This Valentine’s Day, Fall In Love With A Roth IRA
For those of you that are still figuring out what to get your significant other for Valentine’s Day, look no further than your friendly Philadelphia financial planner’s blog. “Hey babe, let’s give each other the gift of tax-free earnings!” I know, I know. Thank me later. But seriously, if you don’t already have a Roth IRA, I hope you’ll book a time for us to chat. In the interim, here are three of my favorite things about Roth IRA’s.
Control
Do you like having control over your income taxes? As of this writing, the Congressional Budget Office (CBO) expects the federal deficit to exceed $1 trillion every year for the next decade. That’s in addition to the $23 trillion and change that’s already on our nation’s collective tab. I am not a tax policy expert. But methinks that our collective debt is going to get paid for, at least in part, with higher future income tax rates. Roth IRA’s allow you to pay the income taxes at today’s tax rates instead of whatever they’ll be in the future. Historically, federal tax rates are pretty low right now. Like, really low.
This is significant to you because a Roth IRA contribution is made with after-tax dollars (no tax deduction like a Traditional IRA). Then, as long as you wait five years AND you’re at least 59.5 years old, your contributions and any earnings can be withdrawn tax and penalty-free. That’s right. Turn the lights down low. Light some candles. Put on “Pony” by Ginuwine. We’re talking about the ultimate financial planning aphrodisiac: tax-free income. Roth IRA’s give you control because they allow you to pre-pay your tax bill, if you will, by making contributions today with money that’s already been taxed at today’s tax rates. Heck, even the lower tax rates associated with the Tax Cuts and Jobs Act of 2017 are set to revert to the higher 2017 levels without further legislation. So whatever happens to tax rates in the future, you’ve already paid Uncle Sam. Unless they change the laws to renege on the unique tax aspects of Roth IRA’s, I think it’s a good bet for at least some of your money. Especially because your employer’s matching contributions will always be with pre-tax dollars, so a Roth IRA could bring some tax diversification and balance to your retirement savings.
Fast forward to when you’re in your 70’s, many years after you started making Roth IRA contributions. Everything hurts. The music’s too loud. The ear hair. Oh the ear hair. Regardless of what tax rates are at that point, you’ve already paid all the taxes you were going to pay and can enjoy tax-free withdrawals. An often overlooked benefit of Roth IRA’s is their ability to keep a lid on the taxation of your Social Security. I have found people are shocked to learn that up to 85% of their Social Security benefit is taxable. The amount of your Social Security that is subject to taxation depends on a funky calculation called your combined income. Your combined income is comprised of your adjusted gross income (AGI) + municipal bond interest + half of your Social Security benefits. Roth IRA’s and their tax-free income don’t increase your AGI and could help you save some taxes on your Social Security. Traditional (pre-tax) 401(k)’s/IRA’s, on the other hand, have not been taxed yet and will count towards your AGI when calculating how much of your Social Security is taxable. Making Roth IRA contributions now is a strategic move that gives you more control over your future income and income tax.
Flexibility
“Say what now? How do you juxtapose control with flexibility!? You loon!” -You, probably. But Roth IRA’s are an incredibly flexible savings vehicle, no matter what age you are. You can withdraw contributions at any time without penalty or taxation (there is a distinction between contributions and conversions, so talk to your tax professional before proceeding with distributions). This makes Roth IRA’s an ideal complement to your emergency fund, college savings, retirement savings, and any other kind of savings accounts you have.
Let’s suppose you’re eligible (2021 Modified Adjusted Gross Income less than $125,000 if you’re single, or less than $198,000 if you’re married filing jointly) to make a full Roth IRA contribution of $6,000. $7,000 if you’re turning 50 in 2021, or already turned 50. Pretend you’re not 50 yet and you’ve made $6,000 contributions for the last 8 years and you have a Roth IRA now worth $55,000. $48,000 of the account balance represents contributions, and $7,000 represents tax-deferred growth. You can withdraw your contributions, or $48,000, at any time, no questions asked. Roth IRA’s could also be useful to help you delay your Social Security benefit too. For every year you delay claiming your Social Security past your Full Retirement Age (FRA), the government will increase your benefit by 8%. You could use your Roth IRA’s to cover living expenses while you’re converting any leftover Traditional IRA’s/401(k)’s to Roth IRA’s AND delaying your Social Security benefit. Simply put, Roth IRA’s give you options.
This makes a Roth IRA a remarkable financial planning tool because you can save and invest in your Roth IRA according to your risk tolerance, time horizon, and goals, but also access the contributions if you need them. Ideally, the funds are exclusively for retirement, but it’s nice to know you can get to the contributions if you need to. Traditional IRA’s and Traditional 401(k)’s are not nearly this flexible, and certainly don’t offer access to your money without penalty and/or taxation, save for the case of the 401(k) loan. This is probably a good time to remind you how important it is to have an appropriate emergency fund, which you can read more about here. In addition to the flexibility Roth IRA’s offer you in regards to getting money out, Roth IRA’s can be funded up until you file your tax return. Easy in, easy out.
Gimme Shelter
Retirement is a vague concept for a lot of people because it might be a few decades away. But, a little planning now, with this much runway until you’re in your 70’s and beyond, would be wise. Traditional IRA’s and 401(k)’s require you to take distributions once you turn 72. When you’re younger and working, Uncle Sam allows you to deduct contributions made to Traditional IRA/401(k) accounts and then allows the accounts to grow tax-deferred. Once you’re 72, the tax man cometh and the IRS publishes a schedule that is meant to liquidate your Traditional (pre-tax) retirement accounts over your remaining life expectancy so the guv’mint can get their tax revenue. These forced distributions are called Required Minimum Distributions.
Fortunately, Roth IRA’s don’t have Required Minimum Distributions (RMD’s). Take as much income as you need, and on your own terms. You already paid your tax bill, unlike a Traditional IRA which is just a tax bill in the making, so the IRS doesn’t care about the account anymore because they already got their tax revenue. Thanks to the passage of the SECURE Act at the end of 2019, those pesky RMD’s aren’t just a problem for people with Traditional IRA’s and 401(k)’s when they’re alive. The SECURE Act now requires any money left behind in a Traditional IRA/401(k) to be liquidated (read: taxed) within 10 years of your death. I’m all for using the money you’ve worked so hard for and enjoying your retirement to the fullest without necessarily planning to leave money behind. But. If you are going to leave money behind, wouldn’t it be great if it was tax-free? Roth IRA’s have already been taxed, so your beneficiaries get to keep enjoying the tax-free distributions you were before your passing. The situation is quite a bit different if you leave your Traditional IRA/401(k) behind. Your children could inherit a Traditional IRA/401(k) in their peak earning years (probably their 50’s/60’s), potentially subjecting the Inherited Traditional IRA to a higher level of taxation since it has to be liquidated within 10 years. This could easily be enough additional income from the RMD’s to move up to a higher tax bracket and subject the IRA to more taxation than if you had converted the IRA to a Roth before your passing.
Making Roth IRA contributions today can help you shelter your future income from increased taxation, help you shelter your Social Security from increased taxation, and help your heirs shelter their inheritance from increased taxation. Please, please, please, talk to a professional about whether a Roth makes sense for you. If your MAGI is more than the $124,000 single and $196,000 married-filing-jointly limits I described above and you’d still like to make Roth IRA contributions, stay tuned for a future blog post on how to get around those limits.
If I’ve made sense and you want to know if a Roth IRA is right for you, your family, and your earnings trajectory, book a time for us to chat or send me an e-mail. If I haven’t made sense and you want to talk about Ginuwine, ear hair, or you want me to clear something up, fire off an e-mail to brendan@meaningfulwealthmanagement.com.
Brendan