The Roth IRA is turning 20 this year. For some of us, it’s still a new idea while for others, it’s been a fixture of their entire investing life. Whatever your perspective, it’s a great tool and it’s been used a lot. Roth IRAs currently hold more than $660 billion in assets, according to the Investment Company Institute. That sure seems like a lot, but it represents only 8 percent of all funds held in IRAs at the end of 2016, according to ICI.
One big reason for the small amount of Roth money is that most IRAs are funded with rollovers from qualified retirement plans. Most of that money is tax-deferred and retirees don’t want to pay taxes on the rollover, so they keep it in a traditional IRA. In 2015, 85 percent of new traditional IRAs were funded solely by rollovers, while the figure was only 15 percent for new Roth IRAs, ICI says.
Most Roths are funded through annual contributions which are limited to $5,500 per year for most savers and $6,500 per year for those better than 50 years of age.
There is no limit on the amount of traditional IRA money you can convert to a Roth IRA. But, research says that from 2007 through 2015, only 6.9 percent of Roth investors initiated a Roth conversion.
One likely reason not to convert is that you pay tax on the converted amount as income in the year of the conversion. So, it increases your tax bill in the current year.
Roth IRA benefits
As a fiduciary financial planner, I love Roth IRAs for my clients for a few reasons:
- Most of my clients find it always stinks to pay taxes, but it stinks less when you are working and have tax withholding taken from your payroll.
- Most of my retired clients hate to take money from their IRAs because they get a tax bill every time. They see the additional money they take out and send to federal and state taxes and it irritates them.
- For clients who plan to leave a legacy, Roth IRAs do not have a required distribution for the owner. This allows the Roth account to compound tax-free throughout the owner’s life. A beneficiary will need to make required distributions starting at age 70½, but the distributions will still be free of tax.
- A combination of retirement savings in both a Roth IRA and a traditional IRA gives retirees more flexibility. They can use Roth money to cover some spending and not create increased tax burdens. It’s a nice option.
But which IRA is a “better” investment?
Like so many things in financial planning, the answer is “it depends.” Generally, I find that for most of my clients the three reasons I mentioned above are enough to justify a Roth IRA. But let’s look at the arithmetic comparing a Roth IRA to a traditional IRA.
If an investor stays in the same income tax bracket throughout their working life and retirement, is a Roth IRA better than a traditional IRA? Mathematically, the amount of spendable money coming out of either IRA is the same.
However, for most real-life humans, things are different in a few ways:
- If they start the Roth IRA early in their career, they are in a lower tax bracket than later in their working life. So they are paying less in taxes overall on the money deposited.
- If the investments create significant capital gains, a traditional IRA account will tax that growth as income when it’s spent instead of taxing it at the lower capital gains tax rate. For a Roth IRA, there is no tax on the growth, so that’s a bonus.
- If you work an “average” job and have a “comfortable” retirement, the odds are that you will be in a similar tax bracket during your last five years working and your first 10 years in retirement. Most of my clients don’t experience a big reduction in their lifestyle in retirement. The fact that you would need to take distributions from your IRA that roughly equal your salary at retirement means that a Roth IRA and tax-free distributions on all growth is a big bonus.
- If you needed to take an IRA distribution before 59½, it would be subject to a 10 percent penalty from a traditional IRA. With the Roth IRA, you can always remove deposits with no penalty at any time.
- Tax laws are constantly changing and it is very hard to predict what your tax rate will be 20 years in the future. There is a benefit in paying the tax now while you can, thus lowering your risk of changes in tax law hurting your spendable return.
Reliable financial advice
When we are trying to make a decision on whether to use a Roth IRA, I work with my clients to evaluate their situation. We consider their goals for the near term and long term, and we can calculate the outcome of a few scenarios to decide what will fit them best. This is a space where an advisor who works only as the client’s advocate – a fiduciary – and an advisor who gets paid only by the client – a fee-only advisor – is a big advantage. The choice is complex and the best path is not clear. My clients find it a comfort to know that my analysis is only focused on their goals and priorities.
If you have questions about where a Roth IRA fits in your overall financial strategy, contact my office at rdunn@dunncreekadvisors.com. I am always happy to talk about your options.
Dunncreek Advisors does not provide legal or tax advice, nor is this article intended to do so.
A Tale of Two Investors
