Downsides to a Roth?

[Guest trixie13]

Hello everyone. I am 24 years old and just recently started my first job. I am looking into investing into a Roth IRA. All the articles I've read and people I've talked to encourage a Roth, but no one every really mentions any downsides.

So my question is, ARE there any negatives to a Roth IRA over another type of retirement investment. Has anyone had any bad experiences I should look out for?

Thanks!

[Guest DBtech]

I can't think of any downsides to a Roth IRA other than market risk. For example, the stock market decline in 1973 was not recovered until 1982. But if you deversify between stocks and bonds, foreign and domestic, you'll have much less risk than a fund invested all in common stock. Also, before investing in a Roth IRA, I'd make sure to get the full employer match in any 401(k) plan.

[dh003i]

Good question. There are some downsides, though I think they're outweighed by the upsides:

1. The tax-benefit is in the future, thus uncertain. At one point, it was thought that Social Security payments would never be taxable; they now are. It is possible that Congress may at some point decide to tax Roth IRA distributions. That said, there'd be a lot of opposition, and there would probably be a Constitutional challenge.

2. As I noted in this thread, if you are close to a breakpoint for obtaining the retirement savers credit, placing money in a Roth vs. a Traditional IRA would not reduce your AGI, thus not help you out in meeting the breakpoint. If you're within a couple hundred dollars of a breakpoint, it may be worth it to divert that money to a Traditional IRA (that said, many companies have large minimums for establishing Traditional IRAs, relative to what would be optimum for you).

3. If you expect your income to decline from the date or Roth IRA contributions, or taxes to decline, it may be more wise to contribute to a Traditional IRA.

4. If your employer matches your contributions, you should contribute to a 401(k) up to the point of matching, then, with your remaining disposable income, contribute to the Roth IRA up to the limit, then with whatever's left over (if anything) contribute to the 401(k). That is: 401(k) to max out matches => Roth IRA up to max => 401(k) as much as possible.

All that said, I still think a Roth IRA is the best way to go (with the one exception for 2, and that would mean contributing as little to a Traditional as you could). With a Roth, the longer you leave your money in, the greater the benefit becomes, because of tax-free (not tax-deferred) growth. Since you're 24, it is highly unlikely that your income in retirement will be lower than it now is. Furthermore, it would take a monumental leap of Faith to believe that somehow taxes aren't going to be getting higher and higher.

Other benefits of a Roth IRA: (1) there are no minimum required distributions during your lifetime, so you don't have to start taking money out at 70.5 if you don't want to; (2) You can always take out your basis in a Roth IRA without any taxes or penalty.

[John G]

"the stock market decline in 1973 was not recovered until 1982"

There are lots of ways to take snapshots of "the market", and this quote is in my opinion very misleading. Let me give an example using Washington Mutual Investors Fund which represents a diversified portfolio of blue chips with a slight bias towards growth stocks.

(Note: this is a loaded fund that I use only as an example and I am not endorsing... they just publish lots of stats and have been around for 53 years. Expense ratio was 0.65%)

Lets look at the annual return with dividends reinvested....

Two Back to Back Down Years

1973 -9.0%

1974 -17.3%

Two Great Years

1975 +44.7% [recovery of prior two down years in one year!]

1976 +31.2

Back to Negative

1977 -4.0%

Then a run of 12 up years

1978 +7.9

1979 +14.4

1980 +23.6 [after this year, portfolio was 2x from start of 1973]

1981 +7.5

1982 +34.7 [now up 150%, a lot more than "recovery"]

1983 +26.2

1984 +8.5 [portfolio doubled again, now 4x from start of 1973]

1985 +32.1

1986 +22.5

1987 +1.4

1988 +17.7 [portfolio doubled again, now 8x from start of 1973]

1989 +29.0

Note, eight of these years exceeded the often cited 10% annual return for stocks.

Folks who were in this fund in 1973 took a two big hits. But, if they ignored the short term (yes, 2 yrs are short term) and stuck with their fund saw their assets go up about 1000% by 1989... their assets doubled, doubled and doubled again. The three down years were overwhelmed by 14 up years - another snapshot where good years outnumber bad by about 5:1

A 24 year old beginning investor needs to understand that stocks go up and down in the short term. But, in the last 100 years, the long term results look very positive. Spend some time reading about investing. Get a feel for the performance - both good and negative.

[GBurns]

John G

What is the outcome if you had continued until the end of 2004 essentially 31 Years?

[John G]

I don't have 2003 and 2004 data on the chart I use with my JA classes, but it looks like they were decent years after a negative 14.9% in 2002.

An investment of $1,000 at the start of 1973 became $39,450 in 2002, a 39x increase in value. That is a little over five doubles in value, or a double roughly every 6 years.

Over 52 years, this fund has averaged a 12.7% annual return. I would call this fairly typical of a well run fund that while broadly diversified but with a slight bias towards growth. Twelve down years, 40 positive years over the 52 year history.

A recent list of the major holdings of this fund include:

JPMorgan Chase & Co. 3.4 percent

ChevronTexaco 2.9 percent

Exxon Mobil 2.8 percent

General Electric 2.7 percent

Bank of America 2.4 percent

Bristol-Myers Squibb 2.2 percent

SBC Communications 2.1 percent

Fannie Mae 2.0 percent

Wells Fargo & Co. 2.0 percent

Verizon Communications 1.9 percent

Well known names, all large companies, NYSE stocks, very typical of a big fund.

Note, I am not recommending this loaded fund. I use them because they have a long track record and provide useful charts for my "investor basics" classes.

[John G]

OK, I found the last two years, and the answer is that $1,000 in this fund in Jan 1973 grew to $54,000 by the end of 2004.

The raw data for Washington Mutual Investors Fund:

Year Pct Gain/loss The result Jan '73 = $1.00

73 -9.0 % $ 0.91 resulting value

74 -17.3 0.75

75 44.7 1.09

76 31.2 1.43

77 -4.0 1.37

78 7.9 1.48

79 14.4 1.69

80 23.6 2.09

81 7.5 2.25

82 34.7 3.03

83 26.2 3.82

84 8.5 4.15

85 32.1 5.48

86 22.5 6.71

87 1.4 6.81

88 17.7 8.01

89 29 10.34

90 -3.9 9.93

91 23.5 12.27

92 9.1 13.38

93 13.1 15.14

94 0.5 15.21

95 41.2 21.48

96 20.2 25.82

97 33.3 34.42

98 19.4 41.10

99 1.2 41.59

2000 9.1 45.38

2001 1.5 46.06

2002 -14.9 39.19

2003 25.73 49.28

2004 9.71 % $ 54.06

Sorry about the format problems with the above.

[mbozek]

The downsides to a Roth are:

1. Lack of liquidity because earnings in excess of contributions are subject to a 10%penalty for early withdrawal. Funds invested in a regular investment account are subject to ordinary income tax or cap gains at a 5/15% rate when sold.

2. Loss of tax deduction on the contribution increases the cost. E.g., taxpayer in 20% fed/state bracket will have an incremential cost of 25% on roth contribution because of lack of tax deduction. eg. need $125 in wages to contribute $100 to roth after taxes are paid.

3. Roth investments are limited to permissible investments for IRAs and exclude life insurance, options, futures, leveraged Limited partnerships and odd securities that are not publicaly traded.

While Congress can change the taxation of Roth accounts it highly unlikely that it would tax roth account balances attributable to contributions which had been taxed at inception because Congress is not inclined to upset the expectations of taxpayers who have been promised a tax benefit. E.g., when the universal IRA was repealed in 1986, Congress allowed all amounts deferred before the change to remain tax deferred. The recent changes in taxation of NQDC only applies to amounts deferred after 12/31/04.

[John G]

MBozek, given this is a "just getting started" person, I think your comments on negatives needs some clarifications.

1. Liquidity: you can take out contributions at any time without a penalty with a Roth. You also can withdraw funds for some specific uses like buying a first home. That is a reasonable amount of flexibility initially.

2. The tax deduction comparison only applies to the regular contributory IRA. Here you might get a tax break up front, but then you pay regular income taxes (not long term capital gains) on distributions.

3. I agree that there are many restrictions on allowed investments. In practice, a beginner investor is likely to have plenty of choices in stocks, bonds and funds.

I forgot to add some of my potential negatives to the above posts. Congress can change the rules. While I think it is unlikely that Congress will tax Roths, you can not guarentee it. Any radical change to a national sales tax (highly unlikely in my view) would radically change the assumptions about the value of Roths.

TRIXIE - you also asked about "bad experiences" which should be addressed. I think where most people have had problems is not with the Roth it self, but rather with not understanding about how to make investment choices. Some folks made single stock investments or got hurt in the dot.com collapse. Folks who thought the stock market always goes up, or had unrealistic goals, might have been discouraged in some of the recent down years. Beginners often have trouble understanding the long term nature of investing. You are wise to start a program of investing at a young age.... but educating yourself about investing at age 24 is probably more important than your initial "results". You are not just investing to retirement (perhaps 4 decades away) but additional decades after you retire.

Post again if you have questions about your choices.

[GBurns]

Trixie

The biggest downside in this whole issue is not whether to Roth or not Roth, but whether to save or not to save.

Any savings is better than none. Any investment is better than none. Even a Roth sitting in a savings account would be better than no Roth.

So the best thing is get prepared to start saving and start early.

[John G]

Gburns - well said. The above responses were very perhaps too complex. Better to get started now and learn as you go.

Trixie may want to consider setting up an automatic system to set aside a fixed amount each month straight from her checking account.

And... do ask questions about your employer based plans. An employee match is often a great way to proceed..... but it is not a question of which, as you can do both a Roth and participate in your employee plan.

[GBurns]

I had not considered that there might be an employer plan. If there is and if it has a match, the first priority should be to as much as is necessary qualify for as much of the match as possible before doing the Roth even if both will be done.

[John G]

Gburns - I would generally agree that the match tips the scale with two caveats: (1) the match is at least 20%, and (2) the investment options are broader than just company stock. Examples of the second problem include: Enron and every dot.com (Webvan, El Sitio, and that goofy sock puppet company) that died.