The second in a series on various options for retirement savings. If you haven't already seen it, you might like to read Saving for Retirement: Traditional IRAs first.
Named after the late Senator William Roth of Delaware, who pushed for the creation of this variation on the traditional IRA account, the Roth IRA came into being in 1997. Like a traditional IRA account, a Roth IRA account is part of your overall IRA.
Like a traditional IRA account, a Roth account or investment may be an annuity, a brokerage account, a bank or CD account, a mutual fund account, or even a self-directed plan (with the use of a third-party custodian, which may allow one to own real estate or other non-publicly-traded investments). And like a traditional IRA, there are tax advantages (though they are a bit different), the assets in the Roth IRA may be safer from exposure to potential creditors, the assets in a Roth IRA are (usually) not included in college financial-aid computations.
There are a few key differences, however. First off, the tax treatment of a Roth account is the reverse of the tax treatment of a traditional IRA (particularly one funded with deductible contributions.) When you make a contribution to a Roth IRA, you does not get to deduct that contribution from your income for calculating your income taxes. In other words, the Roth IRA is funded with after-tax money. While this may seem, at first, to be a disadvantage -- after all, we'd all love the tax break right now -- the payoff comes in a few ways. One: since you got no tax break for putting contributions in, you may be able to take those contributions out with no penalties or tax consequences; Two: if you let the investments grow and wait until you're 59-1/2 years old (or you qualify under one of the other rules), distributions from the Roth IRA -- including the investment growth -- are income-tax free; Three: no RMDs -- meaning that, unlike with a traditional IRA account, once you reach 70-1/2, you are not forced to start taking distributions; Four: you can effectively shelter a lot more money since it's after-tax money, but the limits are the same as for a traditional IRA.
So what's the downside? The biggest is that you're paying taxes at your current marginal income-tax rate, and you may qualify for a lower rate when you retire since your income may be a lot lower by then. On the other hand, nobody knows where tax rates are going to go in the future and they're pretty low right now compared to their history, so this may well be another advantage. Also, while qualified distributions are currently income-tax-free, nobody knows what Congress may do in the future and by investing in a Roth IRA, you're taking the chance that Congress could always tack on some form of penalty or tax.
So how does it work? It's basically as simple as opening an account and making a contribution. You won't get a break on your income taxes (though if you make below a certain amount of money, and are otherwise qualified, you may be able to get a non-refundable credit towards your income taxes of up to 50% of what you put into a Roth IRA. See the end of the article on traditional IRAs, the paragraph about the Savers's credit (link to IRS.)
[We'll be addressing RMDs (Required Minimum Distributions) and the Saver's Credit in future articles.]
There are some restrictions on who may contribute to a Roth IRA. Mainly, you (or your spouse) needs to have earned income for the year. And your income must be below certain thresholds. As usual, there are different thresholds for married and unmarried people. Unlike the traditional IRA, however, it doesn't matter whether you have access to a retirement plan through your employer. Generally, it's as simple as this: if you don't make "too much" money, you can contribute. And if you do make too much, you may still have an opportunity to contribute to a Roth IRA indirectly - through a "conversion". For more details about Roth conversions, and particularly how to get around the income limit, see Can I put money into a Roth IRA?
In our previous article, we used the example of Bill, who is in the 25% income tax bracket and is considering saving the proceeds of $1000 of his earnings for retirement. With the traditional IRA, since he got to deduct the $1000 from his income, he paid no income taxes on that $1000 and was able to invest the entire $1000.
Suppose Bill's income was such that he qualified to use a Roth IRA. Since he won't get a tax deduction for making his Roth IRA contribution, and he's got $1000 of earnings available to use, he's really only got $750 available to contribute to the Roth.
In other words, the impact on the amount of money Bill has available to spend - to be equivalent - has to be adjusted for taxes. (This leads to one of the advantages of a Roth - you can put more into one - we'll talk about this later). Anyway, if Bill put $1000 into a deductible, traditional IRA, his after-tax spending power is reduced by $750 because if he hadn't put it into the deductible IRA, he'd have paid 25% taxes on it and only had $750 left to spend. Since Bill isn't taking a tax deduction for his Roth IRA contribution, to reduce his after-tax spending power by the same amount, he'll put $750 in.
Now, following the numbers used in the traditional IRA example, suppose Bill's investment grows at 4%/year. And that he lets it compound and grow for 20 years. That $750 will grow to $1643. And since it's a Roth account, if he wants to pull the money out and spend it, he gets to take the entire $1643 and not pay any income taxes on it.
If he'd invested that same $750 into a taxable account, and assuming that, as in the previous example, the 4% return is fully taxable each year (ie. interest on a taxable bond portfolio), even though he earns 4% each year, he only gets to keep 3% of it - he's got to pay 25% income taxes each year on the earnings. So his after-tax return is only 3%. Over the same 20 years, the taxable portfolio, therefore, grows only to $1354. Huge advantage to the Roth.
One interesting thing to notice, especially if you've read the article on the traditional IRAs: the amount Bill gets to spend at the end is identical whether he uses the Roth IRA or the traditional IRA. The math demonstrates why:
Roth IRA: [(amount earned)(1-tax_rate)]*(1+growth_rate)^years_compounded
Traditional IRA: [(amount earned)*(1+growth_rate)^years_compounded]*(1-tax_rate)
If all the assumptions are the same: income-tax rate, investment growth rate, amount of earnings available to invest, years compounded -- then the Roth IRA and the traditional IRA result in the same amount to spend at the end - it's just a matter of rearranging the order of the multiplication.
However, note that in reality, there are still sometimes advantages to one versus the other. For example, if you are in a peak earning year (with a high tax rate) but know you'll be in a lower income tax bracket later, it may make sense to make a deductible contribution (IRA or 401(k) or otherwise) now and make Roth contributions later on in the lower-tax year. Or vice-versa.
The Roth has other advantages, too: regular contributions may come back out at any time without penalty (conversions have a 5-year period during which there is a penalty, but this doesn't apply to direct contributions). This means that at least the contributions (if not the earnings attributable to them) are available for other purposes before retirement if you like. This is a huge advantage.
Another advantage: you can put more into a Roth. This is the advantage mentioned earlier. In Bill's example, we assumed that he had the same amount of earnings available to contribute to the Roth. In other words, he wanted to reduce his spendable amount of available money the same amount whether he did the Roth, the traditional or the taxable account. For folks who spend a lot less than they earn, or folks who have accumulated some savings which may be available to dedicate to retirement which isn't yet in a retirement account, the limiting factor for IRA and other retirement savings might not be cash available but rather the fact that IRAs have a contribution limit. Each year, you may contribute a total of $5000 ($6000 if you're over 50) to your IRA. And that limit applies to the combination of your traditional IRA (whether deductible or not) and your Roth IRA in total. If you put $3000 into the Roth, you may put $2000 into your traditional IRA. You may not put $5000 into each. (Though for married couples, each spouse has his or her own $5000 limit).
So how does this give the Roth an advantage? Remember the "spendable equivalent" we discussed regarding Bill's IRA contributions? In his case, putting $750 into the Roth IRA was equivalent to putting $1000 into the traditional IRA. Now suppose the limiting factor was the IRA limit, not his available cash. He could put $5000 into the traditional IRA or he could put $5000 into the Roth IRA. Since the Roth IRA money is after-tax money, putting $5000 into the Roth, in his case, would have been equivalent to putting $6667 into the traditional IRA. But he can't put $6667 into a traditional IRA. Having the same limit - $5000 - but applying it either before- or after-tax - has very different results. If Bill had $6667 of pre-tax earnings available to invest and he put the $5000 into the traditional IRA, he'd still have $1667 pre-tax money as yet uninvested. He'd have to pay income taxes on the $1667, leaving $1250 to invest on an after-tax basis. And that investment would have to go into a taxable account which, as discussed above, results in a lot less growth over time than a Roth or traditional IRA.
Remember: a dollar after-tax is worth more than a dollar before-taxes. This important truth effectively makes the Roth IRA contribution limit much higher, and it may have a substantial impact in other areas as well. And it makes every dollar in your Roth worth more than a dollar in a traditional IRA (and possibly even in a taxable account).
One final note on tax diversification: We talk about diversifying amongst securities and amongst assets classes in order to reduce portfolio risk. It's worth considering diversifying amongst different tax treatments of investments as well, to allow for both risk reduction (ie. rates can go up or down) as well as to allow for certain opportunistic tax moves. An example noted above was that in a high-income-tax year, you might make deductible contributions to a 401(k) or IRA, and in a low-income-tax year, you might make contributions to a Roth IRA (or even a Roth 401(k) account). But it goes a step further than that as well -- once you've reached retirement, you may also get the opportunity to choose which type of account to take distributions from, in order to maximize your use of the tax advantages. For example, after retirement, since traditional IRA distributions are taxable as income, if you're in the lowest bracket (paying no income taxes at all), you might want to take IRA distributions just enough to reach the threshold of that tax bracket, and take Roth distributions or use money in taxable accounts to the extent that you need more than that. There are a lot of opportunities that come along with all the complexity of our tax situation. Often, it's worth doing some what-if scenarios in your tax software if you're not sure. Or have your accountant do some.
For more information about IRAs, see IRS Publication 590, available here:
as a web page: www.irs.gov/publications/p590/index.html
or as a PDF: www.irs.gov/pub/irs-pdf/p590.pdf