Created by Congress twenty years ago, the Roth IRA is starting to show up in seasoned retirement plans in a big way. I remember when the Roth IRA first came out, I thought of it as a tool best suited for younger people in lower tax brackets. Now with real data available, I have come to realize that most people should consider a Roth IRA as an augmentation to their primary retirement plans, regardless of age or tax bracket.
You pay taxes on what you contribute to a Roth IRA, so there is no tax deduction in the current year for what you put away. However, the investment return in a Roth IRA grows tax free and will never be taxed as long as you use it after age 59½ or for other qualified purposes. I know, giving up a tax deduction in the current year is almost un-American, but the future benefits of tax-free return can be staggering.
Take this real-life scenario. My client will sell their business in the next two years and retire. A conservative estimate of what they can net from the transaction, along with the sale of real property, is projected to last until age 88 (see chart). This plan could work out okay, but due to the uncertainties of inflation, return, mortality and expenses, it’s not ideal by any means.
But somewhere along the way, my client was able to slowly accumulate almost $360,000 in Roth IRA funds. Look at what their Roth accounts are projected to do over the course of their retirement:
The Roth accounts in the graph are represented by yellow bars. As you can see, the Roth IRA portion of their portfolio is small compared to their other accounts and proceeds from the sale of the business (represented by blue bars). The plan calls for a spend down of the blue accounts that are subject to taxes. The Roth accounts are allowed to rapidly grow tax-free and unmolested; preserving their wealth nicely throughout retirement. If they run into trouble with unforeseen expenses or lower than expected return, their Roth IRA’s are the safety net. If all goes well, the Roth IRA’s can move to their kids, where they will continue to enjoy income tax-free treatment.
Funding Roth IRA’s can be tricky. There are income limits that disallow Roth IRA contributions for higher wage earners. You can convert an existing IRA to a Roth IRA with no income limits, but you must pay ordinary income taxes on the converted amount. There’s a fighting chance your 401(k) plan at work allows after-tax Roth deferrals up to the maximum allowed for your plan. Consult your advisers when considering any of these changes, since they are tax sensitive.
Bottom Line: The magic of compounding returns just gets even better when you use a Roth IRA.
Not sure where to start? Contact me and I can help analyze your specific situation and provide assistance.