Tax season has now come and gone—a time when perhaps too many four lettered words cross our lips. Millennials, however, should consider adding one more to their repertoire: Roth. This may be a good time to take advantage of this type of investment vehicle. So what is it and how does it work?
Named after former lawyer and US Senator, William Roth, the Roth IRA was first introduced in the late 1990’s. Contrary to the traditional tax-deductible IRA, this type of investment account allows for contributions to be made after income taxes have been collected.1 This seemingly small distinction could potentially make a significant difference in the future value of your retirement account. While any wage-earner that files their taxes as a single and earns less than $122,000—$193,000 for joint filers, in 2019 can make contributions up to $6,000/year to a Roth IRA, younger workers may wish to consider the benefits. Let’s take a look at three reasons why this may be true.
1. Similar to traditional tax-deductible IRAs, the money grows tax-deferred (you do not have to pay capital gains taxes). However, unlike in a traditional tax-deductible IRA, , all investment earnings gained over the life of the account become tax-free when it’s time to take distributions.2 Because younger workers have a longer time horizon and “the all-powerful”3 compounding interest on their side, the benefits of receiving the tax-free income in retirement may outweigh the short-term benefit of the immediate tax deduction. Let’s take a look at one possible comparison of the two; assuming we are able to contribute the maximum annual amount regardless of whether we make the deductions pre or post tax.
-If we are able to make 10 years of the maximum contribution of $6,000, and let that grow for 30 total years, assuming a 7% average annual market return, the total assets would equal $343,247.19. 4
-If we made the contributions pre-tax, and we moved up just one tax bracket in today’s structure from 22% to 24% from now until retirement, we would pay a total of $82,379 in taxes, assuming a lump sum withdrawal in year 30 on the retirement distributions. This brings the total to $260,868.5
-Conversely, if we made those same contributions to a Roth account, at our current tax rate of 22%, we would have only paid a total of $13,200 in taxes on the way in leaving us with $330,047.
-In this specific example, we would be saving ourselves $69,179, or more than 20% of the total value at retirement.6
2. In general, Millennials in the beginning stages of their careers are currently in a lower tax bracket than they will be later on in life. Making contributions to a Roth account requires paying taxes now rather than paying taxes on the earnings in the future, when in a potentially higher tax bracket. The 2017 Tax Cuts and Jobs Act has created a historically low tax environment in the U.S.7 —which may provide further incentive to pay the taxes now. This is just another way to mitigate the risk of rising taxes in the future.
3. Unlike withdrawals from a traditional, tax-deductible IRA, which cannot be made without a 10% IRS penalty before the age of 59½, all contributions made to a Roth IRA can be withdrawn without penalty. This may enable your retirement account to double as an emergency fund for any unforeseen life events8. In addition, you can withdraw all contributions, interest, and capital gains up to $10,000 at any age and without penalty after 5 years of account establishment—as long as it’s used for the purchase of your first home.9
Aside from the Roth IRA, most employer-sponsored plans today—think 401(k), 403(b), etc., also offer the ability to make Roth contributions. The tax benefits are the same, with the only significant difference being that there are no income restrictions on Roth contributions within an employer-sponsored plan. To determine whether or not you can benefit from these options, I recommend having a conversation with your financial advisor.
An investor can withdraw his or her contributions to a Roth IRA at any time without tax or penalty. But that does not apply to any earnings or interest that you have earned on your Roth IRA investment.
In order to withdraw your earnings from a Roth IRA tax and penalty free, not only must you be over 59½ years old, but your initial contributions must also have been made to your Roth IRA five years before the date when you start withdrawing funds. If you did not start contributing in your Roth IRA five years before your withdrawal, your earnings will not be considered a qualified distribution from your Roth IRA because the withdrawal violates the five-year rule. Any withdrawal that is made before the five-year time frame is complete will trigger a 10 percent penalty for an early withdrawal, regardless of your age. It will also subject you to the requirement to pay taxes on the earnings you take out.
This communication does not constitute legal, accounting, tax, other professional counsel or investment advice, is not predictive of future performance, and should not be construed as an offer to sell or a solicitation to buy any security or make an offer where otherwise unlawful. The information has been provided without taking into account the investment objective, financial situation or needs of any particular person.
About the Author
As an associate and registered investment advisor at BWC, Rob Bier works with private clients, defined contribution plans and institutional accounts to asses and service their needs. His responsibilities include client asset allocation review and development, and designing and implementing employer-sponsored retirement plans. Rob is Series 65 registered and insurance licensed. He is also a candidate for the Level I Chartered Financial Analyst (CFA) designation.
About Beirne Wealth Consulting Services, LLC
Beirne Wealth Consulting Services, LLC (“BWC”) is a growing, privately owned, SEC Registered Investment Advisor with offices in Connecticut, Pennsylvania and Florida. BWC provides independent, fee-based investment management services and customized financial planning solutions. Our institutional business provides consulting expertise to defined benefit and defined contribution plans, endowments, foundations and non-profit organizations. Our private clients include high net-worth individuals and prominent families, many of whom bring complex wealth management challenges and multigenerational planning needs. For more information, please visit www.beirnewealth.com or give us a call today at 888-231-6372.
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1While this article is comparing a Roth only to a traditional tax-deductible IRA, it is possible to contribute after-tax money to a traditional non-deductible IRA.
2Traditional non-deductible IRA contributions can be withdrawn tax-free as well, however, the investment earnings from them cannot.
3Quote from Albert Einstein. Reference Source: https://www.cbsnews.com/news/compound-interest-the-most-powerful-force-in-the-universe/
4The average annual market return of 7% is a hypothetical assumption. Actual market returns vary and an investor may experience loss of principal.
5Tax brackets and income tax rates may change over time and an investor’s income tax bracket may be higher or lower in the future
6Assumes tax brackets remain the same we moved up one bracket from 22% to 24%, contributions are made as a lump sum in the beginning of the period, retirement distributions are made with an average tax rate of 24% Over what period/duration of time? Is it an annual distribution for 20 years, monthly for 30, and are there any assumptions regarding ongoing earnings in the account during the distribution phase?
8Restrictions apply. In order to withdraw your earnings from a Roth IRA tax and penalty free, not only must you be over 59½ years old, but your initial contributions must also have been made to your Roth IRA five years before the date when you start withdrawing funds.
9Funds must be used directly toward home acquisition (down payment, closing costs, etc.)