Why You Want a Roth IRA

Recent research indicates that if you don’t have a Roth, you should.

For years I have been asking my clients to look seriously at Roth’s as a saving vehicle for retirement. Some have and others haven’t. It always perplexes me when clients chose not to; I see the benefits so clearly. Both my husband and I have Roths.

Now, others are unequivocally recommending Roth IRAs, and one of them isn’t beating around the bush when a decision has to be made. His name is Scott Cederburg and he is doing research on the subject. He says “do it.”

Cederburg is a professor of finance at the Eller College of Management at the University of Arizona in Tuscan. He wrote “Tax Uncertainty and Retirement Savings Diversification” with David C. Brown, also from the University of Arizona, and Michael S. O’Doherty, from the University of Missouri at Columbia Department of Finance. It is a working paper.

In it, they examine the effect of progressive tax rates and insecurity regarding the future tax rate on ideal retirement savings. Their methods involve modeling, mathematics, and statistics. Reading their methods and results is tedious, something that even a mother could not love. For those who are interested, I refer them to the paper.

The authors discovered that both a pre-tax traditional and a post-tax Roth offer benefits. Traditional savings are useful as a tool to manage taxable income and generate a desirable correlation between investment performance and marginal tax rates. Cederburg explained in an email: “The relative advantage for traditional accounts comes from an interaction between uncertainty about your retirement account investment performance and the progressive tax schedule. If your investments do really well and you end up having enough wealth to support a high, steady income in retirement, you will also be paying relatively high marginal tax rates on the income.”

“On the other hand,” he says, “if your investments perform poorly such that your retirement income is relatively low, this bad outcome will be softened somewhat by the low marginal tax rates on your low income.” The Roth enables investors to remove the risk of future high taxes on a portion of retirement savings. The authors found this was particularly true for high-income investors--an unexpected finding.

Cederburg, though only 34 years old, is splitting his contributions 50/50 between a Roth and a traditional option. This goes right along with the results of the research paper, that both Roth and traditional retirement plans are best used for optimal results.

Doing what the authors recommend might be tough for some employees. Right now, according to a recent Vanguard Group study, forty percent of employers do not offer Roth’s. Thereby, an employee cannot invest in one within her company plan at those companies. Brown, Cederburg and O’ Doherty made it clear that they would like to see this change.

Related links: Impoverished: Retirement in Jeopardy | PMD What You Need to Know about Roth’s from Vanguard