Why Roth IRAs Are So Awesome

Originally called an "IRA Plus", these retirement accounts were established as part of the Tax Relief Act of 1997. Unlike Traditional IRAs, distributions from Roths are income tax free, as long as the account holder is at least 59(1/2) years old and the account has been established for at least 5 years.

Contributions to Roths follow the same guidelines as Traditional IRAs; $5,500 annual contributions ($6,500 for seasoned investors age 50+). However, you can't make a $5,500 IRA contribution AND a $5,500 Roth contribution. It's $5,500 total, not $5,500 each.

To put the Roth tax free distribution benefit in perspective, consider two $1,000,000 accounts; an IRA and a Roth. An couple with income falling between $75,300 and $151,900 are in the 25% marginal tax bracket. This means that 25% of the $1,000,000 will be lost to taxes in the IRA. In effect, the IRA really doesn't have $1,000,000 in it. More like $750,000.

We are all familiar with the concept of diversifying your investments. From a financial planning standpoint, it also makes sense to diversify how your retirement income will be taxed. The problem I usually encounter with clients is a disproportionate amount of assets scheduled to be taxed at the highest rates (ordinary income). Here's how the typical investor normally shakes out.

It's important to diversify the tax on retirement asset distributions. You can't control future tax brackets or their respective rates. And, you can only influence how much income you're willing to take (or not take) based on the lifestyle you want to live, i.e., I've never met someone in the 33% bracket willing to live out retirement in the 15% bracket. That said, if an investor had all their retirement earmarked assets in a 401(k) and tax rates went up during his retirement, his financial plan could fall apart.

Holding assets in a tax free Roth structure is a great way to reduce your future tax risk. It sounds good, but like everything, there's a tradeoff. Getting money into a Roth does not provide a current tax benefit like a 401(k) contribution does. I like to explain the tradeoff as "pain now vs. pain later".

Now that you've accepted your inability to escape tax pain, let's look at the numbers to see when it's best to realize the pain. Consider a 50 year old hypothetical investor; I compared $15,000 of annual contributions (higher contribution limits than a Roth IRA) in a Roth 401(k) to a traditional 401(k). The investor started with a $0 balance, and made contributions for 17 years. Total contributions equal $255,000. The assumed rate of return is 7%, their current tax bracket is 28%, and their retirement tax bracket is 25%.

The following graph shows a balance of $479,962 in the Roth 401(k), $109,990 more than the traditional 401(k) after tax balance. In this example, the "after tax" definition applied to the traditional 401(k) is the sum of two parts: 1) The value of the account after you pay income taxes on all earnings and tax deductible contributions, and 2) what you would have earned if you had invested (in an ordinary taxable account) any income tax savings.

Clearly, taking the tax pain upfront is better, right? Not so fast. The opportunity cost of Roth 401(k) contributions in my example is 17 years worth of lost deductions had traditional 401(k) contributions been made instead. Since my investor is in the 28% bracket, we must add $4,200 in tax deductions (28% of a $15,000 contribution) back in. Over 17 years, that's $71,400 in lost tax deductions!

But, remember that the Roth 401(k) balance was $109,990 MORE than the traditional 401(k) after tax balance. The Roth 401(k) investor is still up nearly $40,000 over the traditional 401(k) investor. That's enough for an extra car (a really nice one) in retirement!

My hypothetical investor is just one example where the Roth turns out to be a better. If you don't have much time until Roth IRA distributions begin, a big capital gain bill in a given year, or if you are the unicorn investor I don't believe exists who will voluntarily and dramatically reduce their tax bracket in retirement, then making the traditional 401(k) contribution can be advantageous.

If you're unsure if your current strategy is the best to reduce your overall tax pain, we can show you. All you have to do is get in touch! Use the Shoot Us An Email function down in the site footer below. We'd love to show you how much tax pain you can expect, and when you should accept it.

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