Many years ago a financial planner pointed out to me that when I retired, all of my sources of income would be taxable (pension, traditional IRAs, Social Security). He suggested I start a Roth IRA so that I would have an option to draw down funds without any tax consequence. This is one of the best pieces of advice I’ve ever received!
What’s a Roth IRA?
Most retirement accounts (traditional IRAs, employer sponsored retirement accounts) are tax deferred. Your taxable income is reduced by the amount you contribute to the account. This lowers your tax bill now. However, when you draw from the account in retirement, you have to pay the piper—your draws are taxed as ordinary income. If you contribute $5,000 to a traditional IRA, you save yourself from paying taxes on $5,000 of income this year. If it doubles to $10,000, that’s what you’ll be taxed on later, when you take the money out.
With a Roth IRA, there’s no tax deferral. You pay taxes on your income now, but you don’t owe anything when you take money out of the Roth in retirement. If your current tax is 20%, you’ll pay $1,000 in taxes on your $5,000 and end up with $4,000 to contribute to your Roth. But then when it has doubled to $8,000, you won’t pay taxes on drawing that money down in retirement--sweet!
Both is a better strategy
There are lots of good reasons to use both tax deferred accounts and a Roth IRA as part of your investment strategy:
If you can participate in an employer sponsored retirement plan to which your employer will also contribute—do it and lucky you! For example, if you have the option of a 401k with a match up to 3%, definitely contribute the 3%. While you’ll have to wait for the employer’s matching 3% to vest, you still have twice as many dollars in your retirement account today to grow and compound.
It makes good sense not to pay today what we can defer until tomorrow or even later. As Wimpy says, “I’ll gladly pay you Tuesday for a hamburger today" This is the logic behind tax deferred accounts—you defer paying taxes until some date far in the future. Because a dollar today is worth more than a future dollar, the later we pay the better. However, realize that when you do pay taxes down the road, it won’t be on the amount you contributed (the $5,000 on the example above)…it’ll be on the entire appreciated value that you draw—or the $10,000 above. So, if you were in the 20% tax bracket, you saved paying $1,000 when you made the contribution, but now you’re going to pay $2,000 when the money comes out.
If money is so tight that they only way you can contribute to an IRA is with the tax break available with traditional IRAs, go for it—better to save for retirement than not to save.
Part of the case for tax deferred retirement accounts is that we’ll be in a lower tax bracket when we retire than while we’re working. For example, you were in the 20% tax bracket when you earned the $5,000, so you deferred paying $1,000 in taxes. Now in retirement you’re in the 15% tax bracket, so you’ll only pay $750 on the original $5,000 (or $1,500 on the entire appreciated balance of $10,000).
There’s no way of predicting if and how our tax code will change. It doesn’t make sense to bank on getting better tax treatment in retirement than you do today.
What if the tax code doesn’t change? You may not actually be in a lower tax bracket when you retire. Most of us would like to have as much income in retirement as we do while working. As one pre-retiree points out, in retirement “every day is gonna be Saturday, but I’m supposed to spend less? Unlikely!” Of course, you won’t have the expense of contributing to retirement savings accounts or commuting or buying work clothes…but it doesn’t take too many trips to see the grandkids or volunteer to help hurricane victims or see the world to keep your expenses in retirement at a pre-retirement level.
Psychologically, it’s easier to pay taxes during your earning/accumulation years than during your retirement/spending down years. We have more financial flexibility while we’re still in the work force seeing dollars roll in, particularly during our peak earning years.
Unlike traditional IRAs and employer sponsored retirement plans, there are no RMDs on Roth IRAs. You have the ability to take money or not in retirement. The timing is up to you.
A final important difference between Roth and traditional IRAs is that you can take back the funds you’ve contributed to a Roth (but NOT any appreciation or earnings on those funds) without a penalty or tax consequence. There are far greater restrictions on taking money out of a traditional IRA before reaching age 59-1/2. With a Roth, the dollars you contribute are after tax, so you can also take them back out without being taxed. Hold on, now—you do need to save for retirement! I’m not suggesting that you pull funds from your Roth IRA to remodel the kitchen or ski at Breckenridge. However, a Roth can be a nice place to stash your emergency funds—you can easily take your contributions back out and, in the meantime, you don’t pay taxes on the bit of interest they earn.
Ideally, though, the Roth is a good home for your highest return assets. It feels great to invest after tax dollars in a Roth IRA and see them double and then double again over time, knowing that the taxes are already paid and what’s in there is free and clear!
The Fine Print
My love story about Roth IRAs (Roth 401ks have similar benefits but are beyond the scope of this post) is just intended to get you thinking. I don’t give investment advice except to clients whose situations I know enough about to do a good job. However, the IRS does have rules on who can contribute to Roth IRAs:
Married couples filing jointly with modified adjusted gross income of less than $189,000, and
Singles with modified gross income of less than $120,000
You can still make 2018 contributions until your 2018 income tax return is due—April 15, 2019 for most of us!
You can contribute the lesser of:
$5,500 ($6,500 if you are 50 or over) or
your taxable compensation
And the contribution limits will go up in 2019 to $6,000 or $7,000 for people 50 or over.
I’m now stepping down from my soapbox. If you want to work with a financial planner to figure out whether a Roth IRA is right for you, give me a call at (336) 701-2612.