Why do Roth IRAs exist?

Lately, I have been getting this question frequently. For some folks, it’s the first time they’re hearing about tax-free growth. For others who have been saving in a Roth for a long time, or are converting pre-tax dollars to Roth IRA, they have never really considered just how beneficial tax-free growth truly is. This is especially true when you have a 10, 15, even 20+ year timeline. The fact of the matter is that Roth savings are not the end-all-be-all best option for everyone, but it is incredibly beneficial for a large concentration of savers. As a rule of thumb, younger savers who are in low tax brackets, or retirees with reduced income (compared to their working years) can all benefit from either contributing or converting to Roth.

Now we all know the IRS exists to collect tax revenue, and they’re pretty darn good at it. So why on earth would they let me, someone who plans to work for 30 or more years, save my money in a vehicle that compounds growth over those 30 years without paying any taxes on it? To understand that, we need to take a trip back in time.

The Birth of the Roth IRA

Roth IRAs were signed into law as a part of the taxpayer relief act of 1997(1). Prior to that, most retirement savings happened in traditional IRAs and other tax-deferred vehicles. Previously, I wrote an article explaining the different tax treatments of your investments [https://fsgmichigan.com/blog/defer-or-diversify-how-should-i-save-for-retirement], but essentially “tax-deferred” means you can delay the timing of when you pay taxes on your investments until you start taking distributions (rather than paying it as the money is growing). With IRAs and other retirement plans, you also get the benefit of reducing your taxable income in the year that you make your contributions. Tax-deferral is especially beneficial for folks that are in higher tax brackets during their working years but plan to pay less in taxes during retirement. Eventually, lawmakers realized how much tax revenue was being missed out on as a result of this. Thus, enters the Roth IRA. It was designed to motivate people to pay those taxes today and receive tax-free growth as the trade-off.

The Tax Landscape

The trade-off of paying taxes on the “seed or the harvest” ie: Roth savings (taxing the “seed”) vs Tax-Deferred savings (taxing the “harvest”) used to be a much more difficult decision. As this article is written in 2021, the U.S. is in a historically low tax environment with high standard deductions, so the decision is pretty easy for most people. The tax benefit of reducing your taxable income is relatively small compared to the benefit of compounding tax-free growth. However, in 1997 tax rates were much higher. A married couple making $75,000 in 1997 found themselves in the second-tier tax rate of 28% (2), in today’s numbers that couple would be making around $127,000 and would be in the third tier tax rate of just 22% (3). If you do the math, the 1997 and the 2021 couple actually end up paying almost the same dollar amount in taxes (not relative to inflation rates), the actual same dollar amount! So, in 1997, the IRS really had to incentivize people to bite the bullet and pay taxes on their retirement savings.

In a Nutshell

When looking at Roth savings through today’s perspective, it’s a no-brainer for a lot of people. However, the world was a different place when Roth was created in 1997. In the same respect, the world will be a different place 24 years from now, and your financial plan should allow you the flexibility to adapt to those changes. The decision on where and how to save can be a complex one. If you’re considering starting a Roth savings or converting tax-deferred dollars to a Roth IRA I encourage you to consult with a fiduciary financial advisor to ensure you are making the best decision for yourself long-term.

Sources:
https://www.congress.gov/105/plaws/publ34/PLAW-105publ34.pdf
https://www.irs.gov/pub/irs-prior/i1040tt--1997.pdf
putnam.com/literature/pdf/II985.pdf

https://fsgmichigan.com/podcast/episode-2-roth-iras-what-you-need-to-know

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Written by: Justin Meyer