You’ve probably heard of “Roth” investment accounts, or you might even have some money in a Roth IRA or Roth 401(k). These accounts can provide significant tax advantages in certain circumstances, but they aren’t right for every situation.
Before you decide to allocate your retirement savings to Roth, it is important to understand what you could gain by doing so – and what you stand to lose. The following overview of Roth accounts will help you understand this type of retirement savings vehicle and the circumstances when it is most valuable.
What is Roth and Why Was It Invented?
Most early retirement savings accounts were “deductible” – meaning they provided a tax deduction for contributions and delayed taxes until retirement. Then, in 1997, Delaware Senator William Roth sponsored a law that introduced a new type of “non-deductible” retirement savings account. This revolutionary new account was aptly named the Roth IRA.
Unlike “traditional” retirement accounts, Roth IRAs do not provide a tax deduction when you contribute to the plan. Instead, you avoid taxes on withdrawals in retirement – provided you meet the criteria for a qualified distribution.
The concept of non-deductible retirement accounts proved to be a popular option with savers, and it was expanded to employer sponsored plans – like 401(k)s – in 2001. Today, IRAs and about 90% of 401(k) plans offer a choice between traditional and Roth options, but how do you know which is right for you?
Roth May Be Right for You If You Expect to Have High Income in Retirement
The United States has a progressive tax system – meaning people with higher income pay higher taxes. For this reason, traditional retirement accounts provide advantages for individuals with high income during their saving years who expect lower income during retirement. These people receive a deduction for their contribution that offsets income during their highest earning years. Then, they pay tax on those funds in retirement, during their lowest earning years.
On the other hand, Roth can be especially beneficial if you expect your income to remain the same or increase in retirement. In particular, people at the beginning of their career often choose Roth because it allows them to pay tax on retirement funds while their income is low and avoid taxes later when their income is higher.
Roth May Be Right for You If You Expect High Investment Returns
As previously mentioned, traditional accounts delay taxes until retirement. It is important to note that these taxes apply to the amount you contribute and the amount your investments earn. This means you don’t owe tax each year on the interest your investments earn, but you must pay income tax on investment returns in retirement.
Conversely, Roth accounts require you to pay tax on your contribution upfront, but that is the extent of your tax liability. Like traditional accounts, you do not owe tax each year on interest. Unlike traditional accounts, you also do not owe income tax on qualified distributions. Therefore, if you meet the criteria for a qualified withdrawal, you never owe tax on investment returns.
Aggressive Investors Often Prefer Roth Over Traditional Accounts
If you favor aggressive investments that prioritize potential growth over safety, you have the potential to accumulate significant investment returns over the course of your life. With a Roth IRA or Roth 401(k) you can avoid all taxation on these returns.
Young Investors Tend to Favor Roth Over Traditional Accounts
Even if you don’t invest aggressively, you can accumulate significant investment returns over an extended period of time due to compounding returns. The effects of compounding are particularly outsized when you have many years to invest.
For example, a $1,000 investment earning 10% compounding returns would grow to about $1,600 over the course of 5 years and roughly $17,500 over a 30-year timeframe. In these scenarios, you have the potential to avoid taxes on $600 to $16,500 in investment returns with a Roth account. As you can see, a Roth account can provide significant tax savings if you are investing for the long term.
Roth May Be Right for You If You Want to Avoid RMDs
Traditional retirement accounts – including IRAs and 401(k)s – are subject to Required Minimum Distributions [RMDs] in retirement. These rules were put in place to keep retirement accounts from becoming indefinite tax shelters and force you to withdraw a portion of your account each year after you reach age 73.
Since Roth accounts are already taxed, the IRS does not need to force account holders to make taxable withdrawals. For this reason, Roth IRAs have never been subject to RMDs and Roth 401(k)s are no longer subject to minimum withdrawals beginning in 2024.
For many people, RMDs are not an issue because they already plan to withdraw from their account each year during retirement. However, if you anticipate that there will be years you don’t need to access your savings, a Roth account could help you avoid unnecessary withdrawals.
Roth May Be Right for You If You Want to Avoid Uncertain Tax Liability
Congress has the authority to change tax brackets, deductions, and credits from year to year. These changes can affect the amount of tax you owe on withdrawals from a traditional retirement account.
The uncertainty of future tax policy makes some investors wary of traditional retirement accounts. Conversely, with a Roth account, you know from the moment you contribute how much you will pay on a qualified withdrawal – zero.
Roth IRAs and Roth 401(k)s can provide peace of mind in retirement and significant tax advantages for certain people, but they are not the right choice in every situation. To determine if Roth is the right option for your retirement plan, consult an experienced financial advisor who can evaluate your situation and help you weigh the options.
Determine If Roth Is Right for You with Investing Gameplan
At DreamWork Financial Group, we can help you determine if Roth is right for your retirement plan. Our advisors will evaluate your entire financial picture including retirement goals, income and expenses, investment preferences, and projected tax benefits to determine if this investment vehicle is right for you.
Whether you choose a Roth or traditional account, our advisors can help you grow your savings and stay on the right path to financial success. Our innovative personal wealth management program, Investing Gameplan™, offers custom portfolios comprised of individual stocks and low-cost ETFs. And best of all, our services are accessible to all investors, regardless of their account balance. That’s why we say You Don’t Have to Be Wealthy to Have Wealth Management®.
To learn more or get started, contact us today.