Do you know a retirement account is?
Do you have a retirement account of any kind?
Jeff Rose from Good Financial Cents was curious about those very questions.
In fact, he asked those very questions to 50 college seniors at his alma matter.
Know what the result was?
None of the 50 attendees knew what a Roth IRA was.
That’s why he created and organized The Roth IRA Movement.
But that wasn’t really surprising to me.
Even with all of the advances in information technology younger generations have at their disposal, a large number of them use it for such things as gaming.
Or worrying about what others are doing on social media sites.
Or trying to create stupid trends with viral videos.
Other generally unproductive tasks when they could be using these powerful tools to expand their knowledge and improve their lives (at least in my opinion) as well.
Personally, I have a Roth IRA as a part of my financial planning process.
To be honest, I can’t imagine why anyone would choose to use a traditional IRA if this more beneficial option is available to them.
I won’t bore you with the details of the Roth IRA rules.
You can read them for yourself in the publication published by the IRS.
Instead, I want to explain what makes the Roth IRA my preferred option for individual retirement savings.
Roth IRA May Provide Tax Savings In Retirement
Early in your career, you are most likely starting out on the ground floor.
Your income won’t be anywhere near where it should be as you approach retirement age.
You may be asking yourself:
If my income is going to be low, why would I choose to invest my after-tax money?You
The answer is quite simple if you think about it.
When you have a low income, your nominal tax rate is low.
Rather than investing your money in a tax-deferred retirement account (where you pay taxes upon withdrawal), if you opt to invest in a Roth IRA from the beginning, you will be paying taxes on just the contributions.
Everything that you withdraw will be tax-exempt (assuming you make qualified withdrawals when the time comes).
That means everything you invest gets to grow tax-free:
- Dividends you may earn
- The increases in the stocks/bonds/ETFs
- The capital gains paid and
- Any interest payments made to your account
Which would you rather do:
- Pay taxes of 10%-15% on the $5,000 maximum contribution each year for the first few years, with incremental increases in the tax rate or
- End up paying let’s say 35% on the potential exponential growth of those investments at the time of withdrawal?
I would choose to pay taxes while I was in a low bracket any day of the week and twice on Sunday!
Plenty Of Other Deductions Early In Life
Your younger years are the times when you should have an abundance of tax deductions available to you that can reduce your tax liability.
You have student loan interest deductions and possibly even education credits depending on your situation when you are younger.
Your first, and probably second and third, house purchases typically occur when you are just starting out in your adult life.
With that comes a mortgage as well as real estate taxes which combined give tremendous tax savings (note: the tax savings alone is never a good reason to buy vs. rent a home).
People generally have children well before retirement age, which gives you additional child tax credits.
All of these can help make up for any lost tax savings by choosing to pay the tax and investing in a Roth IRA.
In later stages of life those deductions and credits start to disappear, so having tax-exempt income is even more attractive.
It’s also more common that in retirement many people will be mortgage-free which would eliminate a significant deduction.
Roth IRA Provides Financial Flexibility
Tax law changes occur all of the time.
There may be low tax rates associated with certain investments at one point, or the government may decide to eliminate preferential rates on dividends.
As time goes on, your risk tolerance may change, and your investment time frame will definitely change leading to a shift in investing style.
The great thing about a Roth IRA is that you always have a way to shield yourself from high investment taxes.
When you are starting out, you can be aggressive, putting your Roth IRA money into high-growth rate choices, and not worry about having to pay high capital gains taxes when you sell.
At the same time, you can use a taxable investment account to invest in whatever has preferential tax treatment at a certain time.
When circumstances change, you can shift course and start buying investments like high-yielding dividend stocks should their preferential tax treatment end within the Roth-IRA, and get those dividends, plus any growth from the natural market cycle or reinvestment of those dividends tax-free.
As you start nearing retirement age, you can invest in tax-advantaged municipal bonds or mutual funds within a taxable account while using the Roth IRA to buy income-producing investments that would otherwise be taxable outside of that account.
Roth IRA Has An Unlimited Timeline
Unlike the Traditional IRA, you do not have to take required minimum distributions from a Roth IRA while the account holder is living.
That is especially important if you continue to work past the time when you turn 70 1/2 which is the year you must begin taking required minimum distributions.
You don’t need to continue to work for this to be beneficial either.
If your Roth IRA will grow at a faster rate than any of your other investments, you may choose to use those vehicles to cover your cost of living in order to maximize the Roth’s earning power.
Everyone will have their own views on whether a Roth IRA works for them or not.
Some people are traditionalists who want to get the tax savings immediately and don’t care about what happens later on.
Others will be more than happy to pay the taxes upfront and take the time advantage for their investments to grow tax-free.
It’s up to each person to decide for themselves.
I just hope I was able to open your eyes to the possible advantages a Roth IRA can offer you and maybe even taught you something you didn’t even know about Roth IRAs.
Tax Deduction Update
Unfortunately in 2017, the tax laws were drastically changed.
Tax brackets were changed.
Personal exemptions were eliminated.
Instead, the standard deduction was doubled for everyone.
At the same time, SALT taxes–State And Local Taxes which include your state income and all real estate taxes–were limited to $10,000.
This all makes it much more difficult to itemize, which further reduces the tax benefits of owning a home.
It may have changed the way you look at the decision of Traditional vs. Roth IRA.
Are you in the same situation as those college seniors at their age? Are you any wiser about retirement options now? What’s your preferred retirement vehicle–is a Roth IRA part of your plan?