Everyone Should Own a Roth IRA
Steve Hill, BFA™
Investment Advisor Representative
Have you given with regards to all of the confusion of the IRA world? Traditional, Simple, Roth, SEP, Rollover IRAs—the merry-go-round goes round and round. What's so hard to understand? Let's try to make this easy. Simple IRAs are for small business owners/employees, and SEP IRAs are for self-employed persons, so for many of you, that eliminates what you may need to know right there, and so we'll leave a discussion of these IRA types for another day. Rollover IRAs are used for moving employer-sponsored retirement plans, such as 401(k)s, 403(b)s, 401(a)s, and Thrift Savings Plans, into your own personal tax-deferred savings plan. Once the money is rolled over to the rollover IRA (without tax consequence), it operates as a Traditional IRA. Growth is tax-deferred, and withdrawals are taxed as ordinary income in the year of the withdrawal. Contributions to the Traditional IRA bring an added benefit of an above the line tax deduction for the amount of the contribution, bringing with it similar preferential tax treatment as a pretax contribution to a similar type of employer-sponsored plan. Similar to the employer-sponsored plans named earlier, the Traditional IRA is subject to Required Minimum Distributions in the year the participant turns age 70 ½. Let's now turn the rest of our discussion to the benefits and tradeoffs of the Roth IRA because it's a very different type of tax-advantaged retirement plan.
Normally I'm not too fond of bold, generalized statements, but in this case, I'm going to violate my sentiment and make one: Everyone should own a Roth IRA. But the reality is everyone cannot because there are earned income limits that restrict some from utilizing this savings strategy. In 2017, you cannot make a Roth IRA contribution if your modified adjusted gross income exceeds $196,000 for a married couple or $133,000 for a single filer (reduction from full contribution allowable begins at $186,000/$118,000). Roth IRAs are funded with dollars that have already been taxed and thus do not create an immediate tax advantage/deduction, but once inside the Roth, all growth, distributions, and wealth transfer (inheritance) occur without tax consequence. One of the main benefits of the Roth IRA, compared to the Traditional IRA and most employer-sponsored qualified retirement plans, is the ability to access money prior to age 59 ½. Normally there is a 10% penalty associated with distributions before age 59 ½ for most of these plans, but for Roth IRAs, withdrawals of "contributions" are both a penalty and tax-free at any time. This is an especially nice benefit for younger savers, giving them the peace of mind that if something comes up along the journey towards retirement whereby they really need to access money, they can access up to the amount of their previous contributions without being penalized. Current year contribution limits to an IRA (Roth or Traditional) are $5,500 annually, with an additional $1,000 catch-up contribution allowed for those over age 50.
With the exception of the Roth IRA, qualified retirement plans are built to provide the desired income stream in retirement, replacing the earned income we've lived on for years. As we are accustomed to having taxes come out of our paycheck during our working years, as previously mentioned, these "income" distributions from our tax-deferred plans will be taxed as well. However, regular monthly income needs are not the only type of expenses that we will have in retirement that will need to be supported by the savings we accumulate during our working years. There will be irregular expense needs that we refer to as "big ticket" items that occur in retirement, just as they did prior to retirement, such as expenses for travel, helping children/grandchildren, down payments for automobiles, home improvements/upgrades, etc. If we use our 401(k)s, Traditional IRAs, and other tax-deferred savings vehicles for these high dollar expenses this will create a big tax bill, and in many cases sizeable withdrawals from tax-deferred savings positions may cause a bump up into a higher tax bracket. Before recommending a Roth IRA, many advisors first analyze whether or not their client will likely be in a higher, lower, or the same tax bracket in retirement, and will also consider how long it will likely take to recover the taxes paid on the money used to fund the Roth; nevertheless, regardless of your tax bracket, avoiding a taxable event when taking large distributions of this kind is never a bad thing for those in need of cash.
On a related side note, some employer-sponsored qualified plans are now offering a Roth option, the 401(k) Roth as an example. If your employer offers you a company-sponsored plan, we suggest you find out if a true Roth option is available to you. If your company has any kind of "contribution match" program, their contributions will always have to go into the pretax, tax-deferred side of plan, but we suggest it may be beneficial for you to begin directing some of your contributions into the Roth option. Also, employer-sponsored plan annual contribution limits are much higher than personal IRA contribution limits, so it may be in your best financial interest to increase the amount you are saving into your company plan.
As you can see, all IRAs are not created equally!