Michael Kitces is Head of Planning Strategy at Buckingham Wealth Partners , a turnkey wealth management services provider supporting thousands of independent financial advisors. The inspiration for today's blog post is financial planner Jeff Rose, who recently called on the personal finance blogosphere to start a Roth IRA movement. Jeff lamented that when speaking to a group of seniors at his alma mater, not one of the 50 students in the audience knew what a Roth IRA was - which means, to say the least, that none of them were likely to contribute to one anytime soon!
Jeff was inspired to help get the word out on Roth IRAs. In the case of financial planners, the existence of the Roth isn't exactly news; it's something we learn about as a basic part of our training. Yet at the same time, while most planners are aware of Roths and their basic features, there is often a remarkable amount of confusion with many myths about what the value really is, and is not, when using a Roth. I've written about this issue extensively in the past, in my May issue of The Kitces Report , but here are the basic highlights.
There are only four factors that impact the wealth outcome when choosing between a Roth or traditional IRA or other retirement account.
They are: current vs future tax rates, the impact of required minimum distributions, the opportunity to avoid using up the contribution limit with an embedded tax liability, and the impact of state but not Federal estate taxes. Some of these factors solely benefit the Roth, but others can benefit the pre-tax account; failing to evaluate the situation properly for a client can turn a Roth decision from a wealth creator into a long-term wealth destroyer!
By far, the most dominating factor in determining whether a Roth or traditional retirement account is better is a comparison of current versus future tax rates. Current tax rates means the marginal tax rate that will be paid today or the marginal tax rate on the deduction that would be received by contributing or using a pre-tax retirement account versus contribution or converting to a Roth account.
Future tax rates means whatever tax rate would apply to the funds in the retirement account when withdrawn in the future - ostensibly in retirement, or possibly even by the next generation if the retirement account is not expected to be depleted during the lifetime of the owner.
The principle of this equation is remarkably straightforward - the greatest wealth is created by paying taxes when the rates are lowest.
If rates are low today and higher in the future - e. If rates will be lower in the future - e. Getting the tax rate equation wrong can result in a significant destruction of client wealth, by unnecessarily paying taxes at high rates!
One important distinction about Roth IRAs although not Roth k accounts is that they are not subject to required minimum distributions RMDs during the lifetime of the account owner, while traditional IRAs are. The net result is a slight benefit in favor of the Roth IRA, for the simple reason that it allows more dollars to stay inside their tax-preferenced wrapper. This is an outright benefit for Roths, compared to the traditional IRA that slowly self-liquidates from RMDs, forcing money into taxable accounts where their future growth will be slowed by ongoing tax drag.
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The information on this site does not modify any insurance policy terms in any way. A Roth IRA and a traditional IRA individual retirement account offer valuable retirement-planning benefits, but with different structures, income limits and pros and cons.
Traditional IRAs offer the potential for tax deductibility in the present, while Roth IRAs are made with after-tax dollars meaning there is no benefit in the here-and-now.
Both of these IRAs are sound choices that will help you prepare for the future. A common piece of the Roth IRA vs. Instead, look at that road to retirement as a downhill ski slope. Think of your savings as a snowball rolling down that slope: You want it to get bigger and bigger as it reaches the bottom.
Consider it a way to thank yourself later: You paid the taxes early so that you can enjoy that whole car-sized chunk of cash. The longer you have between now and retirement, the more that the prospect of compounded tax-free growth in a Roth IRA stands out as a big differentiator. You can have both: As you compare Roth vs. If you want to be in full control over the investing decisions, look for firms that empower you with a full slate of educational offerings about the market and potential places to grow your money.
If you would rather put your IRA on cruise control, a target-date retirement fund or robo-advisor that can deliver sophisticated, low-cost investing tailored to your needs will be a simple way to save. How We Make Money. Editorial disclosure. Written by. He leads a team responsible for researching financial products, providing analysis, and …. Edited By Lance Davis. Edited by. Lance Davis. For most, a Roth is the right choice, according to many financial experts.
The two types of accounts both offer tax advantages, the main difference being whether you want to pay taxes now or later. With a traditional IRA, your contributions lower your taxable income for the current year. Similar to a workplace k , you've deferred your tax bill. With a Roth IRA, you invest money that's already been taxed.
When you withdraw it in retirement, you get the gains tax-free, assuming you follow the withdrawal requirements. Basically, you've pre-paid your taxes.
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