Why a ROTH IRA?

In a previous blog I recommended starting a ROTH IRA as a suitable retirement savings option but didn’t I didn’t tell you what a ROTH IRA is and what it can do for you. I intend to correct that omission now.  This Blog will discuss what a ROTH IRA is and why I recommend it over a Traditional IRA 9 times out of 10.

What is an IRA?

IRA is an acronym for Individual Retirement Account. This is an account with specialized rules, regulations and benefits designed to make it easier for folks to prepare themselves for retirement. This blog will focus on the ROTH IRA which has a few very important differences from the normal or Traditional IRA. It is these differences that prompt such a strong recommendation from me towards the ROTH IRA over the Traditional for anyone in the middle class or below. This will be discussed in further detail a little bit later.  

Here is a list of what the Traditional and ROTH IRA have in common;

·         Contribution limits: Both IRAs allow a person to contribute up to $5,000 annually for anyone under the age of 50. Anyone over 50 can contribute an additional $1,000.

·         An individual can contribute to both a ROTH and a Traditional IRA if they would like but the total of those contributions cannot exceed the annual contribution limit ($5,000).

·         Penalty free distributions after the age of 59 ½. “Distributions” is just a fancy way of saying withdrawal.

·         A person must have real income in the form of wages, tips, salaries, bonuses or fees to contribute. Stay at home spouses may contribute if taxes are filed jointly.

·         There is some form a tax benefit for each IRA.

Why a ROTH?

The biggest difference between the ROTH IRA and the Traditional IRA is the tax benefit. The Traditional IRA allows you to defer taxes on up to 100% of your annual contribution depending on your income level. Instead of paying taxes on the money now you pay for it in when you take withdrawals. At first glance that seems like an amazing benefit and it is under some circumstances but I see two concerning issues with tax deferment in most cases;

1.       Not only will your contributions be taxed when you start to take distributions but any gains you made over the life of your account will as well. That means that the government defers taxes on a small amount now only to reap the rewards of your investments over the course of 30+ years.

2.       Currently we know how much we are taxed. Whether you like that number or not, it is a known quantity. The same cannot be said for the tax rates 20, 30 or 40 years from now. The money you withdraw in the future will be taxed at that future rate, whatever it is,  not the current known rate. I don’t know for sure whether taxes will go up or down over the next 30 years but I prefer not to chance it either way. (NOTE: I have a different opinion on this regarding 401ks, I will explain that in a separate blog)

Why is the ROTH better? Contributions to a ROTH are not tax deferred at all. So what’s the benefit?

By forgoing the instant gratification of a small tax deferment now, all future withdrawals are TAX FREE. This means that when you pull money out after the age of 59 ½ both the money you contributed and any additional money that you have earned throughout the life of the account is completely, 100% TAX FREE. In almost every scenario I can image tax free beats tax deferred hands down. The chart below is an illustration of the difference in the amount of taxes paid between the two. 

There are too many variables for this chart to be really accurate but if all things remain equal including tax bracket (28%) this is what the difference might be.

A ROTH IRA can double as an emergency savings account.

Yes, you read that right. All the money you contribute to a ROTH IRA can be withdrawn without penalty (or tax) at any time for any reason. It is very important to recognize the “all the money you contribute…” part of that sentence. You cannot pull out more than you have put in or you will be penalized 10% (still not taxed).

This isn’t so for the Traditional IRA. Not only will you be taxed for an early withdrawal but you will be penalized an additional 10% as well. This could mean giving as much as 40% of your hard earned retirement distribution to Uncle Sam.

Also important to note is It is not as “liquid” (meaning quickly converted to cash) as a typical savings account. Since the IRA is likely made up of mutual funds, stocks and bonds it may take one to three days for the money to be on hand.

And for the record, when I say “emergency savings” I don’t mean buying an “emergency” Lexus or taking an “emergency” Caribbean cruise. When you’re considering pulling money out think about this example;

Say you want to pull out $10,000 for a down payment on a house and you have 30 years until you retire. That $10,000 would have conservatively turned into just over $100,000 by the time you retire. You may be saving yourself 5% interest over the course of the 30 year mortgage but you are losing out on 8-10% return you would have received annually over that same time.   

You can contribute as long as you want.

Should you find yourself in the unbearable predicament of having extra disposable income well into your 60s, 70s or even into your 100s, you can still contribute to your ROTH IRA. That is not so for a Traditional IRA. In fact, a Traditional IRA requires distributions to start at the age of 70 ½ whether you need the money or not.

The ROTH IRA does not have mandatory distributions.

If you don’t need the money, you don’t have to take distributions, not ever. Why wouldn’t you take the money? Perhaps you happen to have a spouse without retirement benefits of their own or perhaps you just want to leave a sizeable inheritance to a favored grandchild.

The ROTH can be passed on to an heir without penalty. The spouse is the beneficiary if the account owner dies. If the spouse already has a ROTH of his/her own then these two accounts will be rolled together. If the spouse has also passed on then the account can be willed to another penalty free (estate tax does apply but is reduced because taxes have already been paid for all of the contributions) and but now there are rules regarding mandatory distribution.      

Restrictions

The ROTH IRA is a powerful tool for retirement savings and as such it has restrictions. A person has to earn under a certain amount each year to be eligible to contribute to a ROTH IRA. The numbers change periodically to keep up with the cost of living. Right now a couple that is married filing jointly must have an annual income of less than $177,000 for instance.  

Wrap up - So in a nutshell that it why I recommend the ROTH IRA 9 times out of 10. There are other options and in some cases better options depending on your individual circumstance. I will discuss 401K plans and an overall retirement philosophy here in the near future. Stay tuned and feel free to post questions and I will do my best to answer them.