Roth IRAs: Investing In Your Future

When it comes to planning for retirement, the landscape is filled with various types of accounts to help with saving, each with its unique advantages and restrictions. In addition to the more familiar accounts – 401k, 403b, and IRA accounts being the most common – there is another option: the Roth IRA.   

A Roth IRA is a type of tax-advantaged retirement savings account that allows your investments to grow tax-free. Unlike traditional IRAs, where contributions may be tax-deductible and withdrawals in retirement are taxed, Roth IRA contributions are made with after-tax dollars, meaning you pay taxes on the money before you contribute. The primary advantage is that both your investment gains and withdrawals in retirement are tax-free, provided certain conditions are met. 

As with most retirement planning questions, the decision is nuanced and the best option depends on your specific circumstances around tax rates, income, and the landscape of other assets.

A Brief History

Traditional pre-tax retirement plans, including the Individual Retirement Account (IRA) and 401k, have been available to the public since the 1970s. Comparatively, the Roth IRA is the new kid on the block, introduced as part of the Taxpayer Relief Act of 1997. Senator William Roth, chairman of the Senate Finance Committee, pushed forward several proposals strengthening IRA accounts by increasing the amount of money that can be saved for retirement and allowing penalty-free withdrawals for first-time home buyers and educational expenses. 

A key part of Senator Roth’s agenda to expand retirement opportunities was the creation of the Roth IRA, a new type of account that allows individuals to save post-tax income and withdraw that money tax-free after the age of 59 ½. 

Protecting Against Higher Tax Rates

One key question when deciding where to save for retirement is whether to prioritize a Traditional IRA or a Roth IRA, and the general logic is as follows:  

• If you think your tax rate will be lower in retirement than it is during your working years, then contribute to a Traditional IRA. You get a tax deduction for contributions now when rates are higher, and you’ll get to pay taxes at a lower rate when you withdraw money in the future. 
• If you think your tax rate will be higher in retirement than it is during your working years, contribute to a Roth IRA. You will pay taxes now at a lower tax rate, and won’t have to pay taxes later when rates are higher. 

What affects your tax rate in retirement? Your income level, tax filing status, tax deductions, and any change to future tax law. You have control over the first three factors, as well as a certain degree of predictability. However, with future tax law, you have neither control nor predictability, and it can have an enormous impact on long-term finances.

A Different Kind of Diversification

With uncertainty about future tax rates, particularly in the context of rising national debt and the need for more tax revenue, we see significant value in having tax diversification. By utilizing both Roth IRAs and Traditional IRAs, investors can benefit from a blend of tax advantages that can enhance their financial flexibility and efficiency over time.  

Just as we emphasize diversification between stocks and bonds within investment portfolios, we similarly see value in diversifying between post-tax retirement savings, pre-tax retirement savings, and non-retirement savings. Each bucket is valuable in different moments, both for spending during your lifetime as well as legacy and estate planning. This combination allows us to hedge against the uncertainty of future tax rates and to strategically choose from which account to withdraw funds based on the tax situation each year in retirement. 

Planning Opportunities

As well as key tax benefits, the Roth also provides planning opportunities that can help diversify your retirement assets: 

• Roth Conversions: There is often a period of low taxable income following retirement, and before taking Social Security, that presents a unique opportunity. Roth conversions allow you to take funds from your pretax account (401k/Traditional IRA) and convert them into your Roth IRA. Taxes are paid on the conversion amount while you are in a lower tax bracket and funds grow tax-free in the Roth. 
• No Required Minimum Distributions (RMDs):  Since you have already paid taxes on these retirement dollars, the government does not force you to take RMDs starting at age 73. This allows you to retain greater control over distribution timing and taxable income as you consider the broader landscape of tax planning.  
• Backdoor Roth Contributions: Backdoor Roth contributions allow you to make Roth contributions even if your income exceeds the IRS phase-out limits. Executing this strategy involves multiple considerations and limitations, but it can be a powerful way to save into a tax-free structure over and above your regular retirement savings. 
• Custodial Roth IRA: Custodial Roth IRAs provide a great way to get your kids started on the road to saving and investing. Parents can open a custodial Roth IRA in their child’s name and make contributions on their behalf as long as the child has earned income and files a tax return. The rules around what is considered earned income are fairly liberal and can include babysitting, mowing lawns, dog walking, etc. Saving for retirement at such an early age has a powerful impact over decades of compound interest. 

It’s All About Balance

In the big picture, every time your earnings are set aside for retirement, whether it be in a 401k or a Roth IRA, it should be celebrated. Having retirement money in both a Roth and a 401k gives you the choice to take either taxable or non-taxable income. This choice allows you to be deliberate about your source of income and taxes. 

Despite the numerous benefits of a Roth IRA, there is no one-size-fits-all investment solution. At North Berkeley, we help our clients assess these decisions through the filters of their goals, their life circumstances, their current and future income levels and tax rates, along with multiple other factors that determine the best path forward.