The more classes we teach, the more questions we get on when and how to best use Roth IRAs. Questions also include the recently instituted Roth 401(k) that many businesses have started offering in the last two years. The purpose of this week’s blog will be to try and simplify not only what these Roth investments are but how to take best advantage of them depending on your age and situation.
Roth contributions and withdrawals are taxed differently from traditional IRAs and 401(k)s. Roth contributions are made with after-tax money. Because the money has already been taxed, you will not pay taxes when you make a qualified withdrawal of your contributions or earnings; they are “tax-free”. In contrast, contributions to a traditional IRA or 401(k) are deductible from your taxable income. Because they are not taxed initially, they are referred to as “tax-deferred”; in other words, the government will tax them when withdrawn. That an IRA can reduce current taxes while a Roth can reduce future taxes can be helpful when making a decision about which choice is best for you. In any case, please know that there are complex rules for both contributions and withdrawals that you should be familiar with before making a transaction.
Now some general thoughts on how, who, and when to take advantage of the Roth’s tax deferral:
1) If you are under the age of 45 it would be rare to not advise you to save all of your long-term savings into either the Roth IRA or the Roth 401(k).
2) Unless you have the ability to leave a Roth investment alone for at least 20 years, you are better served using a tax-deferred vehicle.
3) If you are very likely to retire into a lower tax bracket, then a tax deferred IRA and/or 401(k) are a better choice for you. However, I must tell you that trying to predict that outcome has been a costly mistake for a lot of retirees the last couple of decades as tax brackets seem to always be changing.
4) Roth IRAs are the best way to pass on assets to the next generation. Therefore they should be the last thing that a retiree uses in their lifetime.
5) Since the longer you leave this tax free investment alone improves this decision, it should also be invested in more growth then any other of your investments. It is almost always a good decision to invest 100% of it in a globally diversified stock index portfolio.
Finally, remember that these are general guidelines to help you understand the importance of taking full advantage of this tax-free investment vehicle in your own planning. It is actually a very easy decision for young people but once you get into your 50s, the analysis becomes more complex. As always, feel free to come in and talk to us.