Why You Should Do A ROTH IRA Yesterday

A blog post from the unique mind of Harrison Hodges

Why You Should Do a Roth IRA Yesterday

Usually the first questions I get when someone I know finds out I work in finance is: Where do I start? I have a 401(k) plan at work, but is that enough?

It’s either that or they ask for some stock picks, which is the wrong place to begin.

The right place to begin if you have questions is to ask what kind of accounts you are using to save and invest for your future.

It’s not an exciting place to start—making a ton of money on well-placed market bets is definitely much more tantalizing than figuring out whether your finances are organized to optimize your investments vs. savings mix and tax flexibility. But the reality is most normal folks would benefit as much, if not more, from solid organization than market plays. And it requires much less luck and speculation—ANYONE can do it!

With that being said, those of us who are fortunate enough to accumulate funds for retirement need to be asking ourself one question in particular: do I have a Roth IRA?

There’s a real problem with the financial services industry, but it’s not really high fees and commissions any more. It’s accessibility to in-depth financial planning. It’s the ability to get sound, prudent financial advice when you are accumulating money, not when you already have it.

And that problem is precisely why a Roth IRA should be at the forefront of the mind of any person who is trying to accumulate wealth for retirement. Why?

The answer is simple: Roth IRAs, used effectively, may be THE most useful retirement savings tool at our fingertips. They provide massive tax advantages and flexibility, two of the most important factors in saving for retirement. And getting one started is a relatively quick and easy step almost anyone can take.

However, people may have a limited amount of time (or resources) to put towards a Roth, and that is why it is of critical importance to get started on one early if you can.

Most people who are fortunate enough to be able to set aside money for retirement are doing so in a tax-deferred retirement plan offered through their job, such as a 401(k). These plans are excellent retirement savings vehicles, and anything you put into them can be deducted from your income for the year, thus reducing your tax liability.

However, reducing your tax liability down the line may not end up being as attractive as it seems. Taxes constantly change. The way your 401(k) funds are taxed 20, 30 years from now could be vastly different from the present. Taxes are actually at historic lows right now. The idea when you contribute to a tax deferred plan is to reduce your income now because your income in retirement will be lower, and so will your tax liability. But the reality is that we don’t know what things will look like that far down the line, so there is some risk.

I’m not saying anyone should stop contributing to their tax-deferred retirement plans. You should at the VERY least contribute up to the company match because free money is the best money. But flexibility is incredibly important in financial planning, and that is why I believe Roth IRAs are critical to virtually everyone’s financial plan.

Enough ambiguous rambling. What ARE the real material benefits (and limitations) of Roth IRAs?

• TAX-FREE GROWTH of your investments! I cannot overstate how important this is.

• To put this into proper perspective: let’s say you are able to invest 20k into a Roth IRA by age 30. According to the Rule of 72*, at a 9 percent rate of return, which is about the average return for the S&P 500, that money should double every nine years with no further contributions. If you retire at 66 your money will have doubled four times, and that Roth IRA will be worth 320 thousand dollars. That 300 grand of growth beyond your initial contribution of 20k carries a tax bill of ZERO. You could withdraw every penny of the account and pay nothing in taxes.

• When you compare that to a tax-deferred account the advantage is clear. How about if you had a tax-deferred retirement account that grew at the exact same rate. Now that 320 is still subject to income tax! At a 25% tax rate 80 grand of that is actually not yours to keep.

• Flexibility with contributions: life can be unpredictable, and in the event you are in a financial bind that requires you to access retirement savings before age 59.5, your Roth can really help save the day. All contributions (provided they weren’t converted from a tax-deferred account within the last 5 years) can be accessed free of penalty. Keep in mind accessing growth in the account DOES come with the 10% early distribution penalty.

• Compare that with a tax-deferred account which carries a 10% penalty on ALL withdrawals regardless of whether the money is from contributions or growth.

• Roth IRAs are excellent estate tools as well. They provide a tax-free inheritance for your beneficiaries and carry no withdrawal obligations.

• For comparison, inheritors of tax-deferred money come with the headache of mandatory yearly taxable withdrawals from the account until it is drained.

Roth IRAs do have a couple of limitations. The first is that contributions are not tax-deductible. In other words, you cannot use Roth contributions to offset income and reduce your tax liability, which is the advantage of contributions to tax-deferred retirement plans and IRAs.

The next limitation is the income thresholds, which can be found in the footnotes. These thresholds are why it is critical to try to get money into a Roth sooner than later, as it becomes much more complicated to do so once you exceed the limits. You are able to convert money from a tax-deferred account into a Roth IRA, and if you deducted those funds from your income when you contributed them you will have to pay taxes on the funds. You can either do that or open a tax-deferred account, contribute to it, then convert the funds over to a Roth IRA immediately. These are called backdoor conversions. While it still makes funding a Roth IRA possible the process is much more complicated and can lead to potential tax headaches.

Is it too late to contribute? Never. Roth contribution limits are 6k per person per year for those under 50, and includes the catch-up provision of an additional 1k per year for those over age 50. The bottom line is as long as you have earned income you can contribute to one.

While we truly believe Roth IRAs are incredibly useful to virtually anyone who is looking to solidify their retirement savings, it is prudent to ensure that they work for YOU. It’s also important to get your funds invested appropriately.

So how do you know for sure? How do you properly allocate your funds?

If you’re a do-it-yourself type you can organize your total financial picture and do the research to see if a Roth IRA would make sense. This would require some time, effort, knowledge, and enthusiasm to accomplish. If you are missing one of those factors it’s perfectly okay, and it’s probably a good idea to work with a financial advisor to put your financial pieces together. Check out our article on how to pick a financial advisor you can trust.

As with any investment or investment strategy, the outcome depends upon many factors including: investment objectives, income, net worth, tax bracket, risk tolerance, as well as economic and market factors. Before investing or using any strategy, individuals should consult with their tax, legal, or financial advisor. All information contained in this presentation has been derived from sources deemed to be reliable but cannot be guaranteed.

*Roth IRA Income Limits: https://www.irs.gov/retirement-plans/amount-of-roth-ira-contributions-that-you-can-make-for-2021

*The Rule of 72 is a simple mathematical formula that can be used to calculate how quickly one can double their money depending on the return they get.