To Roth or not to Roth……A Case for Roth

Pink or blue. Right or left. An apple or orange… We make an array of decisions daily: some are simple and inconsequential while others could have more impact in later times. Somewhere in the upper side on that scale lies a decision about a Roth account as a retirement savings choice.

The question of Roth has become quite the contested issue among financial professionals and the general public alike. In recent years, Roth has gained some momentum and more employers are offering Roth 401(k) in addition to traditional 401(k) programs.

The biggest difference between a Roth account and a non Roth retirement account is that you contribute to it with after tax dollars and consequently the withdrawals are income tax free if made after age 59½. It can only be funded with earned income including alimony but not an investment income or gifts.

There are several conditions and benefits to consider in deciding for Roth.

Current marginal income tax rate vs. marginal tax rate in retirement:

For a young worker who has a very low current income tax rate and pays no or little income tax, Roth is a powerful option. Consider a teenager who works at her first job making a few grand a year. She can put a way all of her earned income up to $5000 in a Roth IRA in 2011 that can grow tax-free. If she makes only 5 annual $5000 contributions and the account grows at annual rate of 8%, her nest egg will grow to  $468,394 over 40 years. So when your teenager pesters you wanting to hang out with you instead of going out with his friends, this would be a great topic of conversation!

Diversification and Maximum Contributions:

Consider a recently empty nested couple who file a joint income tax return. The husband maxes out his retirement contributions through his employer and the wife brings in ‘spending money’ through her voice lessons to students. If they are trying to save extra in a tax investment account, she should consider a uni Roth 401(k) in which she can contribute up to $22,000 with catch up amount if she is over 50 years of age. This will offer a measure of diversification in that their retirement savings are divided among tax deferred accounts as well as a Roth account. It also means that since her contribution is made with after tax dollars, she is putting away more for retirement than she would in a regular retirement account.

 Flexibility:

If you withdraw from regular retirement accounts before 59 ½, this withdrawal will be taxed as regular income (there are a few exceptions) plus an additional 10% penalty on the amount of distribution. With a Roth account, which follows first in first out rule, you can always withdraw your contribution amounts without tax or penalty. If you dip into earnings you may be subject to tax and or penalties.  Another key benefit is that you do not have Required Minimum Distributions from a Roth account the year you turn 70 ½. If you fail to withdraw RMDs from a regular retirement account, the penalty is 50% on the short fall. Thus, you can have a greater flexibility in how much and when you withdraw from you Roth accounts or if you desire to leave the funds to your heirs if not needed. In addition, there is no lower or upper age limit to contribution so long as you have earned income. Even if you work past 70, you can continue to contribute to your Roth account.

If you expect to be in a higher or same income tax bracket in retirement or you desire maximum savings, diversification and flexibility,  a Roth account can be a very powerful tool in retirement planning. If you have further questions on Roth, do not hesitate to contact me at bg@beaconfinancialmgmt.com or 760 473 3335.