Sunday, July 17, 2016

Jim Cramer Mystifies the Roth IRA Mystery

July 15, 2016
Cramer: To Roth or not to Roth? Untangling the IRA, 401(k) Roth mystery

"The less you make, the more likely it is that a Roth is for you. It's that simple." -Jim Cramer

Simple decision!

When deciding among a Roth IRA, 401(k) or a traditional account, it depends if it makes more sense to pay income tax now or to wait and pay income tax after retirement. This is a complicated decision that has more to do with the specifics of a situation and whether one anticipates they will be in a higher tax bracket at retirement.

Complicated decision!

"For anyone whose marginal tax rate is 25 percent or less, which is most of America, I think you go with a Roth. Better to take the hit up front, then allow your Roth IRA to compound tax free for the rest of your life," Cramer said.

Simple decision!

There's no math to support that simple decision, of course. The complicated decision was simply swept under the rug. You just have his word on it, and apparently it works for everyone in the 25% tax bracket or lower.

Why is it better for a lower income worker to lock in the 25% tax rate? Beats me! I'm retired. When I was working, I was generally in the 28% tax bracket. Thanks to low inflation, low interest rates, and no job, I'm now solidly in the 15% tax bracket. Glad I didn't lock in 28%!

And then there's this silly emotional inference that the Roth IRA is superior because it compounds tax free. If you prepay 25% in taxes or pay 25% when you withdraw, it's all the same. The difference between a traditional IRA and a Roth IRA can be seen in the following formulas with $1000, a 25% tax rate, 6% growth, and 30 years.

(75% x $1000) x 1.06^30 = $4,307.62
($1000 x 1.06^30) x 75% = $4,307.62

There is no difference between taking it out in the beginning or taking it out at the end. None. There will be a difference if the tax rate changes though. That's why it is a complicated decision. One needs to know what will happen to the tax rate in order to decide which IRA to use.

I'm in the camp which believes that the tax rate will likely be lower in retirement for most people, especially for poorer people, just like mine is. I no longer have a job that pays me a salary. Lower income, lower tax rate.

That doesn't mean all my taxes are lower though. The government finds other ways to tax me. Sales tax rates only seem to go up. It's all the way up to 9.5% in King County, WA. Ouch. Property taxes are climbing substantially again too, because we all apparently love inflating the bejesus out of housing prices. The Roth IRA does not protect against either of those. And don't even get me started if the US someday adopts a value-added tax (VAT). Roth IRA investors could easily become the tax bagholders. Prepay the income taxes and then pay the consumption taxes later? Ouch. Could happen.

The decision to invest in a Roth IRA is not a simple one, no matter what Cramer says. It just isn't.

One thing is nearly certain though. If you are in retirement, and have prepaid the taxes on all your investments, then you probably won't be paying much in income tax. Without income to be taxed, how will you be in a high tax bracket? Just something to think about, not that Cramer thinks you should think. Simple decision. Right?

I do not mean to imply that I have replaced Cramer's simple decision with a simple decision to do the opposite. For example, if inflation picks up and stays extremely elevated, my inflation-protected treasury investments, held outside my retirement account, would likely push me into a much higher tax bracket. So far, so good. Unfortunately, past performance is not necessarily indicative of future results. Sigh.

This is definitely not simple investment advice. At best, it's complicated opinions on a complicated topic. Want some real advice? Your lifetime individual retirement account decisions are not a Mad Money lightning round! Take some time to think them through.

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