So you've accomplished the first step in investing: deciding that you'd like to do it in the first place. Maybe you've even conquered the second step: determining how much you can and will contribute. If you've been following us, hopefully you've also learned a thing or two about investment accounts, and now it's time to take action. But how do you know which type of retirement account is right for you? Should you utilize a traditional account, which is probably what most people are more familiar with, or a Roth account? I hate to assume, but I'll take a leap that when deciding between the two, you might need a little more information about how Roth accounts work. That's what we're here to share today, and hopefully it gives you some help!
So ... What Should I Know About Roth Accounts?
Am I Even Eligible?
If you're reading this article, you probably have a decent level of interest in your financial well-being. And if you're familiar with Roth accounts, it's likely that you've heard someone tell you to use them while you still can. That advice became common because until recently, it was very possible that you would have no way to directly contribute to a Roth account once your income exceeded a certain threshold. In fact, Roth IRAs (Individual Retirement Accounts) still have these income limitations, phasing out single taxpayers' ability to contribute once they reach $118,000 in earnings, while the phase out for married couples filing jointly begins at $186,000 of income. Investors working in fields with defined income growth that would likely exceed these earnings (e.g. physicians, corporate attorneys) would use their training years to fund Roth IRAs until they were no longer eligible. Fortunately, the continuing evolution of workplace retirement accounts has provided another Roth option to employees. Roth 401(k)s and Roth 403(b)s are now an option to all workers whose companies offer them, regardless of income level. Entrepreneurs or workers whose jobs don't offer these plans will still need to utilize IRAs if they would like to use Roth accounts, but the elimination of the income requirement in workplace Roth plans has added a needed option for employees planning their future.
Much of the decision between choosing a Roth account or a traditional account depends on whether you think you'll owe more taxes on your income now or in the future. If you watched our video on how retirement accounts work, you'll recall that traditional retirement accounts allow you to avoid paying income taxes on the money you contribute when you contribute it. In exchange, you must pay income taxes on the amounts you withdraw in retirement. Roth accounts are the exact opposite: you pay taxes on your contributions now, and money you take out in retirement is excluded from your taxable income. If you're expecting consistent pay increases over the coming years, that is certainly a reason to consider getting your taxes out of the way now and contributing to a Roth account. I'm no gambling man, but if I were I'd wager that future income is the largest consideration for people deciding for or against a Roth: will I or will I not make more in the future and be subject to more income taxes? There SHOULD be a second consideration: even if your income doesn't increase, what if the tax code changes in the future? While popular opinion might suggest otherwise, we are actually subjected to some of the lowest income tax rates in modern history. Investors who plan to be around for the next 30-40 years would be ill-advised to plan as if taxes will not or cannot increase. The possibility certainly exists that those changes could benefit you, and that is why the choice between traditional and Roth accounts has no definitive answer. The best that one can do is use the information you have (projected income growth, current tax laws, etc.) to make a decision and move forward.
Required Minimum Distributions
We often come across investors who have accumulated assets in their traditional retirement accounts, and many expect these funds to be passed to their next generation. While it is possible that your heirs could live well off of your retirement funds, traditional accounts do have requirements that can limit their effectiveness as a tool for generational wealth. It is true that traditional accounts allow you to avoid paying income taxes on your contributions. It is ALSO true that the government is going to make sure that money is taxed at some point! To ensure that they get their money, they created Required Minimum Distributions, or RMDs for short. At age 70 1/2, whether you need the money or not, the IRS will start making you take withdrawals from traditional accounts each year using a formula that can be found on www.irs.gov. Each year the percentage of the required distribution increases, and if you live a long time in retirement it's possible that the amount you must withdraw becomes harder and harder to replace with your investments. Even if you die early in retirement and pass your accounts to your beneficiaries, they will still have to take required distributions based upon the age you would have been if you were still alive. There are ways to utilize traditional accounts while still providing a guaranteed* death benefit for your heirs, such as purchasing an annuity with a death benefit rider (a much more complicated topic for another day). But Roth retirement investing offers a simple solution that gives you more control on the back end in terms of how taxes will affect the transfer of your assets.
Unfortunately, more and more people are depending on Social Security as their primary source of income in retirement. In 2014, a study published by AARP found that Social Security represents 90% of income for 23% of recipients age 65 or older. While we certainly hope that the tips we share can help you avoid that situation, it's clear that maximizing your Social Security is a big deal. When you're using traditional retirement accounts for income, however, you risk having your Social Security benefits subjected to income taxes. For people taking Social Security, the IRS looks at your provisional income (adjusted gross income + tax free interest + 50% of your Social Security benefit) to determine if your benefits are taxable. Single taxpayers earning $25,000-$34,000 and married couples filing jointly earning $32,000-$44,000 can expect 50% of their benefit to be taxable, while those earning above these thresholds will see 85% of their benefits taxed! Traditional retirement account withdrawals are added onto your adjusted gross income, meaning they push your provisional income higher as well. Roth account withdrawals are not considered provisional income, allowing you to withdraw as much as needed without worrying these amounts will negatively impact your Social Security benefits. It is tempting to take the tax deduction that can come with traditional accounts now, but investors who want to maximize their retirement income should consider the consequences of kicking the can down the road.
Withdrawals Before 59 1/2
Whether you have a traditional or a Roth account, full retirement age is 59 1/2. There are certain allowances for penalty-free distributions before 59 1/2, such as the purchase of your first home, but age 59 1/2 is the age where withdrawals for any reason are free from penalty. With a Roth IRA, there is an added benefit that allows investors to withdraw funds if needed without penalty. Investors who have had their Roth IRA a minimum of 5 years can withdraw their contributions - not the growth - from their accounts without penalty. And because these funds were already taxed before they were invested, no income-tax is due on the early distribution. Roth 401(k)s and 403(b)s do not offer this benefit, but if the plan allows for loans then Roth plans would be eligible in the same manner as traditional accounts. I definitely don't recommend dipping into a Roth account just because you can, but if there is a need, having access to your contributions is a feature worth considering.
Is a Traditional Account Ever The Right Option?
Absolutely! As I said, this post is more to show the reasons why a person might consider a Roth account. Naturally I'm highlighting some things that a traditional account doesn't offer, but there are plenty of reasons one might still feel that these accounts are right for them. I know entrepreneurs that keep both a traditional and Roth account, and often do not or cannot decide on which to use until the end of the year when they found out if they are eligible to contribute to a Roth and whether or not they need the tax deduction that comes with traditional retirement contributions. You may also find yourself in a situation where you would like to invest for retirement but money is tight. Because traditional contributions are excluded from income taxes, your taxable burden is lowered and you could keep more money in your pocket while you save. Whatever your reason, the fact that you are saving in the first place is a great place to start. But I hope that some of the things we covered today helped you understand why Roth accounts can be an excellent fit for your portfolio!
*All Guarantees are based on the financial strength and claims-paying ability of the issuing insurance company.
The information presented is not intended as tax, legal or financial advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek such advice from your professional advisors. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any product or security.