Taxpayers have until April 15th to add to their Roth IRAs for 2014. Although this investment seems to appeal to mostly younger investors, it could also be a good choice for some more “seasoned” ones as well. I’m passing along an useful article about the subject:
This is shared with permission from T.R. Price.
January 23, 2015
Stuart Ritter, CFP®, is a senior financial planner with T. Rowe Price. Stuart Ritter, CFP®, is a senior financial planner with T. Rowe Price.
The Advantages of Roth IRAs
Roth IRAs are generally more effective retirement savings vehicles than Traditional IRAs.
Millennials are choosing Roth IRAs over Traditional IRAs by a wide margin when it comes to saving for retirement. In fact, investors under 34 years of age have over eight times more money in Roth IRAs than in Traditional IRAs, according to recent T. Rowe Price customer data.1
Why is this group choosing to forgo the tax deduction they would receive from contributing to a Traditional IRA? The answer: tax-free retirement withdrawals. “Even though the Roth IRA contribution doesn’t qualify for an income tax deduction, decades of compounding tax-free money can generate more spendable income in retirement,” says T. Rowe Price senior financial planner Stuart Ritter.
A Roth is often the better option
Younger investors stand to benefit most from the tax advantages of Roth IRAs because of the longer time horizon for their contributions to compound tax-free. Additionally, younger investors may be in a lower tax bracket today than when they retire. This means the income taxes they pay on their Roth IRA contributions are taxed at a lower rate today than they would pay when they withdraw them in the future.
“It’s great that so many young investors are selecting the Roth IRA,” Ritter says. “While the benefits of Roth IRAs are more pronounced for millennials, our research shows the majority of investors would still be better off using a Roth IRA than a Traditional IRA.” Indeed, T. Rowe Price customers in their 40s have almost twice as much money in Roth IRAs than they have in Traditional IRAs. A preference for Traditional IRAs emerges only when looking at investors over age 50-this despite the fact that contributing to a Roth still makes sense for most investors in their 60s (see Spendable Income in Retirement chart).
Ritter conducted a comparison of spendable income in retirement for an investor who used a Roth IRA and an investor who used a Traditional IRA. His study made a few assumptions about both investors, namely that they:
retired at age 65 and their retirement lasts for 30 years
depleted the account over the 30-year period2
made a one-time contribution of $1,000 to their respective IRAs
were in the 25% tax bracket when they made their contributions
earned an annualized 7% return on their IRA accounts leading up to retirement, then 6% after retirement
Additionally, the study assumed the $250 tax deduction from the Traditional IRA was invested in a separate taxable account, which also earned 7% per year prior to retirement and 6% during retirement. Taxes, based on a 25% tax bracket, were subtracted annually from the taxable account and similarly reduced the income stream in retirement.
In this analysis, a 25-year old who used a Roth IRA and stayed in the same tax bracket in retirement would have nearly 20% more spendable income in retirement than an investor who selected a Traditional IRA instead. In fact, the Roth IRA produced more spendable retirement income in most of the scenarios analyzed, with the exception of an investor over 55 years of age whose tax bracket drops by at least 7% or an investor over 65 years of age whose tax rate drops 5% or more.
“A significant drop in tax rates between when the investor made her IRA contribution and began retirement withdrawals can often be offset by the power of tax-free compounding,” Ritter says. “But for investors nearing retirement, there isn’t enough time for the money to compound at a rate to counter the significant reduction in their tax bracket during retirement.”
Additional Roth benefits
There are other benefits to Roth IRAs beyond the ability to maximize income:
Flexibility when saving. While it’s best to leave IRAs untouched until retirement, investors can generally withdraw their contributions to a Roth IRA at any time without taxes or penalties. However, any contributions withdrawn from a Traditional IRA would be subject to a 10% penalty if they’re taken before age 59½, with some exceptions, and are always subject to income taxes.
Flexibility when retired. Roth IRAs enable retirees to withdraw large sums of money, whether for a medical expense or home repair, without worrying about potential tax consequences. Large withdrawals from a Traditional IRA are taxed as regular income, however, and could move the retiree into a higher tax bracket, increase Medicare premiums, subject more Social Security benefits to taxation, and have other effects. Additionally, Roth IRAs are not subject to the required minimum distributions that Traditional IRAs are.
“The benefits of tomorrow’s tax-free retirement withdrawals3 with a Roth IRA outweigh the benefits of today’s tax deduction,” Ritter says. “This is true for most age groups, and the Roth IRA could generate more spendable income even for an investor who made contributions at age 65.”
Spendable Income in Retirement: Roth versus Traditional IRAs
For people in a variety of age groups, saving $1,000 in a Roth IRA can offer more spendable income in retirement than saving the same amount in a Traditional IRA. The reason: Tax-free withdrawals in retirement offer a greater benefit than a tax deduction today.