Wednesday, March 02, 2005

Responding to IraqNow

Jason over at IraqNow makes a thoughtful response to my call to abolish the Roth IRA, pointing out a few things I didn't think of and giving a few other comments.

I think I can accurately summarize his criticisms thus:

  • It's very hard to get the same growth (g) in a non-tax-deferred account as you can get in a tax-deferred account.
  • There are some very important differences between retirement accounts in how they are treated at death. I am unmarried and childless, so estate-planning concerns didn't occur to me. While I only considered "withdrawable balance" to mean "How much cash can I turn it into?", there should also be a consideration of "how much would my spouse/kids get if I kicked off tomorrow?"
  • You can rebalance a tax-deferred account much more easily.
His first point is very valid. I had a comment about it in an earlier draft of the posts, but it slipped out. All that's left of it is a quick gloss about how Neal should keep his money in a growing non-dividend paying stock. Capital gains and dividends, which make up the bulk of non-growth income in an investment account, are currently taxed at 15%.

This means that if your IRA is growing at x%, then your non-deferred account will grow at somewhere between (x * .85%) and x%, depending on what percentage of your growth is taxable. If your growth doesn't fall into these categories, your growth can be as low as x * 65% if you are in the 35% tax bracket.

Jason mentions that the S&P 500 issues a dividend of around 1.87%. If you put $1000 into a S&P fund, you'll get $18.70 in dividends, which will mean that you will owe an additional $2.81 in federal taxes, reducing your growth by almost 0.3%. Compound that over 30 years, and your non-deferred account will have about 9% less money in it than your Roth IRA does. However, if you're not yet 59.5 years old, that slightly smaller balance can be withdrawn at a far lower tax rate than the Roth IRA can be. As I said initially, the Roth IRA will (assuming identical growth and g > 1) always have a higher withdrawable balance after age 59.5 than before.

However, there are lots of other problems with the Roth IRA:
  • They create an entire class of people who consciously don't care what happens to tax rates, and (I believe) subconsciously want them to rise.
  • They result in significantly smaller initial investments in the economy when people decide to save for retirement.
  • They take away the government's ability to Borrow a Trillion Dollars. While I'm mostly libertarian, I'm all for the US using its collective "riskless" credit rating to earn tens of billions of dollars per year.
  • Unless tax rates change, they will still always have the same withdrawable balance as a traditional IRA / 401(k) at retirement (but maybe not death)
  • Their ability to make investment choices without considerations of tax consequences is also available in traditional IRAs / 401(k)s.