Traditional vs. Roth IRAs

When I introduced the Ideal IRA, I modeled it on the Traditional IRA vs. the Roth IRA. I did so for three reasons:

  1. The Roth IRA tax break is deficit spending in disguise, and our federal budget deficit is already unacceptably high.
  2. The Traditional IRA results in more money for the government in the long run without hurting retirees one bit! Yes, this is Santa Claus Economics, on par with the Laffer Curve, and it works.
  3. The Traditional IRA model could function without special penalties (form 5329) and still not be a gaping loophole for the rich.

Let’s look at these in more detail.

The Roth IRA as Hidden Deficit Spending

With the Traditional IRA, today’s Congress sees the impact of the tax break in today’s budget. People take the tax break; the IRS receives less money this year. This shows up in the deficit figures and the pundits scream accordingly.

Congress is supposed to have a short time horizon. The future’s issues should be decided by future Congresses. This is democracy. Debt should be for capital improvements – where the future receives the benefit of today’s spending – and for national emergencies. When there is no emergency, deficit spending should be no greater than net federal capital spending: improvements – depreciation. In other words, mere road maintenance should not be paid for with deficit spending. Run up some debt if and only if today’s extra spending means less need for spending in the future.

Actually, in between national emergencies we should be paying down debt run up during emergencies.

Instead, our elected officials are addicted to deficit spending, acting as if every year is an emergency. Not only do we have bonds and bills issued to the public, Congress plays bookkeeping tricks to hide the true size of the deficit: underfunded pensions, internal borrowing from the Social Security Trust Fund, unfunded mandates to the states, new entitlements whose costs land in the laps of future Congresses, and a host of loan guarantees may of which will blow up later.

The Roth IRA is one of these bookkeeping tricks. With the Roth, Congress is demanding that a future Congress not tax future retirement earnings. This is but a law, not a Constitutional amendment. A future Congress is legally entitled to change its mind. If deficit spending continues at its current rate, Congress might have to, or even play dirtier tricks to keep the government from going bankrupt. I would rather Congress raise taxes now in an orderly fashion to prevent such a crisis. (Some spending cuts would be nice as well.)

More Money for the Government Without Hurting Taxpayers

Not only does the Roth IRA hide the true extent of deficit spending, it costs the government money in the long run – at least if the U.S. government manages to maintain its post Hamiltonian credit rating.

Consider a worker who has $4,000 of pre tax money to save for retirement. And to keep the math simple assume the worker is in a 25% tax bracket now and will be upon retirement as well. Suppose the worker makes a 4% real rate of return over 35 years with this money. This comes out to close 400% total return.

With the Roth IRA, the taxpayer has $3,000 after tax to put in the account. After 35 years this becomes $15,000 available to take out tax free.

With the Traditional IRA, the taxpayer has $4,000 to put in the account. After 35 years this becomes $20,000, which is then taxed at 25% to leave $15,000 for the retiree. From the point of the retiree it’s a wash as long as the marginal tax rates are the same at both ends. (For those with more than the Traditional IRA maximum to put in, the Roth is superior since both IRAs have the same maximum deposit amounts but post tax money is worth more than pre tax.)

From the government’s perspective, however, the Traditional IRA is superior! For the Roth the government gets $1,000 while for the Traditional the government gets $5,000. Recall that we are working with real, not nominal, dollars here. True, $5,000 in 35 years is not the same as $5,000 today even for the government. But as long as the U.S. government maintains a decent credit rating, the Treasury will continue to pay less interest than the returns on investments in other securities. For example, as of May 2014, the Treasury is paying out a hair less than a percent on its inflation protected securities. $1,000 dollars today is a bit over $1,400 35 years hence at 1% real interest.

The government gets more money while the retiree gets the same amount with the Traditional IRA! This may look like some kind of Voodoo Economics, but it is not magic. We are simply taking advantages of Thomas Piketty’s r > g; that is, the rate of return on investments is greater than economic growth. When the working class saves more, the working class takes advantage of this dynamic. A better IRA is a key component to a more egalitarian society without resorting to socialism and stagnation. When the working class puts in more up front and the government taxes the returns on the back end, the government gets to take advantage of r > g without direct government ownership of the means of production.

What about inflation? Let’s try throwing in 4% inflation. Nominal return is now 8% and TIPS pay out 5%.

With the Roth, the worker puts in $3,000. The nominal gain over 35 years is now 1,479%, which means the taxpayer has $44,370 tax free upon retirement in nominal terms. That $1000 tax collected at the beginning is equivalent to $5,516 in future dollars.

With the Traditional IRA, the worker puts in $4,000. This compounds up to $59,160 in nominal terms in 35 years. Shave of 25% in taxes and I come up with $44,370. The government gets $14,790 in future taxes, which beats $5,516. The regular IRA beats the Roth for the government by a factor of 2.68. For the earlier zero inflation scenario the regular IRA beat the Roth by a factor of 3.57.

Unless I made a goof, it appears the government gets punished for inflating the currency with the Traditional IRA. I’m going to leave it as an exercise to the reader to figure out why the difference.

No Need for Special Penalties

I hate complicated tax forms. I despise the petty clawbacks and other nitnoids which pollute the tax code in order to squeeze another percent of marginal tax rate. “Just adjust the tax rate and be done with it,” is my motto.

So let’s see if we could dispense with IRS form 5329. As I mentioned before, the ideal savings plan would not be strictly a retirement plan; it would foster savings for any reason. So we can dispense with the penalties for early withdrawal.

But what about penalties for putting in too much? I have suggested that the paltry $5,500 IRA limitation should be bumped up to at least $30K , but preferably up to $50K/year or even more. This would allow middle aged Baby Boomers to do some serious catch up savings. This would still be chump change to the super rich.

What would happen if an NFL quarterback or Silicon Valley superstar opted to plunk a million dollars into an Ideal IRA in one year? Should we keep the 6%/year penalty currently calculated in form 5329? Should we require people keep track of their excess deposits year to year and pay an annual excise tax thereon?

Nah.

Just limit the tax deduction for making a deposit capped at an upper middle class value and allow the excess deposit. Yes, our high income tax gamer gets to compound gains without intermediate taxation, but when he cashes in the gains and the principal are taxable. In return for some tax deferrals he loses his tax basis! This is a pretty big implicit penalty. To get back that penalty requires some pretty phenomenal compounded gains or serious patience.

Let us consider a taxpayer in the highest tax bracket (39.6%) who takes a million dollars of after tax income and puts it in a traditional style IRA vs. investing outside in either income producing assets or a buy-and-hold growth portfolio. We will compare the performance of the excess $950,000 with money kept outside in either a buy-and-hold growth portfolio or an income generating portfolio. The columns in the chart below will show how much is available after tax for withdrawal in each account each year assuming a 7% nominal rate of return on investment before tax. For the income portfolio this return is taxed each year. For the growth portfolio, we collect 20% on the gains every 4 years to simulate trading and collect 20% capital gains tax on remaining unrealized gains upon withdrawal.

YearAvailable From Income PortfolioAvailable From GrowthPortfolioAvailable From IdealIRA
0$950000$950000$573800
1$990166$1003200$613966
2$1032030$1060124$656944
3$1075664$1121033$702930
4$1121144$1186205$752135
5$1168545$1252632$804784
6$1217952$1323710$861119
7$1269447$1399763$921397
8$1323119$1481139$985895
9$1379060$1564083$1054908
10$1437367$1652833$1128751
11$1498139$1747795$1207764
12$1561480$1849405$1292308
13$1627499$1952972$1382769
14$1696310$2063788$1479563
15$1768030$2182361$1583132
16$1842782$2309235$1693952
17$1920695$2438552$1812528
18$2001902$2576922$1939405
19$2086543$2724977$2075163
20$2174762$2883396$2220425
21$2266711$3044866$2375855
22$2362547$3217639$2542165
23$2462436$3402506$2720116
24$2566548$3600314$2910524
25$2675061$3801932$3114261
26$2788163$4017663$3332259
27$2906046$4248495$3565517
28$3028914$4495485$3815103
29$3156976$4747232$4082161
30$3290453$5016601$4367912
31$3429574$5304827$4673666
32$3574576$5613228$5000822
33$3725709$5927569$5350880
34$3883232$6263913$5725442
35$4047415$6623802$6126222
36$4218540$7008883$6555058
37$4396900$7401380$7013912
38$4582801$7821353$7504886
39$4776561$8270723$8030228
40$4978515$8751549$8592344

After something like 20 years the excess earnings into the IRA are doing better than the income portfolio – finally! They take a very long time to catch up with a limited trading growth portfolio, since today capital gains are taxed at a lower rate than ordinary income. If we did tax capital gains at the same rate as ordinary income, the IRA does catch up with a growth portfolio more quickly, but with my simulation it took 20+ years—with complete tradeout every 4 years. For a less actively traded growth portfolio it would take even longer. This is a tax break for the rich that I think we should simply live with for the sake of tax simplicity. Besides, the government will get a nice windfall when the compounded gains are finally cashed in.