MONEY TALKS - In today’s day and age, retirement planning has gotten more complicated than ever. This is primarily due to the complexity of the tax code as well as the vast choices available. Unless you are a retirement benefit specialist, understanding the differences between a 401(k), 403(b), 457, SIMPLE, SEP, SARSEP, and IRA can be agonizing. Yet the reality of the situation is; there is a lesser known retirement plan called a Roth IRA that provides tremendous flexibility in retirement and beyond. What's more, because of the low cost nature of these plans nearly anyone can participate regardless of their employment status.
Tax Free Distributions - Most of us have at least heard the term “Individual Retirement Account” or “IRA”. However, a lot of people are still in the dark when it comes to understanding Roth IRAs. A Roth IRA is a retirement account where after tax money is contributed and the contributions, as well as any earnings, grow tax free. However the major advantage of a Roth, that separates it from other retirement vehicles, is the tax treatment of the distributions, or withdrawals. Any qualified distributions from a Roth IRA, no matter how large, are tax free!
Basic Differences - In order to fully understand the benefits of a Roth IRA, I think it’s worthwhile to understand the basic differences between the two retirement accounts. The primary difference between a Traditional and a Roth IRA is the tax treatment of the both the contributions and the distributions. In a Traditional IRA, contributions are tax-deductible, similar to a 401(k) plan, however contributions to a Roth IRA are not tax deductible. On the other hand, qualified distributions from a Traditional IRA are taxable, yet any qualified distributions from a Roth IRA are tax free.
Capital Appreciation - To put this in perspective, let’s assume throughout your career you contributed $50,000 into your retirement savings. Presume your investments performed well and the balance grew to $200,000 by the time you retired. If you had contributed to a Traditional IRA you would have saved taxes on the $50,000 you contributed however you would be obligated to pay taxes on the entire $200,000 upon withdrawal. Contrastingly, if you contributed to a Roth IRA, you would not save any taxes on the $50,000 you contributed, because Roth IRA contributions are made with after tax dollars, however the entire $200,000 would be tax free upon withdrawal. Despite not receiving any initial tax benefit from your contributions to a Roth IRA, the benefits of tax free withdrawals far outweigh the initial tax savings due to the capital appreciation within the account.
Flexibility - A Roth IRA can also be particularly advantageous when a retired individual has other sources of income, whether that be from a part time job, social security, and/or pensions. If they had a Traditional IRA, once they turn 70½, they would have to start taking required minimum distributions (RMDs) based on their life expectancy. These distributions could catapult them into a higher tax bracket where they would be paying taxes on money they may not currently need. If instead the funds were in a Roth IRA, which generally does not have RMDs, the account holder would have the flexibility of deciding when or if they wanted to take a distribution. Not to mention, even if the account holder wanted to take a distribution to supplement their income, it would be tax free.
Estate Planning - Another advantage of the Roth IRA is when it is used as a vehicle for Estate Planning. As previously mentioned a Roth IRA has no RMDs during the lifetime of the owner. Moreover, if the surviving spouse is the sole beneficiary of a Roth IRA, there are no RMDs during the life of the surviving spouse either. Once the surviving spouse passes, assuming a child is the beneficiary, the account balance must be distributed over the life expectancy of the child, which could be 20+ years. Keep in mind that balance will continue to grow tax free and the distributions still remain tax free. The ability to stretch this tax free benefit from one generation the next simply cannot be understated.
In summary, the tax free nature of the Roth IRA distributions, along with the lack of required distribution rules, creates tremendous opportunities for clients with Roth IRAs. If you would like to find out more about whether a Roth IRA might be a good fit for you please contact your local financial advisor.