Friday, February 14, 2014

The Roth IRA

During the course of one year Sally and Joe both save the same amount of money towards their retirement, investing identical amounts in identical funds. Sally puts her pre-tax money into a 401(k). Joe puts his after tax money in a Roth IRA. At the end of the year they both retire and withdraw all of the money from their accounts. They have exactly the same amount of money. Why and when should you use a Roth IRA comes down to your perception of your future Vs current tax liabilities. If you think your taxes will be higher today, during your peak earning years, the 401(k) gives you a lower taxable income today, when it will give you the most good. If you plan on becoming an evil rich person in your old age or if you believe that your income tax rates will increase over time then it is better to put your money in a Roth IRA, where the Government will allow you to use that money, tax free, forever.

Always! Always! Always! Take the free money first! If your employer offers any matching money with a 401(k), always take that money and run. You simply can not beat a 100% instantaneous tax preferred return on your investment.

Once you have the free money, think about the Roth IRA. Since you will be investing after tax dollars in the Roth, you won’t be getting any tax deduction today, but income and capital gains generated by this account will never be taxed. You will receive a tax deduction today for anything that you deposit into your 401(k), but when the time comes to withdraw that money in your old age, you will be taxed at whatever your current rate might be at that future time.

There is another advantage to the Roth IRA. You can withdraw your contribution at any time and for any reason without penalty. After a 5 year seasoning period or after age 59 ½ you can withdraw any income or capital gains from this account without penalty. Don’t do it. This money is for your retirement, not a down payment on a larger home. Also, the tax laws may have changed in the 2 hours between the time I write this and the time you read it. Always check any move that might have tax consequences with your accountant before pulling the trigger.

Never withdraw money from you 401(k) prior to retirement. It is just too costly and dangerous. A withdraw from a 401(k) is a loan that must be repaid. If it is not repaid the money will be taxed at your current rate and you will be hit with a 10% penalty. This is true even if you lose your job while repaying a loan from your 401(k). Too many young couples roll the dice on this one. It just isn’t worth the risk.

Contributions to the Roth IRA are limited. When the Roth came on the scene it was too little ($2,000 a year) and too late (age 50) to do me much good. My wife and I do have small Roth IRAs but they aren’t worth much of anything. Current limitations are $5,500 per spouse if age 49 or below and $6,500 if age 50 or above. This number is big enough to be of significant value to younger Americans. Starting with an $11,000 deposit, then continuing to deposit $900 a month throughout a 40 year working life will leave this young couple with an outrageous $2,180,000 tax free dollars when they retire, assuming a very realistic 6.5% return on their investments.

Current income limits are $112,000 for a single filer or $178,000 on a joint return. After that the limit on contributions drops.

The biggest argument against the Roth IRA is the difficulty in saving after tax dollars. If properly done, most families will never miss the pretax dollars that go into a 401(k). Taking real after tax money out of your hand and putting it away for some future day is a lot harder, particularly if you need it for the mortgage payment today. Of course you can automate a contribution to your Roth IRA, but remembering to debit your check register every month is only going to be a little less painful. This is one of those know thyself moments. If you are not the kind of person who is likely to save after tax dollars the Roth IRA is not for you.

You can convert a traditional IRA to a Roth IRA. Generally this is not a good idea, but it can be used to reduce your taxable estate. If you don’t think you will be needing that money in your traditional IRA during your lifetime, you can convert. You will pay income taxes on that money, but the size of your estate will be reduced by the amount you paid, thus avoiding any inheritance taxes on that money. Now your money can grow tax free forever. Your heirs can take money out of this account without paying any taxes. Essentially, you have prepaid your heirs’ taxes. You have given them what would normally be considered a taxable gift, without any tax consequences. Please, don’t try to play these games without the advice and counsel of your CPA, estate planner, or attorney. These rules are Byzantine in their complexity and they change constantly. Unless you are an expert, leave this one to the experts.

Whether you choose to put your money into a Roth IRA, a 401(k), or both make certain that you are paying the lowest possible fees on your money. Avoid retail mutual funds sold by a commission sales person or managed accounts that charge 1% or more per year. Since this is patient, long term money use low cost index funds such as those offered by Vanguard, Fidelity, or Schwab. You don’t need to be sending your financial advisor’s daughter to the private university of her choice with your retirement dollars. When I first discovered Roth IRAs, I invested my money with one of these so called financial advisors. I lost money in what this person described as a conservative value fund, an almost impossible feat given the market performance over the years I held those shares. However, I noted that the broker received her commission and gained even as I lost money. I later learned that this particular fund was one of the worst in America and it came loaded with 12B-1 fees. Anyone who attempts to sell you anything with 12B-1 fees is not your friend.

The rules of the game are constantly changing. What if Congress decides to tax Roth IRAs or convert your 401(k) to a Government mandated annuity to bolster the Social Security system? Just one more thought to make sure you vote in the next election.

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