Two Savings Lessons for Retirement
Follow these principles to determine whether a Roth or regular IRA is better
Readers, last week, I closed my life-cycle economics class with a proposition for my students:
If a household wants to save for retirement, is saving through an Individual Retirement Account or a Roth IRA the better choice?
You may have an IRA, want to keep it, and try a Roth this year. Or vice versa. There is a rational reason for having both: taxation differs. Having both accounts gives the benefit of tax diversification: retirement withdrawals from an IRA are taxed just like job-related income. Retirement withdrawals from a Roth are tax-free! The “what should I do” is dependent on your attributes. The wrong choice can cost you tens of thousands of dollars, and the wrong choice is easy to avoid!1
Johnny Sullivan’s updated story from a prior post illustrates the principles of choosing wisely and avoiding throwing away wealth. The first lesson is low-hanging fruit,
Lesson 1: The better choice produces the higher expected lifetime living standard.
Johnny Sullivan’s Story
Johnny Sullivan grew up an East Coast boy who attended Oklahoma for college. Even now, when spring begins on the southern prairie, Johnny gets a whiff of winter wheat and wildflowers, and his mind turns toward tornado season and away from the memories of the bitterly cold winters when a Nor’easter would blow through every crack in his boyhood home.
Johnny is still single, which might be explained by his avocation: storm-chasing. Johnny is on his way to Kansas to start his first job out of college. He was going to work in Wichita for KU Social Media, LLC. A graduate of Oklahoma State University, Johnny was a double major in communications and earth science and a long-distance swimmer on the Cowboy swim team. Johnny grew up in Lowell, MA., and started “The Tornado Club’’ in high school. An avid follower of weather forecasting, Johnny wanted to attend college in Oklahoma and live in Tornado Alley. He fulfilled his dream.
Johnny was a curious student at OSU and graduated with a 3.45 GPA. It would have been higher, except finals were in May. Storm-chasers can’t be concerned with the academic schedule. In college, Johnny became interested in how social media affected people’s perceptions of a daily weather forecast. Did weather followers value social media? If so, which platforms did they prefer? How do they post? How did the platforms use posting frequency and depth to their business advantage? Who, besides Al Roker, is an important influencer? How many people put the WeatherBug on their desktop? Typical questions require some analytics. Johnny received multiple job offers, and KU Social Media offered a $10,000 signing bonus to seal the deal.
Johnny strongly prefers to begin saving for retirement. KU Social Media’s benefits package is built to attract and support a younger employee base. There is no need for an employer-sponsored 401(k) when a minor amount of health insurance, an on-site spa, and free food trucks have been voted the benefits most cherished by Social Media’s Gen-Zers.
Johnny is a saver, an uncompromising preference enforced by his upbringing among the frugal elites. Now that he has a full-time job, he wants to make his first serious effort toward saving long-term. A regular IRA and a Roth IRA are the obvious choices because they come with tax benefits. However, savings for retirement in the near term are challenged by other calls on Johnny’s income. Repaying a student loan he received in Stillwater is as much a non-discretionary expense as Johnny’s food, shelter, and clothing. His annual repayment is $3,374 per year. Still, some savings might be workable, and Johnny devotes saving $2,000 per year to his retirement basket. Taxation differences among tax-favorable retirement accounts, investment returns, and other household financial characteristics complicate the better way to save. Johnny’s better solution is his answer to Lesson 1, and here is the spoiler,
In Johnny’s case, the effect of a regular IRA and a Roth IRA yields a difference of more than $100k!
Roth or Regular IRA for You?
What would you do if you were in Johnny’s shoes and wanted to make a better choice? Like Johnny, you might search for information about IRAs and Roth IRAs. Johnny begins with the sites of three major investment companies: Fidelity, Schwab, and Vanguard. They compare and contrast the Roth and regular IRA choices on their retirement tabs. A glimpse below at the information delivered shows the standard delivery of the content.
1. Fidelity
2. Schwab
3. Vanguard
See a theme? Leading investment companies, but the information pool is shallow. Descriptive information about contribution maximums and the tax law. There is no indication about savings needs, investment choices, or the better choice because taxation is different and households are different. Wouldn’t that be valuable?
Thousands of dollars are at stake in making the better choice. How can an answer to the regular vs. Roth IRA question be more helpful for you? You can rely on me and Personal Finance Economics because banks and investment companies can't get their public presentations to the required level of detail to answer the question with the degree of seriousness everybody needs for decision-making.
Johnny Sullivan’s Better Choice
Johnny’s better choice relies on Johnny’s financial attributes. To re-emphasize, the better advice for Johnny may not be the preferred choice for another Gen-Zer or a 50-year-old couple with kids. Household financial attributes turn the decision toward the best choice. The solution is generalizable and effective for households, advisors, and CFPS because it is grounded in economic theory. Readers don’t need to know a lick of the theory to apply it because the practical engine has been built, and you have me to help.
To illustrate with Johnny, consider that he will earn $78,000 this year and wants a reasonably typical working lifetime, retiring at age 70. Health and family genetics make him expect a long life to a maximum of 90. Prospectively, about 50 years of life with employment and 20 years post-employment. Living in Kansas implies a specific state income tax, and we will hold federal income taxation and social security benefits consistent with current law. Housing expenses are $2,350 per month, and whether Johnny contributes to a regular IRA or Roth, he plans on contributing $2,000 per year, adjusted for 1% growth. All other financial planning details and assumptions are listed in the financial plan, which I will share an updated version if you DM me.
Why would Johnny’s better choice require a more complete approach than describing contribution limits, deductibility rules, and tax effects on accumulations and withdrawals? How the tax law applies varies by plan type, and the earnings on supporting investments matter. Roth account assets grow tax-free and are withdrawn tax-free, while regular IRA account assets grow tax-deferred and are taxed as ordinary income when withdrawn.
Johnny’s solution is found in the two charts below. The upper chart tracks Johnny’s living standard year-by-year in today’s dollars. Under the Roth alternative, Johnny’s living standard is generally lower until age 46, then higher every year after that. The much higher and total effect is the criterion for decision-making.
The cumulative difference in lifetime living is about $110k in favor of the Roth IRA—that is too much money to give up by making the incorrect decision.
Two reasons for this difference. First, lifetime income taxes are lower under the Roth alternative, and second, prospective Medicare Part B premiums are higher. Most of the value the Roth choice adds extends from the tax savings.
What Would Cause the Results to Change?
Generally, the higher the investment returns from year to year, the more value to a Roth. Lower investment returns take away some of the Roth tax advantages. In Johnny’s case, it was assumed that Johnny would earn about 3.75% in real terms on his retirement assets. If his returns only match inflation, with 0% real returns year-over-year, then the regular IRA becomes desirable to Johnny based on Johnny’s comparable living standard under each account type.
Lesson 2: If you are engaged in retirement planning, you have the best choice for your household: an IRA, 401k, 401k with an employer match, or a Roth. Maybe a combination. I will help you learn if you send me a direct message. That is another piece of low-hanging fruit.
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Many individuals have 401k plans through their employers, which allow higher contributions. Having a 401k and an IRA is plausible, but that would be another question to answer. Of course, the living standard approach still applies.