Retirement planning is all about sacrificing now to create your dream retirement in the future. Roth IRAs and Roth 401(k)s put your commitment to this principle to the test because they delay tax benefits as well as income.
While Roth retirement accounts can be a lesson in patience, they can also be a powerful tool for funding your retirement and minimizing taxes. By learning the history of these accounts, you can truly appreciate the benefits they offer and make a more informed choice about your retirement options.
1974: The Individual Retirement Account Was Created
The Employee Retirement Income Security Act of 1974 – more commonly referred to as ERISA – created the Individual Retirement Account [IRA]. Unlike other retirement accounts at the time, the IRA was not tied to an employer but owned solely by the individual contributing to it.
The first IRAs – now known as Traditional IRAs – allowed account holders to deduct their contributions from their taxable income each year. For this reason, they are sometimes called “deductible” IRAs. However, the deductibility of Traditional IRA contributions depends on your income and coverage by an employer sponsored retirement plan. Additionally, IRA contributions are subject to a relatively low contribution limit compared to 401(k)s. Even after decades of inflation adjustments, IRA contributions are limited to just $7,000 per year in 2024.
To prevent IRAs from becoming an indefinite tax shelter, Congress also included a provision requiring minimum distributions to be taken each year after the account holder reached a certain age. These distributions are known as RMDs, and they also apply to 401(k)s.
1997: Congress Introduced the Roth IRA
The Taxpayer Relief Act of 1997 introduced a new type of “nondeductible” IRA called the Roth IRA. This revolutionary type of account was named after Delaware Senator William Roth, the legislative sponsor of the plan.
Unlike Traditional IRAs, Roth IRAs do not provide an immediate deduction but delay tax benefits until retirement. These benefits allow you to withdraw your money – both contributions and earnings – tax-free in retirement, assuming you meet the conditions for a qualified distribution.
Since their introduction, Roth IRAs have proven extremely popular. Two of the main selling points of Roth IRAs are: account holders never pay tax on the investment earnings in their account if they make a qualified withdrawal, and these accounts are not subject to RMDs.
2001: 401(k)s Gained a Roth Option for Elective Deferrals
The Economic Growth and Tax Relief Reconciliation Act of 2001 introduced Designated Roth Accounts for 401(k)s. The initial Roth option was only available for elective deferrals – the contributions that employees make to the plan. Employer matching contributions were still required to be made on a pre-tax basis.
Roth 401(k) accounts provide the same tax benefits as Roth IRAs, and the higher 401(k) contribution limit allowed Americans to apply those tax benefits to a much larger share of their retirement funds. Additionally, the Roth 401(k) option allowed more people to take advantage of Roth accounts because they are not subject to the income limits that apply to Roth IRAs.
The addition of Roth to 401(k) plans provided many benefits for retirement savers but there were still some downsides compared to Roth IRAs. Namely, Roth 401(k)s were still subject to RMDs. However, this problem was recently eliminated.
2022: Roth Option for Employer 401(k) Contributions Added, RMDs Eliminated
The SECURE Act 2.0 introduced sweeping changes for retirement plans including adding a Roth option for employer 401(k) contributions. With this change, employers have the option to allow their employees to designate matching contributions as Roth as well as the money that the employee added to their retirement plan. Finally, Americans at participating employers could create a retirement plan that was wholly tax-free during retirement.
In addition to expanding the Roth option to employer contributions, the SECURE Act 2.0 eliminated RMDs for Roth 401(k)s. This change made Roth an even more attractive option for many investors.
Is a Roth retirement account right for you?
The choice between Roth and Traditional retirement accounts is not always an easy one. It requires you to consider the long- and short-term tax benefits as well as estate planning considerations and retirement income needs.
Roth tends to be the preferred choice for people who:
- Expect a high tax burden in retirement. Those who anticipate high income in retirement and want to avoid taxes on a portion of that income often choose Roth retirement accounts since qualified withdrawals are tax-free.
- Expect high investment returns. Both the money you contribute and the returns on your investments are tax-free with a qualified withdrawal from a Roth account. Therefore, investors who expect high investment returns gain a greater tax benefit with Roth than those who anticipate lower returns.
- Want to leave tax-free money to their heirs. Funds in a Roth account are tax-free for beneficiaries as well as account holders – assuming the criteria for a qualified withdrawal are met.
- Want to avoid RMDs. People often choose Roth when they plan to leave their retirement funds in a tax-advantaged account as long as possible to avoid annual RMDs during retirement.
Every person’s financial situation is different, and their retirement plan should be as well. An experienced wealth manager can help you determine if Roth is the right choice for your plan.
DreamWork Financial Group Can Determine if Roth is Right for You
When you partner with DreamWork, we’ll develop your Investing Gameplan™ and determine if a Roth account is the right choice for your situation. Investing Gameplan™ is a comprehensive investing plan that includes a custom portfolio of ETFs and individual stocks – tailored to your specific goals and tolerance for risk. Best of all, your investments are overseen by a fiduciary advisor with no conflicts of interest.
With Investing Gameplan™ and a partnership with a fiduciary, you have the tools to turn your retirement goals into a reality. Contact us today to learn more and get started.