That is the question – that I received late last week. It was getting late and I was beginning to wonder if I would have a post ready for next week, when I received a text message from my friend.
“Hey buddy, what’s up with this Roth IRA thing? Is this something I should invest in?”
So first of all, thank you for giving me a topic to write about. It’s always been my aim to help answer frequently asked questions in this space.
Second, I think there is a lot of confusion on this topic which is not necessarily appreciated by the advisor community. This is a simple concept and a very useful investing tool but I fear it is not marketed enough. Many people who are not in finance have just not heard a lot about Roth IRAs. So let’s go through a quick pro/con list, but first, the basics.
What is a Roth IRA? Well, IRA stands for Individual Retirement Account, and this is a vehicle that most people can use to save money for retirement. These IRA’s come in two basic varieties – Traditional and Roth. You are allowed to put up to $5,500 ($6,500 if you’re over 50) total into either or both of these accounts per year. The major advantage of the IRA ,which is true for both types, is that your investments inside these accounts will grow without having to pay tax on capital gains, dividends, and interest.
So which should an investor choose? Should they set up a Roth or a traditional IRA? What’s the difference? First of all, most investors should look for some trusted advice. If you hire an accountant to do your taxes, that would be the first place to start. There are also plenty of online resources that can help steer you in the right direction. So let this serve as your disclaimer. Nothing is this article should be construed as financial advice! Please consult your financial advisor (or tax expert) before making any investment decisions. This article is not intended to treat, cure, or prevent any diseases. Did I cover all my bases? Good. Let’s go on.
The main thing to know is that the IRS will get its bite from the apple. An IRA will grow tax-deferred, but you need to pay the piper at some point. With a Roth you pay the tax upfront – meaning you do not get to deduct the contribution from your income tax. A traditional IRA, on the other hand, will enable you to deduct now, but that means that you will have to pay income tax on all the withdrawals out of the account. The only exception to this rule is if you die, and in that case, your heirs can pay the tax for you. To continue the Shakespeare theme:
“He that dies pays all debts” Stefano, Tempest, Act 3, Scene 2
So the bottom line is – Roth is taxed now, while traditional is taxed later. In most cases, I prefer to defer taxes as long as possible. We never know what changes will be made to the tax code in the future and once you pay the government, that money is gone. However, there are plenty of exceptions to this rule.
Now I know what you’re thinking…. “What if I already have a retirement plan at work? I’ve got some kind of 401k thing that HR keeps sending me paperwork for. I can’t still contribute to an IRA, right?”
See? I knew it. Well it turns out you can still contribute to an IRA if you have a retirement plan. The only catch is that your traditional IRA contributions may not be deductible depending on how much money you make. If you make $98,000 per year and you are “Married Filing Jointly” you will be limited on how much of your IRA contribution you can deduct which seriously limits the benefit of the vehicle. Also, if you make over $184,000 per year “Married Filing Jointly”, you will be limited on how much you can contribute to a Roth IRA in any instance. These totals differ if you file as “Single” or “Married Filing Separately”, so you have to check the tables available at IRS.gov.
Here are some cases where contributing to a Roth IRA makes sense.
If you are in a fairly low tax bracket you should be contributing to a Roth. If your taxes are low now, take advantage. You will pay the low rate now, and then never owe tax on that money again.
If you are covered by a retirement plan at work (401k, 403b, or Profit Sharing Plan) and you make more than the limit for your filing status where your contributions to a traditional IRA will no longer be deductible, but you make less than the limit where you cannot contribute to a Roth, than go for the Roth. Again, check some online resources.
Not To Roth…
If you are currently in the highest tax bracket and you are not currently covered by a retirement plan at work. Take the deduction and go for traditional.
If you make more than the limit to contribute to a Roth, you should contribute to a traditional IRA. Even if you lose deductibility on the contribution, it will still give you the deferral of taxes on interest and capital gains.
Do not let indecision stop you from saving. If you are contributing to a traditional IRA when you should be using a Roth, it’s not the worst thing that can happen. The most important thing is that you are saving. However, if you are being kind enough to your future self to save money for retirement, you might as well do it as efficiently as possible. That means doing a little homework and making the determination between Roth and traditional.
I currently contribute to a traditional IRA because I am in a high enough tax bracket to want the deduction, but not high enough for the deduction to get phased out. Sometime soon as my income goes up (way up, hopefully) I will switch to a Roth; and then,d when the income continues to climb over the Roth contribution limits, I will switch back again to the traditional. Make sense?
Until next time…
“Neither a borrower nor a lender be; for loan doth oft lose both itself and friend, and borrowing dulls the edge of husbandry.” Polonius, Hamlet, Act I, Scene ii; William Shakespeare
Photo Credit: Salman Javed via flickr.com (William Shakespeare (Stained Glass), Dome Gallery, State Library of Victoria)