Does a Roth IRA Solve the "Taxflation" Problem?

[gmaynardkrebs]

Due to what is sometimes called "taxflation" or the "inflation tax," the portion of the capital gain from stocks or the interest from bonds that is due purely to inflation is taxed as though it were a real gain. For example, if your stock or mutual fund goes from $10/share to $100/share, you recognize $90 of gain when you sell, even if $45 of that gain is really due to inflation. With bonds, the inflation component of the interest is taxed the same as the "real" component. In a TIRA or 401K, it's the same thing. When you withdraw it, all of the gains made over the years are taxed as real gains, even if a large part of it is simply due to inflation.

It may be that the indexing of tax brackets for inflation has all or partially solved this problem, but I'm having a hard time figuring it out. If there is still a problem, would a ROTH IRA avoid the inflation tax, because you never again pay taxes on any gains, in effect, eliminating the impact of inflation.

[WhiteMaxima]

Yes it will solve some. If you have a 100k investment in Trad IRA, it grow to 1 mil when you retire. because of progressive tax rate, you would have to pay huge % tax (32% let's say). Suppose you rollover 100kTrad IRA into Roth, depend on your marginal rate at the time (let say 20%). Then the future tax rate will drop to zero. It all depend your current tax rate and future tax rate.

[aspiringboglehead]

Due to what is sometimes called "taxflation" or the "inflation tax," the portion of the capital gain from stocks or the interest from bonds that is due purely to inflation is taxed as though it were a real gain. For example, if your stock or mutual fund goes from $10/share to $100/share, you recognize $90 of gain when you sell, even if $45 of that gain is really due to inflation. With bonds, the inflation component of the interest is taxed the same as the "real" component. In a TIRA or 401K, it's the same thing. When you withdraw it, all of the gains made over the years are taxed as real gains, even if a large part of it is simply due to inflation.

It may be that the indexing of tax brackets for inflation has all or partially solved this problem, but I'm having a hard time figuring it out. If there is still a problem, would a ROTH IRA avoid the inflation tax, because you never again pay taxes on any gains, in effect, eliminating the impact of inflation.

Yes. The portion of the tax you're referring to arises only from tax on savings (so for example under a pure wage tax, or pure consumption tax, it would not exist) -- i.e., on the growth of savings to match inflation. Roth IRAs and other Roth accounts eliminate the tax on savings for a portion of people's portfolios.

By contrast, indexing the income-tax brackets for inflation doesn't eliminate this component of tax. You would still have gains on savings just to keep pace with inflation that you would not have had without inflation. For example, say you have $100,000, inflation is 100%, and you keep pace exactly with inflation. You therefore have taxable income of $100,000. Even if your highest marginal bracket now starts at (say) $60,000 rather than or $30,000, you are still paying tax that results from inflation.

(For whatever it's worth, I'm not convinced this component of taxation actually a problem; whether it is or not depends on political matters best left out of discussion here.)

[Ketawa]

Ignoring contributions limits and second order effects, and keeping tax rates constant, Roth and Traditional accounts are equivalent savings vehicles. There is nothing special about a Roth account that allows it to avoid "taxflation" vs a Traditional account. That is caused by how you are framing the scenario. If you view taxation of Traditional withdrawals as deferred taxes on income (that is, after all, what it is for), then it is no longer a tax on the growth. Or consider a Roth account to be an upfront way to pay your tax, and subject to the taxflation tax just like the Traditional account.

[gmaynardkrebs]

Ignoring contributions limits and second order effects, and keeping tax rates constant, Roth and Traditional accounts are equivalent savings vehicles. There is nothing special about a Roth account that allows it to avoid "taxflation" vs a Traditional account. That is caused by how you are framing the scenario. If you view taxation of Traditional withdrawals as deferred taxes on income (that is, after all, what it is for), then it is no longer a tax on the growth. Or consider a Roth account to be an upfront way to pay your tax, and subject to the taxflation tax just like the Traditional account.

Is that because the let’s say $1000 tax payment I make when I convert from TIRA to Roth in 2019 would have to adjusted for future inflation to make a fair comparison?

[Ketawa]

Ignoring contributions limits and second order effects, and keeping tax rates constant, Roth and Traditional accounts are equivalent savings vehicles. There is nothing special about a Roth account that allows it to avoid "taxflation" vs a Traditional account. That is caused by how you are framing the scenario. If you view taxation of Traditional withdrawals as deferred taxes on income (that is, after all, what it is for), then it is no longer a tax on the growth. Or consider a Roth account to be an upfront way to pay your tax, and subject to the taxflation tax just like the Traditional account.

Is that because the let’s say $1000 tax payment I make when I convert from TIRA to Roth in 2019 would have to adjusted for future inflation to make a fair comparison?

Not sure I understand your question. But I'll take your example of converting Traditional to Roth and paying $1000 in tax. Let's say you have a 25% tax bracket to make the numbers easy. This is equivalent to the decision between contributing $4000 to a Traditional IRA vs $3000 to a Roth IRA. Convert vs contribute, it doesn't make a difference except for account limits, money is fungible and the effect is the same. You said the Traditional IRA would be subject to the effects of taxflation, so you can't avoid it by contributing $4000 to a Traditional IRA. To avoid it, you chose a Roth IRA and invested $3000, and ended up paying the tax for taxflation up front instead. Your retirement outcome won't be any better using either account if your marginal tax rate is 25% in retirement. It doesn't matter if this is a conversion or a contribution, in either case you are comparing $4K in Traditional vs $3K in Roth.

Either you can't avoid taxflation, or the concept doesn't apply to an IRA in the first place. Personally, I don't think it's a useful concept anyway, since the reality of taxflation shouldn't affect your investment strategy (Roth vs Traditional vs taxable, what to invest in, etc).

[aspiringboglehead]

The general answer is that both Roth IRAs and traditional IRAs (which, as Ketawa said, are equivalent as long as tax rates, etc., are held constant) are both, equivalently, reductions on a savings tax and thus on the "inflation tax" you are discussing.

In other words, as against taxable savings (in, for example, the case of a "backdoor" Roth IRA), Roth IRAs reduce the savings (and "inflation") tax. As against traditional IRAs, they do not -- but both traditional and Roth IRAs reduce the savings (and "inflation") tax that you are describing. So the full answer to your question, "would a Roth IRA avoid the inflation tax?", is "yes, in the same way a traditional IRA does."

It's very common to see, across tax systems around the world, mechanisms for reducing taxes on savings; such mechanisms push the tax system toward a "purer" wage or consumption tax as a theoretical matter. Some countries provide accounts very much like the "backdoor" Roth IRA explicitly as a tax-free savings vehicle for small investments -- enough to exempt a large portion of the middle class from savings tax.

[DoTheMath]

Ignoring contributions limits and second order effects, and keeping tax rates constant, Roth and Traditional accounts are equivalent savings vehicles. There is nothing special about a Roth account that allows it to avoid "taxflation" vs a Traditional account. That is caused by how you are framing the scenario. If you view taxation of Traditional withdrawals as deferred taxes on income (that is, after all, what it is for), then it is no longer a tax on the growth. Or consider a Roth account to be an upfront way to pay your tax, and subject to the taxflation tax just like the Traditional account.

Is that because the let’s say $1000 tax payment I make when I convert from TIRA to Roth in 2019 would have to adjusted for future inflation to make a fair comparison?

Yes, you have to correctly account for inflation for all comparisons. A dollar paid in tax today is not directly comparable to a dollar paid in tax in the future.

This is easier to parse if you assume your investment earns 0% so that all increase is due to inflation. If you choose to not pay the tax now and instead set that money aside in a parallel investment account, it will grow at the same rate as your investment and will be precisely the amount needed to pay the taxes due to inflation in the future (of course, assuming the same tax rates, etc.). Now if assume your investment accounts actually grow by some amount, the same argument applies. It makes no difference whether the growth comes from inflation or investment gains. This is why folks say Roth and Traditional are equivalent tax-wise.

[dmcmahon]

Due to what is sometimes called "taxflation" or the "inflation tax," the portion of the capital gain from stocks or the interest from bonds that is due purely to inflation is taxed as though it were a real gain. For example, if your stock or mutual fund goes from $10/share to $100/share, you recognize $90 of gain when you sell, even if $45 of that gain is really due to inflation. With bonds, the inflation component of the interest is taxed the same as the "real" component. In a TIRA or 401K, it's the same thing. When you withdraw it, all of the gains made over the years are taxed as real gains, even if a large part of it is simply due to inflation.

It may be that the indexing of tax brackets for inflation has all or partially solved this problem, but I'm having a hard time figuring it out. If there is still a problem, would a ROTH IRA avoid the inflation tax, because you never again pay taxes on any gains, in effect, eliminating the impact of inflation.

No, indexing tax brackets does not solve this problem, because the tax rates are the issue, as well as their imposition on an annual/continuous basis. Indexing brackets helps keep the problem from worsening over time, although there is still the phenomenon of “real bracket creep”.

The only solution I’ve found is to try to avoid paying tax on the inflation component of your returns. Stocks sort-of let you do this, in that, to the extent that the inflation is showing up in the form of unrealized capital gains, you can defer the tax payments rather than be subject to the continuous drag of taxflation. Over time this lets compound growth (on the yet-to-be-paid tax) work in your favor as well. If you die with the unrealized gains, your heirs may completely avoid the tax by getting a stepped-up cost basis on the assets, although if you have a lot of assets they’ll pay it back in estate tax. One other advantage is that under current law the income from such investments is taxed at lower rates, further reducing the tax drag.

Others have pointed out the advantage of tax-deferred and tax-free savings. These also avoid taxflation, and to some extent there’s little difference between paying the tax up front (Roth) and paying it as you withdraw (Traditional). There’s no favorable rate structure here, though. But, on the other hand, you can own fixed income investments without the taxflation drag here. Space is limited by law in the form of annual contribution limits. There are other vehicles that can get around the limits but that are more costly, complex, and risky. For example, variable annuities from low-cost providers. An old fashioned defined benefit pension plan is possibly the best way to beat taxflation, but unless your employer offers you one, you’d have to be working in a special circumstance to take advantage of that.

[vtMaps]

How about this example:

Five years ago you bought a $1000 ibond with zero coupon. You also contributed $1000 to a Roth Account and bought a 5 year TIPS with zero coupon.

Today each of them is worth $1100. When you redeem the ibond, you must pay tax on the $100 gain. The gain in the Roth is tax free. In this example, it appears that the Roth avoids the tax on the $100 inflation.

In my example, we are comparing two ways to invest $1000 of after-tax money. Many of the examples and comparisons in this thread involve deferred taxation of pre-tax money.

--vtMaps

[gmaynardkrebs]

How about this example:

Five years ago you bought a $1000 ibond with zero coupon. You also contributed $1000 to a Roth Account and bought a 5 year TIPS with zero coupon.

Today each of them is worth $1100. When you redeem the ibond, you must pay tax on the $100 gain. The gain in the Roth is tax free. In this example, it appears that the Roth avoids the tax on the $100 inflation.

In my example, we are comparing two ways to invest $1000 of after-tax money. Many of the examples and comparisons in this thread involve deferred taxation of pre-tax money.

--vtMaps

Interesting. For me, the only way to get money into a Roth is backdoor. So I'd be using pretax money.

[LongRoad]

How about this example:

Five years ago you bought a $1000 ibond with zero coupon. You also contributed $1000 to a Roth Account and bought a 5 year TIPS with zero coupon.

Today each of them is worth $1100. When you redeem the ibond, you must pay tax on the $100 gain. The gain in the Roth is tax free. In this example, it appears that the Roth avoids the tax on the $100 inflation.

In my example, we are comparing two ways to invest $1000 of after-tax money. Many of the examples and comparisons in this thread involve deferred taxation of pre-tax money.

--vtMaps

Interesting. For me, the only way to get money into a Roth is backdoor. So I'd be using pretax money.

Maybe a newbie question, but doesn’t the backdoor Roth start with a post-tax tIRA, so wouldn’t it still be considered after tax in the Roth?

[gmaynardkrebs]

How about this example:

Five years ago you bought a $1000 ibond with zero coupon. You also contributed $1000 to a Roth Account and bought a 5 year TIPS with zero coupon.

Today each of them is worth $1100. When you redeem the ibond, you must pay tax on the $100 gain. The gain in the Roth is tax free. In this example, it appears that the Roth avoids the tax on the $100 inflation.

In my example, we are comparing two ways to invest $1000 of after-tax money. Many of the examples and comparisons in this thread involve deferred taxation of pre-tax money.

--vtMaps

Interesting. For me, the only way to get money into a Roth is backdoor. So I'd be using pretax money.

Maybe a newbie question, but doesn’t the backdoor Roth start with a post-tax tIRA, so wouldn’t it still be considered after tax in the Roth?

I've never done a backdoor Roth, but my basic understanding is that you take the money from a TIRA, which is pre-tax. Once it's in the Roth it is post tax.

[cherijoh]

How about this example:

Five years ago you bought a $1000 ibond with zero coupon. You also contributed $1000 to a Roth Account and bought a 5 year TIPS with zero coupon.

Today each of them is worth $1100. When you redeem the ibond, you must pay tax on the $100 gain. The gain in the Roth is tax free. In this example, it appears that the Roth avoids the tax on the $100 inflation.

In my example, we are comparing two ways to invest $1000 of after-tax money. Many of the examples and comparisons in this thread involve deferred taxation of pre-tax money.

--vtMaps

Interesting. For me, the only way to get money into a Roth is backdoor. So I'd be using pretax money.

Maybe a newbie question, but doesn’t the backdoor Roth start with a post-tax tIRA, so wouldn’t it still be considered after tax in the Roth?

I've never done a backdoor Roth, but my basic understanding is that you take the money from a TIRA, which is pre-tax. Once it's in the Roth it is post tax.

NO - tIRAs can be pre-tax and post-tax. If you have a workplace retirement plan there is an income limit on pre-tax contributions, but no income limits on after-tax. LongRoad is correct about Backdoor Roths starting with an after-tax contribution.

[gmaynardkrebs]

How about this example:

Five years ago you bought a $1000 ibond with zero coupon. You also contributed $1000 to a Roth Account and bought a 5 year TIPS with zero coupon.

Today each of them is worth $1100. When you redeem the ibond, you must pay tax on the $100 gain. The gain in the Roth is tax free. In this example, it appears that the Roth avoids the tax on the $100 inflation.

In my example, we are comparing two ways to invest $1000 of after-tax money. Many of the examples and comparisons in this thread involve deferred taxation of pre-tax money.

--vtMaps

Interesting. For me, the only way to get money into a Roth is backdoor. So I'd be using pretax money.

Maybe a newbie question, but doesn’t the backdoor Roth start with a post-tax tIRA, so wouldn’t it still be considered after tax in the Roth?

I've never done a backdoor Roth, but my basic understanding is that you take the money from a TIRA, which is pre-tax. Once it's in the Roth it is post tax.

NO - tIRAs can be pre-tax and post-tax. If you have a workplace retirement plan there is an income limit on pre-tax contributions, but no income limits on after-tax. LongRoad is correct about Backdoor Roths starting with an after-tax contribution.

Thanks for the clarification on the backdoor ROTH. Maybe I should be doing backdoor Roths, as I expect my brackets to be about the same. I guess I better read the BH WIKI

[vtMaps]

Thanks for the clarification on the backdoor ROTH. Maybe I should be doing backdoor Roths, as I expect my brackets to be about the same.

Read about the pro-rating rule. If you have both pre and post tax dollars in your IRAs, you can't Roth convert just the post-tax dollars.

--vtMaps

[Nahtanoj]

Unless I am missing something, the Roth is a hedge against higher inflation rates in the future. Consider two accounts - a traditional IRA and a Roth IRA - that both return $100 over a specified period of time, with half of the return (or $50) consisting of inflation and the other half (the other $50) consisting of the “real” return. For ease of calculation, let’s assume the account owner is in a 25% income tax bracket. If the account owner withdraws the $100 return from the traditional account, he/she will pay $25 in tax, which represents 50% of the real return. The same amout withdrawn from the Roth would be free of tax, so the investor would keep 100% of the real return.

But consider what happens in a much higher inflation environment where the real return is still $50, but the nominal return is $200, with $150 of the return consisting of inflation. In that case, the traditional IRA account owner withdraws $200 and pays $50 of tax (at the 25% marginal rate). His or her real, after tax and after inflation return in the traditional IRA is 0%. All of the real return has been eaten up by taxes. By contrast, when the owner of the Roth IRA withdraws the $200 return, he or she still gets to keep 100% of the $50 real return. The Roth IRA successfully insulates the account holder from having the real investment return be eaten up by taxes, while the traditional IRA doesn’t necessarily do that - especially in conditions of high inflation.

[grabiner]

Any tax-deferred account, traditional or Roth, avoids the issue of taxation on inflation gains.

Suppose that you put $6000 in a Roth IRA. Prices double (over many years), and your investment doubles in value. You can withdraw $12,000 from the Roth IRA, and keep your purchasing power. Similarly, if your investment quadruples, you can withdraw $24,000, doubling your purchasing power.

Now suppose that you put $8000 in a traditional 401(k) instead, paying $6000 out of pocket in a 25% tax bracket. Again, prices double and your investment doubles in value. You can withdraw $16,000, which becomes $12,000 after tax, and keep your purchasing power. Similarly, if your investment quadruples, you can withdraw $32,000 which is $24,000 after tax, doubling your purchasing power.

This doesn't work in a taxable account. If you put $6000 in a stock which does not pay dividends, and the stock price rises to $12,000 while prices double, you will owe $900 in tax when you sell the stock, not keeping up with inflation. If the stock price rises to $24,000, you will owe $2700 in tax, not getting quite the doubling of purchasing power. Dividends make it even worse.

Similarly, TIPS in a traditional or Roth account have a guaranteed return above inflation. TIPS in a taxable account cause you to lose 25% of annual inflation to taxes if you are in a 25% tax bracket. (They may still be good taxable investments because they are exempt from state tax; if you pay 22% federal and 8% state tax, you pay 30% tax on most bonds, but only 22% on TIPS.)

[Ketawa]

Unless I am missing something, the Roth is a hedge against higher inflation rates in the future. Consider two accounts - a traditional IRA and a Roth IRA - that both return $100 over a specified period of time, with half of the return (or $50) consisting of inflation and the other half (the other $50) consisting of the “real” return. For ease of calculation, let’s assume the account owner is in a 25% income tax bracket. If the account owner withdraws the $100 return from the traditional account, he/she will pay $25 in tax, which represents 50% of the real return. The same amout withdrawn from the Roth would be free of tax, so the investor would keep 100% of the real return.

But consider what happens in a much higher inflation environment where the real return is still $50, but the nominal return is $200, with $150 of the return consisting of inflation. In that case, the traditional IRA account owner withdraws $200 and pays $50 of tax (at the 25% marginal rate). His or her real, after tax and after inflation return in the traditional IRA is 0%. All of the real return has been eaten up by taxes. By contrast, when the owner of the Roth IRA withdraws the $200 return, he or she still gets to keep 100% of the $50 real return. The Roth IRA successfully insulates the account holder from having the real investment return be eaten up by taxes, while the traditional IRA doesn’t necessarily do that - especially in conditions of high inflation.

This example doesn't demonstrate what you claim. In your example, having more money in retirement was because the investor saved more, not because the Roth IRA hedged inflation rates. Having the same dollar amount after taxes in the Roth IRA represents a higher savings rate than having the same dollar value pre-tax amount in the Traditional IRA. That is your assumption when you say both accounts returned $100 or $200. Account for a 25% tax rate on both ends, and neither account will be better at hedging inflation and avoiding taxflation.