Swedroe: Choosing Between Roth & Traditional IRAs

July 27, 2016

Who Should Use The Roth Structure?
The authors state: “Roth accounts are primarily useful for low-income investors who can lock in a low marginal rate by paying taxes in the current period.” They add that because “future tax rates are more uncertain over longer retirement horizons” and their analysis of historical tax changes suggests “that the rates associated with higher incomes are more variable,” eliminating “exposure to tax risk is particularly attractive for younger investors with relatively high incomes and correspondingly high savings.”

The authors continue: “Despite high current marginal tax rates, and contrary to conventional financial advice, these investors benefit the most from the tax-strategy diversification offered by Roth accounts.”

Brown, Cederburg and O’Doherty concluded: “Whereas conventional wisdom largely supports choosing between traditional and Roth accounts by comparing current tax rates to expected future tax rates, the hedging benefits of traditional accounts and the usefulness of Roth accounts in managing tax-schedule uncertainty are important considerations in the optimal savings decision.” They note that, for wealthy investors, their analysis shows “tax-strategy diversification is particularly attractive, despite their high current marginal tax rates.”

The authors also examined their findings’ economic implications: “Our results are of practical importance to employers and regulators who determine the retirement savings options available to employees. In particular, broadening access to Roth versions of workplace accounts would provide investors with important tools for managing their exposures to tax risk. Given that these accounts are available under current regulations, encouraging the widespread adoption of, and education about, employer-sponsored Roth plans could substantially improve investors’ welfare.”

What the authors found provides investors with the proper framework to make informed decisions regarding the asset location of their retirement savings and the diversification of tax risk.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

 

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