When I was in law school, I borrowed extra money from my student loans to fund two years of Roth IRA contributions. By my reasoning, the Roth IRA accounts were “use it or lose it” space and it would be silly not to take on additional debt at 6.8% in order to take advantage of $11,000 of tax-free growth forever. It’s probably the only time in my life were I invested on margin, but the benefits of Roth IRA are too big to pass up. They’re wonderful investment vehicles and you should be taking advantage of them too.
THE BASICS OF ROTH IRAS
Anyone who has earned income can contribute up to $5,500 to a Roth IRA. Additionally, you can contribute another $5,500 in a spousal Roth IRA regardless of whether the spouse is working. This is a great way to save money in a retirement account for a non-working spouse. If you’re 50 or older you can contribute $6,500.
There is a contribution limit to Roth IRAs which kicks in at $117,000 for single filers and $184,000 for married filers. It’s easy to bypass this restriction by making it through the “backdoor”, which involves converting a non-deductible Traditional IRA into a Roth IRA. The steps are simple and the end result is the same as if you had made a “front door” Roth IRA contribution. Pretty soon I’ll have a post up on the site showing step-by-step how to make a Roth IRA contribution.
Your contribution to the Roth IRA is with post-tax money but it’s never taxed again. The account won’t be taxed while the investment is growing (i.e. dividends or capital gains) and won’t be taxed when you withdraw the money. Technically you can’t access the money until you reach the age of 59 1/2 but there are many different ways to get access to Roth IRA money before you turn 59 1/2. Unlike 401(k)s or a Traditional IRA, there are no required minimum distributions for a Roth IRA when you reach age 70.
WHAT ARE THE TAX ADVANTAGES?
Obviously, you’re going to save a ton of money on taxes since the investment vehicle is never taxed again after the initial income tax. However, because the initial tax rate you pay is your marginal tax rate, it means that you should prefer Roth IRAs when your income is low and pre tax-deferred accounts (like 401(k)s, Traditional IRAs and the Stealth IRA) when your income is high. In other words, when I invested in a Roth IRA as a 2L, I used post-tax money that was taxed at a low rate of maybe 15%. That’s a much better deal than the post-tax money I use to fund a Roth IRA now which is taxed at a rate of 40%+.
Traditional IRAs can be converted into Roth IRAs at any time and in any amount. Because Traditional IRAs are funded by pre-tax money, you will need to pay income taxes on money converted from a Traditional IRA to a Roth IRA. This can be advantageous in times of low income (e.g. taking a year off work) since you could convert up to $37,650 as a single filer and only pay 15% income tax. This is because converted money is treated as taxable income. Still, it’s another great benefit of Roth IRAs.
Another tax advantage of Roth IRAs is the lack of required minimum distributions. Since you are never required to take money out of your Roth IRA, it’s a good idea to have access to both pre-tax and post-tax retirement money when making tax planning decisions in retirement. For example, you may want to withdraw $50,000 in retirement from your 401(k) and pay the resulting income taxes but then supplement your income with tax-free money from your Roth IRA. By using both accounts you can keep your effective tax rate low rather than paying increasingly higher tax rates had you withdrawn the money entirely from a pre-tax source.
When saving money in retirement accounts, there’s a lot of forum posts debating whether or not tax rates will rise in the future. Another benefit of the Roth IRA is that it eliminates tax rate risk. It won’t matter to you whether or not tax rates rise or fall in the future, since the money will be tax-free. Of course there is a risk that a future government could tax Roth IRA withdrawals, but that seems unlikely.
WHAT ARE THE INVESTING BENEFITS?
Since Roth IRA investments grow tax-free, they are perfect vehicles for tax-inefficient investments like REITs, taxable bonds, bond funds, peer-to-peer lending or TIPS. The “income” generated by these investments are often taxed at your ordinary income rate, the situation you are most trying to avoid. By allocating these tax-inefficient investments to your Roth IRA, you can receive that income in a tax-sheltered account and never pay your ordinary income tax rate on those gains.
Unlike a 401(k), Roth IRAs can be invested in virtually any investment you’re interested in. You own the account and control the investment vehicle. I’d recommend opening an account with Vanguard, especially since they make it easy to make a Backdoor Roth IRA contribution, but you have total flexibility on where to make the investment. Another advantage of a Roth IRA is that you can buy or sell your investments at any time without incurring any taxes. This makes it easy to start out by opening a Vanguard Roth IRA but leaving open the option later to change the investment.
ASSET PROTECTION AND ESTATE PLANNING
In many states, Roth IRAs are exempt from determining your assets should there be a liability judgment against you. In New York, for example, the Roth IRA is exempt from creditors with few limited exemptions. As professionals engaged in practice, it’s smart to make sure you have assets that are protected from judgments. Many times increasing the protection of your assets can result in tax inefficiencies, so Roth IRAs are a simple and clean way to build assets that are protected from creditors.
Roth IRAs also can be great for estate planning. If you inherit a Roth IRA, you are required to take a minimum distribution. Those distributions are calculated by using the IRS life expectancy tables. If you inherited a Roth IRA at 30-years-old you are expected to live another 53.3 years (See IRS Publication 590, Appendix B). To determine your distribution you divide the amount of the Roth IRA by your life expectancy. Next year, you repeat the same process to figure out your required minimum distribution in that year. For a Roth IRA worth $500,000, you’d only be required to withdraw $9,380 ($500,000 / 53.3). At only 1.8% of the portfolio, you might be able to withdraw this amount for quite a long time before you actually put a dent in the principal.
As I’m sure you, this could be a really powerful wealth building machine. Since the owner of the Roth IRA isn’t required to take a minimum distribution, it’s not inconceivable that a large amount could be left to a grandchild. If that grandchild lived to be 80-years-old, the Roth IRA could have been growing for 130 years tax free. Keep in mind that all of the withdrawals taken by the grandchild would be tax-free as well. Grandpa paid the taxes back in the 21st century!
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Let’s talk about it. Do you have a Roth IRA? Have you been maxing it out in connection with your pre-tax retirement accounts?