When the Going Gets Rough, Go Roth

Overlooked advantage of Roth accounts

By Kaye A. Thomas
Posted June 30, 2008

Hard times made harder by early withdrawal penalty.

In writing about the advantages of Roth accounts for our online guide and my book, Go Roth!, I've mentioned but not emphasized a benefit that has become more important as more families face financial hardship. We tend to focus our analysis on what happens if things go as planned and we use the account after retiring, and in particular after reaching the magic age of 59½. That analysis generally favors Roth accounts (including Roth 401k and 403b as well as Roth IRA) primarily because the Roth is effectively bigger. Qualifying withdrawals are tax-free, so the entire account is working to your advantage. A portion of your traditional retirement account is effectively working for the IRS: if the account value doubles, the income you report on your withdrawal will double as well, and the amount of tax you pay may double and then some. Traditional accounts can work out better in some situations, such as people who are approaching retirement and are able to anticipate a lower tax rate for the years they withdraw from their accounts than the years they contribute — but for most people the Roth account makes more sense.

Of mice and men

The best laid plans can go awry, and today's economy is imposing hardships even on people who have been prudent in their financial planning. Many are responding by taking early withdrawals from IRAs and hardship distributions from 401k accounts. Those distributions are generally taxable income, which means someone who withdraws $1,000 doesn't get to spend $1,000. Part of the money has to go to the IRS. State and local income tax can take another portion. The picture is especially ugly for people under 59½ years of age, as they get hit with an additional 10% penalty tax unless they fit within an exception. There's no general exception for economic hardship, though. You may have to withdraw $1,600 or more from your account if you need to have $1,000 in spending money after covering the tax liability.

Roth relief

Compare the result if you have a Roth IRA. You can withdraw your regular contributions to this account at any time, for any reason, without paying tax or penalty. Need $1,000? Take $1,000. It's that simple, at least until your total withdrawals are equal to your total contributions. After that you're withdrawing conversion money (which has its own special rules), or earnings, which are generally taxable (and subject to the 10% penalty tax) the same as money taken from a traditional account, assuming you aren't taking a qualified distribution.

The rules for Roth 401k and 403b accounts are a little different, but you still avoid tax and penalty on the part of your distribution that's treated as a return of your contributions.

Round trip

The importance of this difference is highlighted if we look at the round trip, in other words, the life cycle of the money in your account. Suppose you contributed $4,000 to a traditional IRA a few years ago when things were going better. The contribution saved you $800 in taxes (15% federal and 5% state) but didn't save the tax refund, so that money is gone. The account has grown to $5,000 and you need the money. Take it out and you'll pay $1,500 in taxes (15% federal, 5% state, and 10% early distribution penalty) leaving you with $3,500. Even if we include the $800 in tax savings from the year of the contribution (now just a memory), your total was just $4,300 after growing the account by $1,000, so it's as if you paid 70% tax on that $1,000 of earnings.

Compare the situation if you had put the $4,000 into a Roth IRA and saw the same growth to $5,000. You wouldn't have had that $800 in tax savings in the year of the contribution. Yet you're now in a position where you can achieve the same $3,500 in spending power by taking that much money from the account, leaving $1,500 in savings you wouldn't have in the traditional account. Alternatively you can take all the money from the account and pay tax and penalty only on the last $1,000, providing you with $4,700 of spendable money.

I've been reluctant to stress this advantage of Roth accounts because the main goal is to avoid these withdrawals altogether so you can maximize retirement savings. Yet most Americans now believe there's reason to be concerned about the economy. That's all the more reason to favor Roth accounts over traditional accounts for your current retirement savings.