How 'Roth Hype' Can Hurt Retirement Savers

These are all convincing reasons to consider Roth account contributions, as far as they go, but there’s been so much “Roth hype” in recent months that one planning expert is growing concerned that some savers might be getting the wrong message.

Taking recently to LinkedIn, Cody Garrett, the financial advisor and author, postulated that most Americans benefit more from choosing Roth in the form of conversions made later in low-income years rather than direct contributions while working.

“Sadly, workers are rushing into Roth during high-income years based on fear-driven, political commentary: without fundamental education or realistic assumptions about future income sources,” Garrett wrote. “We need to stop assuming that it’s ‘Roth: Now or Never.’”

Instead, Garrett wrote, the working motto should be: “Roth: Now, Later, or Never.” That is, savers should choose to pay tax in the years when they expect to have less taxable income, not based solely on whether they think overall tax rates will increase in the future.

Is the Roth Hype Train Going Off the Rails?

Garrett shared additional insights with ThinkAdvisor following publication of the post, writing via email that many financial commentators (wittingly or unwittingly) push the idea of “Roth now or never.”

“I encourage advisors and consumers not to let the excitement of Roth or the inchoate fear of ‘getting crushed later in taxes’ lead them to make decisions that go against their best interests,” Garrett wrote. “For many Americans, without significant retirement income sources beyond Social Security and their investment portfolio, the logical approach is to contribute to a traditional retirement account at work and a Roth IRA at home, rather than giving up a significant tax deferral.”

As Garrett pointed out, research shows that a substantial majority of Americans retire before age 65. That leaves more than a decade of opportunity to convert traditional retirement assets to Roth IRAs, he noted, often at much lower tax rates than those avoided while contributing.

To that end, Garrett proposed a rough framework to help savers assess when to go with Roth and when to stick with traditional accounts.

• Roth Now: Contribute or convert in years with low taxable income, whether that be while working or early in their retirement journey.
• Roth Later: Convert strategically in retirement, often during the low-income "golden years" between age 65 and when Social Security and required minimum distributions begin.
• Roth Never: Depending on the client's goals and wealth level, it can make sense to keep funds in traditional retirement accounts to benefit from tax-free charitable giving through qualified charitable distributions/inheritance.

Choosing whether to contribute to a Roth or traditional account should be made on an informed, individual basis, Garrett concludes, and not on speculation about future policy action in Washington.

Additional Perspective

Asked by ThinkAdvisor to critique Garrett’s arguments, Randy Watsek, a financial advisor and market commentator, largely agreed with the sentiment.

“He highlights an important point,” Watsek said. “Many people do contribute to a Roth during high-income, high-tax years when it might be more advantageous to contribute to a traditional IRA or 401(k), take the tax deduction at a high bracket, and then convert to a Roth during lower-income, lower-tax years.”

Suboptimal Roth contributions, Watsek agreed, are often driven by concerns that rising government deficits will lead to higher taxes. While this reasoning is valid, the full answer on where taxes end up is unclear.

So, Watsek said, the prudent planning approach is to act on the many factors and circumstances that can help to inform asset location.

Roth Assets Offer Greater Liquidity

One factor to consider, Watsek said, is that Roth assets are more accessible than traditional IRA or 401(k) assets.

Roth contributions can be withdrawn without penalty at any time.

“In contrast, withdrawing contributions from traditional accounts typically incurs penalties," he said. "This flexibility is a major advantage of Roths, beyond tax considerations.”

Ideally, savers will be able to rely on disposable income, emergency savings accounts and other forms of wealth to meet spending needs during their working years. But in cases where retirement accounts need to be tapped, Roth-style savings have an advantage.

Roths Offer More Tax-Free Growth

If long-term growth is the focus, Watsek observed, it is important to consider that Roth contributions are made with post-tax dollars.

“If you have $1 million in a traditional IRA and withdraw it in retirement at a 37% tax bracket, you would most likely net only $630,000,” Watsek said. “With a Roth, you retain the full $1 million. The tax on traditional accounts is deferred, not eliminated.”

In other words, paying taxes up front via Roth contributions allows a client to contribute more in after-tax value, and that “extra” grows tax-free.

“For those with excess savings, it may make sense to prioritize Roth contributions over traditional accounts,” he said.

Conversions Add Significant Flexibility

Garrett’s point about conversions is perhaps the most important strategy consideration, Watsek said.

“Related to the point above, if you convert a traditional IRA to a Roth and pay the tax with taxable assets, you’ve effectively converted taxable assets into tax-free assets,” Watsek said. “In the example above, suppose a client converted a $1 million traditional IRA and owed $370,000 in taxes. If you paid the tax out of the conversion, you’d have only $630,000 in the Roth.”

Instead, if they paid out of taxable assets, they would have $1 million in Roth assets.

“Effectively, you’d have made a $370,000 Roth contribution, which would then grow tax free,” he said.

The Bottom Line

Watsek agreed that while the tax outlook is unclear, high-income individuals may never see lower tax brackets.

“Regardless of deficits, wealthy individuals may remain in high tax brackets even after retirement,” he said. “For example, someone with substantial rental property, dividend-paying stocks or business interests may generate enough investment income to stay in the top bracket. For them, there may be no future opportunity to convert to a Roth at a lower rate.”

Government deficits are high, he added, and interest payments are becoming a growing burden. Tax increases may be necessary to address these issues.

“However, this should not be the primary reason for choosing one retirement strategy over another,” he agreed. “The future is uncertain, and it’s also possible that the government could reduce or eliminate the tax advantages of both traditional and Roth accounts.”

Responsible financial planning requires personalized analysis, not blanket advice. The best strategy depends on each client’s needs and circumstances.