2 Things You Need to Know About the Roth IRA

by Jonathan G. Cameron, CFP®

One of the most popular ways to save for retirement is in a Roth Individual Retirement Account.  Roth IRAs was first made available in 1997, after they were championed by former Senator William V. Roth of Delaware.

What is a Roth IRA?

Tax-wise, a Roth IRA is like a Traditional IRA in reverse. It may help to compare the two registrations.

In a Traditional IRA, as well as in a 401k, most people get tax deductions for contributing dollars up to certain limits every year. The account accumulates funds over time, perhaps generating some nice earnings, tax-deferred. When it’s time to retire, the full amount of the distribution is taxable at your marginal tax bracket at that time. Using simple math, if your tax bracket at retirement is 24% and you distribute $100 from your Traditional IRA you will get to keep $76. Remember, distributions from a Traditional IRA are fully taxable. Contributions are made before tax.

#1 A Roth IRA Has Tremendous Tax Advantages

By contrast in a Roth IRA, or Roth 401k, you get no tax deductions up front when contributing. The Roth IRA is a tax-deferred retirement registration within which you can purchase various investments, just like the traditional IRA. You can invest in stocks, bonds, mutual funds, exchange-traded funds (ETFs), and more. But when you retire and need income from a Roth, all your distributions – earnings plus contributions – come out tax-free. That is, assuming the same 24% tax bracket, you distribute $100 from your Roth IRA, you’ll receive $100 without a haircut from Uncle Sam. Not bad, eh? Contributions are made after tax.

You may contribute up to $6000 into a Roth per year (2020). If you are 50+ years old, add $1000 to that for “catch-up” contributions. These contributions are after-tax, so you’ll get no tax deduction going in. The key to remember is that Roth distributions are tax-free once you've attained age 59 1/2.  Before then your contributions can always come out tax-free, but there may be a tax on earnings.  So here's the trade-off: a little pain today for much pleasure later on.

Raise your hand if you think taxes will be higher in the future than they are now! That’s a safe bet. This is the beauty of a Roth. Generally speaking, a Roth IRA is best suited for those with a long time horizon. The younger you are the better. And it’s certainly good for those who like to pay less in taxes over the long run!

Roth IRA Income Phase-Out Limits

To contribute to one, you first have to pass the IRS Modified Adjusted Gross Income test. First, you need to have at least some earned income to participate (earned, as opposed to investment income). Second, you have to make less than $124,000 MAGI (2020) if single and $196,000 MAGI (2020) if married to make a full Roth contribution. Clearly higher-income earners cannot contribute to a Roth. Note: If married filing separately, and you lived with your spouse at any time during the year, you are ineligible to contribute to a Roth if your MAGI is above $10,000. So, forget about it. If, however, you are married filing separately and did not live with your spouse at any time during the year, your phase-out begins the same as a single filer at $124,000 MAGI (2020).

Why should I have a Roth IRA?

Bottom line – it’s a huge potential tax savings. I refer back to something I mentioned in point one – you will, in theory, pay Uncle Sam significantly less to retire than if you saved exclusively in a Traditional IRA. I say “in theory” because if you keep Roth contributions in a money market or short-term CDs, you will have very little earnings in the end. If you intend to be ultra-conservative in your long-term investment approach, you might as well take advantage of contribution tax deductions in the short term within a Traditional IRA.

Here’s a scenario using simple math comparing what you can pocket in a Traditional IRA and a Roth IRA:

Assumptions:

• $400 monthly contributions

• 7% = average annual return, compounded monthly

• 30 years = Retirement time horizon, and years contributed

• 24% = Marginal tax rate at retirement

After 30 years, an account would grow to $487,988.39. This would be the same in both the Traditional and Roth IRAs. However, at a 24% marginal tax rate, you only keep 370,871 in a Traditional IRA. You get to keep all of it in a Roth IRA, regardless of your tax bracket. You just saved yourself nearly $117,117! 

#2 The Roth IRA is About Deferred Gratification

Now, in  real life, no one is going to just distribute an IRA.  You'd draw from it as needed.  This illustration is only to make my point:  the tax savings is huge in the distribution phase.  So you have to ask yourself:  Is the tax deduction available to me now in the traditional IRA worth it in the long run?

 So when saving for the future, and if you meet the IRS eligibility phase-outs, do yourself a favor and choose the IRA registration that best meets your needs. Simple decisions early on, like contributing to a Roth IRA, can potentially save you hundreds of thousands of dollars in the long run.

Get in touch! 

If a Roth IRA is something you'd like to explore further, we can help.  Other related blog posts are: 

• Who Should Consider a Roth Conversion?  
• A Guide to Roth IRAs 
• Ins and Outs of Traditional IRAs 
• What Is an IRA?
• Why I Don't Like an Annuity in an IRA

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