The Roth IRA: The Piece To Your Retirement Puzzle?

Roth IRA PuzzleThe popularity of the Roth IRA has brought a myriad of questions about which IRA is best for retirement savings.  The answer is, it depends.  Yet, for some reason the Roth IRA keeps popping up as the single best retirement account for everyone’s money.  It’s simply not true.  Yes, it’s a great way to save for retirement.  But only for the percentage that meet certain tax conditions.  For everyone else it’s just a tax paying vehicle, costing you money.

You see, the government survives on tax revenue.  While deferring taxes until retirement is a great idea for you, it has no added benefit for the government today.  So the Roth IRA was born and with it, a way to collect taxes now on your retirement savings.

The Roth IRA rules state, we put after tax money in and at retirement we don’t have to pay taxes on withdrawals.  We tend to focus too much on the “don’t have to pay taxes” part because it sounds so good.   In turn, we’re blind to the fact that taxes are still paid.  It’s after tax money going in, at today’s tax rates.  But it’s not entirely a bad deal.  Under the right circumstances, the Roth IRA a great retirement vehicle.

The Roth IRA Argument

The argument for the Roth IRA involves it’s added benefits when it should be about tax savings.  There are bonuses, like being able to borrow from it, having no withdrawal limits, and higher taxes at retirement.  All are very good reasons to use it.  It’s the bonus package the government tossed in to make it more enticing.  It doesn’t add any other resale value for most of us, but the hope is it’s enough to convince everyone to contribute and pay their retirement taxes now, instead of later.

The ability to borrow from a Roth IRA might have certain benefits, however small.  I’d argue borrowing money from a retirement account is a bad habit to start.  The no withdrawal limits fit well for those with estate planning needs (assets over $5.2 million for 2012).  Not too many people fall into that group either.

Which brings us to the argument of higher taxes in retirement.  Higher taxes are not a guarantee.  There is also the possibility of the government raising taxes.  Which could happen.  But the government could just as easily lower taxes, as well.  It could also change the tax code entirely and make Roth IRA withdrawals taxable, too.  The fear is to contribute to a Roth IRA, paying a marginal tax rate of 25% only to retire at a lower rate.  Which will happen to most of us.

All of these are “what if’s” that are best planned out by diversifying your income from different retirement accounts with tax deferred (traditional IRA, 401k) and tax-free (Roth IRA, Roth 401k) savings.  The fact is we don’t know what taxes will be five or twenty-five years from now.  What we do know, and what is important, is what our taxes are now and how close we are to the next highest and lowest bracket.

Great For Low Tax Bracket Savers

The Roth IRA is great for young savers, or at least lower-income young savers.  It’s also great for lower-income old savers and every age group in between in the lower tax brackets.

Unless you were a first round draft pick, it’s more likely that you’ll end up in the bottom tax brackets out of college.  That’s just how it works.  Since you are already in the lowest tax brackets, open a Roth IRA and pay the low tax rates now because contributing actually has its benefits.

As you gain job experience, you’ll gain income, eventually reaching the higher tax brackets (25% and up).  Until then you should take advantage of every opportunity the Roth IRA offers.

Great For Those On The Tax Bracket Bubble

This is where you can take advantage of the tax code to our benefit.  The Roth IRA is great for anyone sitting just inside the 25% tax bracket.  The traditional IRA deduction limits allow you to take advantage of the tax code, pay less in taxes, and save for retirement.  You can contribute just enough to a traditional IRA to drop down to the lower, 15% tax bracket, then use the Roth IRA the rest of the way.  That’s working the tax system to your benefit and maximizing your money.

The Perfect Roth IRA Candidate

The Roth IRA has its benefits for the right person in the right tax circumstances.  Contributing to a Roth IRA will eventually come down to:

  • What’s our expected retirement income
  • What tax rates will be at retirement
  • Will those tax rates be higher or lower than your current rates

Of the three reasons, the only one we have control over is our expected retirement income.  Future tax rates aren’t guaranteed, so we use the next best resource we have, today’s tax brackets.  By comparing our expected retirement income with the current federal tax brackets, it will give us the best idea how are current and retirement tax rates will compare.  If you can guarantee that your taxes will be higher in retirement than today, open a Roth IRA.

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  1. says

    I just changed my contribution to max out my Roth each year. For young people, not taking advantage of Roth IRAs is horrible. Sad that so many people don’t even know it exists.

    • says

      Agreed. There are so many people that “need” to buy expensive clothes, the latest iphone/ipad/ianything, etc – and don’t give a second thought to saving. Even some that do save don’t know anything about Roth IRAs. Realistically, financial literacy and knowledge is simply not a priority for many people that are starting out in life.

      • J.P. says

        Unfortunately, financially literacy isn’t a priority for most people until it’s too late. Maybe that is where the focus should be?

  2. says

    Yeah people just starting out are excellent candidates for a Roth. Why not turn that burger flipping you’re doing in high school into some real money? My tax brackets have been all over the place, so I have no idea what they’ll be like in retirement. My strategy is pretty much just to contribute as much to retirement as I possibly can, everywhere I can. So I have a Roth too.

    • says

      My thoughts exactly. Roth IRAs can be especially good for those starting out, but overall it’s best to save, save, and save some more. The earlier in life the better, Roth or not!

      All that said, I like the concept of Roth IRAs and have one.

    • J.P. says

      My strategy is pretty much just to contribute as much to retirement as I possibly can, everywhere I can.

      This should be everyone’s focus!

  3. says

    My biggest problem with Roth IRA is that both political parties are focusing their efforts on alternative taxes like a national sales tax, VAT and carbon tax. I’m starting to wonder if the income tax is going to die out over time. With the traditional IRA, you can lock in your tax advantage and know what it is. The Roth IRA seems much more risky. Who knows what the tax brackets will be in 30 years.

    • J.P. says

      Anytime debt levels grow out of wack, our elected officials tend to come up with some interesting, unique and absolutely crazy new ways to generate tax revenue. I’m sure retirement accounts are on their radar.

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