Hey, everyone! In this week’s tip of the week, I want to explain why I lean toward using Roth accounts, such as Roth IRAs and Roth 401Ks, as opposed to your traditional IRAs and 401ks as an investment and retirement tax shelter. First, what’s the difference. The primary difference is the tax treatment of money going in and coming out. In your traditional IRAs and 401ks, you get a tax deduction when you put money into those accounts. When you take the money out in retirement, it’s taxed as ordinary income. In other words, if you take $10,000 out in retirement and your tax rate is 20%, well you really only receive $8,000.
Roth accounts are the opposite. Nothing changes with your taxes when you put money in, but you won’t owe taxes when you withdraw money from a Roth account in retirement. So, in theory, the math is equivalent regardless of the choice: Roth or Traditional. In theory, if you expect your marginal tax rate to fall in retirement, a traditional IRA or 401k will result in maximum wealth. If you expect your marginal tax rate to increase in retirement, the Roth accounts will maximize your wealth.
And some people will use a fear-based technique to ingrain the expectation that tax rates must rise in the future to pay our growing national debt. That perspective has merit, but I don’t put too much weight on it specifically.
Alright, with the background information out of the way, here are the four main reasons that I generally recommend Roth accounts over traditional retirement accounts.
You can access your Roth IRA contributions at any time without taxes or penalties.
While I don’t recommend that your IRA be used as an emergency fund, the rules of a Roth IRA allow you to withdraw your contributions without taxes or penalties, even before age 59.5. Again, that’s contributions only, not earnings or investment returns. For example, let’s say that you have a Roth IRA and have contributed $20,000 over the last four years and the account value is now $30,000 due to growth in your investments. You could withdraw up to $20,000 from that account without taxes or penalties.
In contrast, a regular IRA withdrawal before ae 59 and a half will result in those funds being taxed as regular income with a 10% penalty added on top.
Even withdrawing from regular brokerage account can cause a taxable event if investments have capital gains.
Retirement withdrawals are not taxed.
Of course, tax-free retirement withdrawals are the primary differentiator of Roth 401ks and Roth IRAs versus the traditional counterparts. There are multiple benefits to this arrangement. First, it’s a hedge against future tax increases. My typical clients are Veterans in their 20s, 30s, and 40s and their potential planning time horizon could be north of 50 years. We really have no idea what is going to happen to tax rates in the intervening period. Roth accounts reduce the impact of those changes.
The other important positive impact of tax-free retirement withdrawals is that they don’t trigger higher taxes on social security benefits. Again, I have no idea how those rules will change in the future but, in the current arrangement, traditional IRA and 401k withdrawals can cause significant tax increases on social security benefits.
Access to Roth accounts is limited.
Contributions to Roth IRAs are not allowed for married couples whose Adjusted Gross Income is greater than $203,000 per year and for unmarried individuals with an AGI north of $137,000. Those amounts are for 2019, by the way. For many people, those income limits won’t be an issue. But they might be for others, especially as they progress in their careers. The point here is that you may not always have the ability to contribute to a Roth IRA.
The other issue here is that many corporate retirement plans don’t offer a Roth option like a Roth 401k or Roth 403b. Given that people will likely switch employers many times throughout their lives, there is a great chance that the next employer does not have a Roth option in its retirement plan.
Flexibility has value.
Finally, and the most often overlooked, is that Roth accounts, especially Roth IRAs, offer flexibility. And flexibility has value. We can access our contributions in a Roth IRA without taxes and penalties, so they aren’t locked up like in a traditional IRA. And we don’t have to worry about the tax impacts of retirement withdrawals because there are none!
With traditional 401ks and IRAs where we pay taxes on withdrawals, we are left hoping that tax rates don’t go up, among other things.
It’s difficult to place a specific dollar value upon the flexibility offered by Roth accounts, but it’s there. It would be nice if life followed a perfect script, but it rarely does. For those times that life goes off-script, Roth accounts offer added flexibility where traditional accounts do not.
Bonus: One last thought. I want to reemphasize that financial planning is not really about squeezing out that last dollar or maximizing wealth absolutely. Instead, it’s about helping clients live their best lives. Many specific variables might result in tax-deductible IRA or 401k contributions being a better option than Roth contributions, especially in a year with higher than normal income.
But if you’re debating Roth vs traditional accounts and trying to precisely calculate which one is better, you may be focusing on the wrong things.
Thanks for watching! Please comment and let me know what you think! Until next time!
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Remember, the topics discussed in this video are for informational purposes only and that past results do not guarantee future performance. If you would like to discuss your financial situation, please email me at Derek.Merkler@Parsonex.com.
Advisory services offered through Parsonex Advisory Services, Inc., 8310 S.Valley Hwy, Suite 110, Englewood, CO 80112. 303-662-8700.