Roth IRAs: 3 Things You Need to Know

by Jonathan G. Cameron, CFP®

One of the most popular ways to save for retirement is in a Roth Individual Retirement Account. Roth IRA’s were first made available in 1997, after they were championed by former Senator William V. Roth of Delaware.

1. What is it? Tax-wise, a Roth IRA is like a Traditional IRA in reverse. It may help to compare the two registrations.

In a Traditional IRA, as well as in a 401k, most people get tax deductions for contributing dollars up to certain limits every year. The account accumulates funds over time, perhaps generating some nice earnings, tax-deferred. When it’s time to retire, the full amount of the distribution is taxable at whatever your marginable tax bracket is at that time. Using simple math, if your tax bracket at retirement is 25% and you distribute $100 from your Traditional IRA you will get to keep $75. Remember, distributions from a Traditional IRA are fully taxable. Contributions are made before tax.

By contrast in a Roth IRA, or Roth 401k, you get no tax deductions up front when contributing. The Roth IRA is a tax-deferred retirement registration within which you can do various investments, just like the traditional IRA. You can invest in stocks, bonds, mutual funds, exchange-traded funds (ETFs), and more. But when you retire and need income from a Roth, all your distributions – earnings plus contributions – come out tax-free. That is, assuming the same 25% tax bracket, and you distribute $100 from your Roth IRA, you’ll receive the same $100 without a haircut from Uncle Sam. Not bad, eh? Contributions are made after tax.

You may contribute up to $5,500 into a Roth per year in 2015. If you are 50+ years old, add $1000 to that for “catch-up” contributions. These contributions are after-tax, so you’ll get no tax deduction going in. The key to remember is that Roth distributions are tax-free. There is a 5-year holding period rule, among other factors, so a Roth isn’t always appropriate for investors with a short time horizon. The catch or the tradeoff: a little pain today for much pleasure later on.

2. Who should have one? Raise your hand if you think taxes will be higher in the future than they are now! That’s a safe bet. This is the beauty of a Roth. Generally speaking, a Roth IRA is best suited for those with a long time horizon. While a Roth IRA does allow for tax and penalty-free withdrawals of documented contributions pre-59 ½, the Roth is designed to be a long-term, retirement play. The younger you are the better. And it’s certainly good for those who like to pay less in taxes over the long run!

To contribute to one, you first have to pass the IRS Modified Adjusted Gross Income test. First, you need to have at least some earned income to participate. Second, you have to make less than $116,000 MAGI if single and $183,000 MAGI if married to make a full Roth contribution in 2015. High-income earners cannot contribute to a Roth. Note: If married filing separately, and you lived with your spouse at any time during the year, you are ineligible to contribute to a Roth if your MAGI is above $10,000. So, forget about it. If, however, you are married filing separately and did not live with your spouse at any time during the year, your phase-out begins the same as a single filer at $116,000 MAGI.

3. Why should I have one? Bottom line – it’s a huge potential tax savings. I refer back to something I mentioned in point one – you will, in theory, pay Uncle Sam significantly less to retire than if you saved exclusively in a Traditional IRA. I say “in theory” because if you keep Roth contributions in a money market or short-term CDs, you will have very little earnings in the end. If you intend to be ultra-conservative in your long-term investment approach, you might as well take advantage of contribution tax deductions in the short term within a Traditional IRA.

Here’s a scenario using simple math comparing what you can pocket in a Traditional IRA and a Roth IRA:

Assumptions:

• $400 monthly contributions

• 7% = average annual return, compounded monthly

• 30 years = Retirement time horizon, and years contributed

• 25% = Marginal tax rate at retirement

After 30 years, an account would grow to $487,988.39. This would be the same in the Traditional and Roth IRAs, all things being equal. However, at a 25% marginal tax rate, you only keep 401,991.29 in a Traditional IRA. You get to keep all of it in a Roth IRA, regardless of your tax bracket. You just saved yourself nearly $86,000! It’s never exactly 25% in real life, but it’s close enough in this case.

The calculation you need to make is whether the small tax deductions now on contributions are more valuable than a little deferred gratification to get tax-free distributions on earnings at retirement. So when saving for the future, and if you meet the IRS eligibility phase-outs, do yourself a favor and choose the IRA registration that best meets your needs. Simple decisions early on, like contributing to a Roth IRA, can potentially save you hundreds of thousands of dollars in the long run.

Jonathan G. Cameron, CFP®

For further guidance, visit www.cameron-downing.com and feel free to contact us if you have questions.

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