The Benefits of the Roth IRA

There’s a lot of hype about the Roth IRA. With a Roth IRA, you pay taxes on the money you invest but you don’t have to pay taxes when you withdraw the money. The traditional IRA and 401(k) is the exact opposite: you invest pre-tax income, but you have to pay taxes when you withdraw the money at retirement. So if your current tax rate is lower now than it will be in retirement, the Roth IRA is a better place to place your money than a traditional IRA/401(k). If you mathematically model the post-tax values of both investment accounts, you can clearly see that this is true:
V_{tIRA}(t) = P (1 + r)^t (1 - t_r)

V_{rIRA}(t) = P (1 - t_c) (1 + r)^t
Where P is the initial principal, t_c is your current tax rate, t_r is your tax rate in retirement, r is your portfolio’s rate of return, and t is time.

This seems like a pretty weak reason to invest in a Roth IRA. You’ll probably have lower expenses in retirement and need less income, so doesn’t it follow that tax rates should be lower? Or maybe not? It is very difficult to predict what tax rates are going to be in the future, so unless you plan on retiring very soon, I don’t think you can say with confidence that your tax rate is lower now than it will be in retirement. I think at best, you can argue that a mix of pre-tax and post-tax investments gives you diversification, since most people considering investing in a Roth IRA already have a traditional IRA/401(k).

The most compelling reason to invest in a Roth IRA is that you can withdraw your basis (initial contributions) at any time for any reason without penalty. This is great if you want to save for retirement, but you also want to save money for non-retirement expenses (houses, cars, vacations, emergency fund, etc.). The Roth IRA is the only investment vehicle I know of where you can enjoy the benefits of a tax-sheltered retirement account (achieving a higher rate of return since you don’t have to pay taxes on capital gains/dividends) while having the flexibility to withdraw the basis at any time without penalty.