Most investors are very well acquainted with traditional Individual Retirement Accounts or IRA’s. They have been around since 1974, when Congress passed the Employee Retirement Income Security Act (ERISA) to allow for tax deductible contributions to an IRA. Since that time, the Investment Company Institute estimates that over $7 trillion has been invested in IRA’s as of their 2014 survey. Next, in 1978, Congress changed a section of the Internal Revenue Code to provide taxpayers a tax break on deferred income and the 401k was invented. Again, investors saw another great way to save for retirement and deposited almost $5 trillion in them, per ICI’s 2014 study. Forty plus years has now established these plans as a major portion of retirement savings for many Americans.
Why Are Roth Accounts Less Popular?
Surprisingly though, the growth of non-traditional IRA and 401k accounts, also known as Roth accounts, is significantly slower. Yes, Roth accounts were established by the Taxpayers Relief Act of 1997, 23 years after the IRA, but have now been around for nineteen years. Yet, assets held in Roth accounts are estimated to be only near $1 trillion, per the ICI. Why are Roth accounts so glaringly less popular?
The easy answer is the salary deferral aspect of a traditional IRA or 401k. No one likes to pay more taxes on April 15 and setting aside a portion of your salary to grow tax deferred until you decide to take distribution is a very enticing and a smart thing to do. In addition, for 401k plans, many employers agree to match the percentage of deductions made by the employee, in effect giving the employee a pay raise.
Another reason, though, could be that many people do not understand the great tax advantages of a Roth. For a traditional IRA or 401k, distributions are taxed at the time of the distribution. Most people assume that they will be in a lower tax bracket after retirement and will reap the benefit of avoiding taxes in the high earnings years of their youth. In general, not a bad assumption and a good tax avoidance strategy.
However, a closer look must be given to the tax aspects of the actual investments held in these retirement accounts. For a Roth account, distributions can be taken out of the account totally income tax free. So to compare the results of a tradition vs a Roth, let’s use an example. Let’s say you defer $500,000 from your salary over the 40 years until you retire. Your portfolio has conservatively doubled in the same time period. If your tax bracket at retirement was 20%, you would end up paying $200,000 in taxes once the account ran dry. However, if you paid the taxes as you went along, say at a higher 30% rate, and invested in a Roth IRA, you would have paid only $150,000 in taxes. The key here is how much the Roth account is able to grow over time.
Because very important assumptions about the future must be made to choose which to invest in, a smart choice may be to do both. Splitting your IRA or 401k into two buckets, taxed and untaxed allows for a lot of flexibility. While your portfolio is growing, you can allocate more aggressive, high growth investments, such as equities, to the Roth portion. These can grow with the anticipated faster gains and be distributed without paying any taxes on the growth. More conservative assets that are designed to balance out your portfolio, and which appreciate at slower rates, can be held in the taxable portion.
Roth accounts allow for management of tax burdens. For example, during retirement, if you are hitting up against the next tax bracket upon normal IRA or 401k distributions, your income can be balanced between already taxed and untaxed by utilizing your Roth designated portion. You can manage your distributions for Social Security payments, pensions, and rental income. Also, if you need an extra distribution for the purchase of a car or some other spending need, you can take it from the Roth bucket and not have to worry about paying extra income taxes.
One very important aspect of a Roth account is that in order to utilize the tax benefits, the account must be held for five years. So start the clock ticking right now and open up a Roth. Even if you are only able to put a small amount of already taxed dollars into the account, at least the five year time requirement will begin.
Please feel free to call Punta Gorda Financial Planning if you have any questions about Roth accounts. We can help you analyze the pros and cons as they relate to your specific circumstances.
Written by Thomas M. Geier, CPA, CFP®, PFS.
My aim is to offer clarity to your finances. I specialize in helping individuals and families determine what is most important in their financial lives, identify short and long-term goals, and make great choices for achieving comfort, security, and peace of mind.
I graduated from Loyola University in Baltimore, Maryland, and have been a Vice President of our investment management affiliate, Geier Asset Management, Inc, since its founding in 1999. I have over 25 years' experience in financial planning and investment management and am licensed as a Certified Financial Planner® professional, a CPA, and Personal Financial Specialist. I am member of the Personal Financial Planning section of the American Institute of CPS's and Florida Chapter of the Financial Planning Association.