What is a Roth and is it important?

November 21, 2019

What is a Roth account?

Roth is a category of retirement accounts in the U.S. Roth IRAs(Individual Retirement Accounts) were introduced in 1997 by Senator William Roth of Delaware in order to get around Senate budget rules when he was trying to reintroduce the Traditional IRA.

The idea was to give a tax deduction to lower income individuals, and give higher income individuals a tax break when they withdraw the money at retirement. The rules have changed since then, but the gist of a Roth Account is that your take home money (also called after tax money) is contributed to the account with no immediate benefit like a tax deduction. However, at retirement the money and its growth can be withdrawn tax free

Advantages of Roth Accounts

  • Market Gains/Earnings on the money invested in the account is withdrawn tax-free, as long as the account is older than 5 years and the owner of the account is over 59.5 years old.
  • The owner of a Roth IRA can contribute even if the owner participates in a Qualified Retirement Plan (QRP) such as a 401k
  • If the owner predeceases their spouse, their spouse can combine the owners Roth IRA account with their own Roth IRA account and continue to make contributions.
  • Roth IRAs do not have Required Minimum Distributions (RMD) for the owner or their spouse.
    • Required Minimum Distributions are based on the account owners age and a formula that calculated the percentage of the account that must be withdrawn each year.
  • QRPs such as Roth 401k can be rolled into a Roth IRA without penalty after leaving your employer or retiring.
  • Inherited Roth IRAs have tax-free withdrawals.

Disadvantages of Roth Accounts

  • You cannot withdraw gains penalty free before age 59.5. (Which is the same for all retirement accounts)
  • Eligibility to contribute to a Roth IRA reduces starting at $122,000 and completely goes away at $137,000 for single tax filers; or $193,000 and completely goes away at $203,000 for married filing jointly. (There is a way to still contribute to a Roth IRA with income above the threshold, we will mention later).
  • There is no tax deduction for Roth contributions (see the first advantage above).

The Difference between Roth IRA and Roth Qualified Retirement Plans (QRP) Such As A 401k

  • You do not lose eligibility to contribute to a QRP if your income exceeds a certain threshold like you do with a Roth IRA.
  • Matching employer contributions are made to the Traditional account of the QRP, while the employee contributions are made to the Roth side of the account.
  • Roth Accounts for QRPs have the same contribution limits as the Traditional QRP which is $19,500 per individual starting in 2020.

How to contribute to a Roth IRA when you exceed the income limits (Backdoor Roth)

As mentioned above, Roth IRA have income limits that will reduce or eventually completely eliminate your ability to contribute directly. There is a way to continue to contribute above the income limits though. The process is called the “Backdoor Roth IRA”. The process requires you to contribute to a Traditional IRA post tax, then convert the Traditional IRA to a Roth IRA. This is still subject to the IRA contribution limit of $6000 per year, per qualified person. This process was included as footnotes to the Tax Cuts and Jobs Act of 2017 footnotes 268 and 269.

Should you be using a Roth Account?

Lets look at a few examples of retirement savings practices to see When and if you should be using a Roth account.

A Young 22 year old, retiring at 69 years old

This person has 47 years ahead of them to save, so does it benefit them to take the tax deduction now, or Tax-Free savings at retirement?

Assumptions:

  • Saving 6,000/year into a Roth Account
  • Receiving market returns of 12% average
  • Income was $100,000/year, Single (24% tax bracket)
  • 8% withdraw rate (Leaves the account to grow 4%)

So they contribute $282,000 over that 47 years, and their account grew to a total of $11,463,540.

Investing in a tax deferred account (Traditional IRA) they would have saved $1440/year in taxes each year. Which means they would have saved $67,680 total in tax deductions using a tax-deferred account. Yet their account grew to $11,463,540, of that 98% or $11,181,540 are gains.

At their 8% withdraw rate their income in retirement would be $917,083 initial, slightly increasing a year while the account continues to grow.

Their tax bracket would be at the highest of 37%, their taxes a year would be $299,184/year as of the 2019 tax rules.

In contrast with a Roth IRA, they would have paid an extra $67,680 in taxes (The amount of tax deduction), but never have to pay taxes on the gains, saving them a whopping $231,504 on taxes in the first year alone. This is a benefit that grows drastically the longer they live in retirement.

In this scenario, clearly the Roth account wins hands down.

A 45 year old, retiring at 69 years old

This person has 24 years ahead of them to save, does a Roth benefit them?

Assumptions:

  • Saving 19,000/year into a 401k Account.
  • Receiving market returns of 12% average
  • Income was $150,000/year, Married filing jointly (22% tax bracket)
  • 8% withdraw rate (Leaves the account to grow 4%)

So they contribute $456,000 in over that 24 years, and their account grew to a total of $2,514,343.

Investing in a tax deferred account (Traditional 401k) they would have saved $4180/year in taxes each year. Which means they would have saved $100,320 total in tax deductions using a tax-deferred account. The gains in their Roth would account for 82% of the value ($2,058,343).

At their 8% withdraw rate their income in retirement would be $201,147 initial.

Their tax bracket would be at the highest of 24%, their taxes a year would be $30,144/year as of the 2019 tax rules.

After paying $30,144 in taxes a year, it would only take 4 years in retirement for the Roth to become a clear benefit.

A 63 year old, retiring at 69 years old

This person has 6 years ahead of them to save, does a Roth benefit them?

Assumptions:

  • Saving 25,000/year into a 401k Account
  • Receiving market returns of 12% average
  • Income was $150,000/year, Married filing jointly (22% tax bracket)
  • 8% withdraw rate (Leaves the account to grow 4%)

So they contribute $150,000 over that 6 years, and their account grew to a total of $227,225.

Investing in a tax deferred account (Traditional 401k) they would have saved $5,500/year in taxes each year. Which means they would have saved $33,000 total in tax deductions using a tax-deferred account. The gains in their Roth would account for 34% of the value ($77,225).

At their 8% withdraw rate their income in retirement would be $18,178 initial.

After the standard tax deduction they actually would not owe taxes on this income. So a Traditional account would be beneficial in the situation. This is the typical type of relationship of Tax bracket when you are working versus tax bracket when retired that is usually discussed.

Conclusion

If you expect your tax bracket while working to be higher than your tax bracket in retirement, then a traditional retirement account is beneficial. If you are starting your retirement investments with more than 5 years until retirement, then Roth retirement accounts are super beneficial, because your retirement income will place you in the same tax bracket or higher in retirement. The more years you have before retirement, the bigger the advantage of using Roth accounts. Almost everyone should be contributing to Roth IRA, and if available Employer Qualified Retirement Plan Roth Accounts.

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