor of three over the same period, the study found.

Inside IRAs

After breaking down income levels, the researchers looked at which IRAs accounted for the wide spread in performance between those making under $200,000 and those making over $200,000.

The group found that the spread between high- and low-income individuals’ performance in Roth IRAs was 15.9% while the spread in traditional IRAs was 4.7%.

“Importantly, this difference is mainly driven by high-income individuals, whose performance in Roth IRA plans is more than twice as large (17.9% versus 8.6%) as that obtained in traditional IRA plans,” the study states.

The authors note that the two plan types “are exploited differently by high-income investors in terms of allocations,” with results suggesting “that high income individuals invest in top performing assets only through their ‘tax-free’ Roth IRA plans.”

The authors conclude that 1) there is “substantial performance heterogeneity between high- and low-income individuals across IRA plans,” and 2) the difference between Roth and traditional IRA performance is so significant as to have government policy implications.

A Closer Look

“The good news is that it isn’t the highest income investors who have the highest Sharpe Ratio Roth portfolios, it is the mass affluent investors making between $100,000 and $500,000 a year,” Michael Finke, professor at The American College of Financial Services, said in an email. “This could be related to higher financial literacy, or it could reflect the impact of professional financial advice.”

That said, “the flip side is that lower-income workers not only get less of a tax benefit from using a tax-sheltered account, but also underperform other investors within the accounts,” adding that “self-directed investing results in greater wealth inequality because of differences in financial literacy and professional advice, and this study bears that out.”

He added that “the very high performance and high standard deviation of investors making more than $1 million is consistent with the idea that some highly sophisticated investors are taking advantage of Roth accounts to shelter non-publicly traded assets.”

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