Our normal Friday Blog Post of the Week! segment will return next week.
The Roth IRA is a Swiss Army knife for financial success.
In our past wildly exciting posts about the Roth IRA here and here, some of the commenters on these stories have discussed the efficacy of the strategies presented by the Other Guy.
In short: is it worth all the trouble jumping through hoops to get as much money into the Roth IRA as possible?
In a word: indubitably (I’ve wanted to use that word since I heard it in Mary Poppins. 10 points!)
While I’ll agree that if the only upside to these strategies are immediate returns on a few exotic Roth IRA gyrations, you’ll only gain a few extra dollars in your pocket for what seems like a lot of work.
…and I get exhausted switching television channels, so let’s not talk about work.
I prefer easy and exciting.
The Roth IRA has one exciting feature beyond those we’ve listed previously—flexibility later in your planning.
The problem with financial planning
When I read well-meaning blog posts about retirement or education planning (including my own), the writer always discusses assumptions.
You know what happens when you assume…but what choice do we have?
We’ll have to assume that the tax rate will go up/down/stay level.
We have to project inflation rates.
Finally, we have to decide when we’re going to die. (Well, at least you do…I’ve got my cryogenic tank next to Walt Disney ready to go. I’m gonna live forever.)
Back on point: Roth IRA plans, for those of you uncomfortable with this type of tax shelter, give you no tax break today but offers tax free income down the line. Many (yawn) dissenters say that tax treatment of a Roth IRA is irrelevant. You’ll pay the tax today or tomorrow. It’s all the same.
No it isn’t.
We’re working for maximum tax flexibility, not a few random bucks. Because I can’t predict income tax rates, capital gains rates, or estate tax rates, I’m going to create a financial future that is as flexible as possible, as soon as two current criteria are met:
– I’ve done what I can to maximize deductions today. I know what tax rates are right now, so I’ll take my tax break, thank you.
– I’m not locking up money unnecessarily for down the road when I’m experiencing short term needs for cash.
Here’s the Roth IRA Game
When you reach retirement, let’s pretend you want to live on $60,000. Tax brackets in America are tiered, meaning that you’ll pay 10 percent on the first dollars you make, until you hit the 15 percent bracket, which is what you’ll pay beginning with the first dollar in that bracket, until you reach the 25 percent bracket…..
Because we don’t know what tax brackets will be in the future, let’s pretend the 25 percent line will be at $50,000.
You Have Two Pots of Money
Most people have a pre-tax retirement plan. As I mentioned, I like my current pretax deductions, so I’ve maximum funded those. Therefore, I have monster amounts of money (otherwise known as oodles) inside of them. These dollars must come out of the plan and get taxed.
I’ll remove $50,000 per year from this plan. Some of it will be taxed at the 15 percent bracket and some at the 10 percent bracket.
Here’s Where the Roth IRA Comes In
Finally, I remove $10,000 from my Roth IRA. Now I’m living in the 25 percent tax bracket but the government is taxing us at the top of the 15 percent bracket.
Lots of Work for Big Payoffs
Now, I’ve avoided a 25 percent tax each year (or whatever my top tax rate would be….) on $10,000, or $2,500 in taxes. Of course, I paid those taxes already, but remember, if I’m worried about the HUGE AMOUNT OF WORK this takes, I’m only investing money after I’ve already secured current tax breaks.
(photo credit: Swiss Army Knife: IK’s World Trip, Flickr; License Plate: Gamma Man, Flickr)
Of course, it is hard to make blanket statements in the financial planning world. I would argue it is NOT indubitably better. Take this example. Someone who is in the 28% marginal tax bracket, but save well over 50% of gross. So, if they retired today, they would be in the 15% marginal tax bracket.
Furthermore, their portfolio could consist of Roth 401k and Roth IRA contributions to the limits for the last 5 years. And their goals may be to retire early, so now they stress the importance of taxable accounts and diversifying into trad 401k while in this uber high tax bracket. Mistake not contributing to a roth or doing roth conversions? I don’t think so, but only time will tell.
Again, we stand by our statement that Roth investment vehicles are VERY powerful, but they are NOT a “slam dunk” for everyone to shove every dollar into them as they can. People should really understand how they work and how their underlying assumptions and goals impact their future after tax proceeds. At the end of the day, people go around and around in these discussions, with the one thing they can agree on being to diversify across all account types.
Replying to the previous comment, it is hard to predict what your tax rate will be during retirement. In such a case, why not invest in both ROTH and a Traditional IRA? They are not mutually exclusive. The restriction is the limit.
Other than the tax rate, ROTH has other advantages like inheritance, no minimum distribution after certain age etc.
We agree account diversification is a good thing, and even suggested it in our comment above (although it may have been implicitly hidden). But, we also encourage people to not get caught up in the hype of roth accounts that most pf blogs feature without understanding how they work and how their assumptions impact their choices.
And yes, it is difficult to predict the future. Our tea leaves give us guidance, and each person should look towards their own talisman for what they think. But, you should understand how those readings guide your decisions today! If you’re curious to know what you would have paid federal income tax wise in the past, you can look at spreadsheet we have in this post and it goes back to the early 20th century. http://wp.me/p2h40p-R
we are firmly cemented right in the middle of our tax bracket.. but if they ever shift the brackets or we experience a dramatic increase (or decrease) in our income.. we will certainly look into using a Roth to get us “under” the hump
Just remember that this has nothing to do with tax brackets now….it’s tax brackets when you’re taking money OUT of retirement plans. The Roth is worthless for tax relief now (except, I suppose, a little tax break on dividends/capital gains on investments inside of the Roth).