Roth IRAs have long appealed to investors in the early
stages of their careers who expect to pay taxes at a higher rate in retirement.
Older investors may also be tempted to use Roths to generate more retirement
income than they could with a traditional individual retirement account or
401(k), even if they expect to pay taxes at a lower rate down the road.
The strategy may work in some circumstances, but the
advantage for those investors of saving with a Roth could be relatively
small—and is no sure thing. Roths are essentially mirror versions of
traditional IRAs and 401(k)s; each is designed to build retirement assets over
time by putting money into stocks, bonds and other investments. With a
traditional IRA or 401(k), you get a tax deduction upfront or invest pretax
dollars. When you withdraw money later on, you pay taxes on the contribution
and any investment gains.
With a Roth, by contrast, you contribute after-tax dollars,
and you can generally withdraw the contributions and any gains tax-free in
retirement. Investors who expect their marginal tax rate to be higher in
retirement can benefit, in particular, by in effect avoiding higher taxes in
the future.
Research released recently by T. Rowe Price Group, indicates
that investors in their 50s and early 60s who pay taxes at a lower rate in
retirement can fare better in a Roth, as well. High earners can't contribute
directly to popular Roth individual retirement accounts. But there's still a
way in a simple two-step strategy that works for many people.
Consider a hypothetical 55-year-old investor plugged into a
spreadsheet supplied by T. Rowe Price. The investor pays taxes at the 28% rate and
drops to a 25% rate after retiring at 65. The investor could end up with 8%
more after-tax income during a 30-year retirement by contributing to a Roth
instead of a traditional account.
The advantage is smaller over the shorter term. An investor who contributed the same amount to
a traditional IRA—and who invested the tax savings in a separate taxable
account—would end up with less than with the Roth. Paying taxes on that
separate account each year is what gives the Roth its advantage. But investors
who want to capitalize on this advantage by choosing a Roth IRA or 401(k) over
a traditional account should be aware of two important caveats.
First, since the advantage is relatively small, it can take
many years for an investment in a Roth to develop a meaningful edge over a
traditional account if an investor will be moving to a lower tax rate in
retirement.
The hypothetical investor achieves the 8% increase in
after-tax income in retirement by keeping the Roth IRA invested for 40 years,
including the 10 years before retirement at 65 and the 30 years during
retirement in which the money earns 6% annually and is gradually withdrawn.
The second caveat is that an investor who expects to drop to
a lower tax rate would need to contribute the maximum allowable amount to a
Roth to take full advantage of the boost a Roth can provide.
Even if you don't know what your tax rate will be, a Roth
can be useful. By having money in both Roth and traditional accounts, you may
be able to diversify your tax exposure so not every cent of your retirement
savings is taxed at whatever rate some future Congress sets for ordinary
income. And tax-free Roth distributions won't trigger taxes on your Social
Security benefits, as can sometimes happen with withdrawals from a traditional
IRA or 401(k).
Click here to access the full
article on The Wall Street Journal.