Pretend for a minute and think of yourself in the future where you don’t rely on a paycheck from a job, you have a nice nest egg built up, and you are retired. All is great until you begin taking distributions from your IRA, 401k or any other pre-tax retirement plan you have. Even though you see the amount your account has grown to, it really isn’t all yours. You are in a partnership with the federal government, and they want their cut of your account. To make matters even worse, when you turn 70 ½ you MUST take distributions from your pre-tax retirement accounts. This is what is referred to as the required minimum distribution, or RMD. Why is this such as big deal? Well, what if your required minimum distribution is more than you need for income? Then you pay more tax than you need to. What if the required minimum distribution puts you into a higher tax bracket? Now you really have more issues than you wanted. At this point, you’ll be asking yourself, “Why didn’t I put some of my money into a Roth, so I can better control these distributions”?
Now, back to reality where you still have time to plan for these financial events that will happen in the future. Are you contributing to a Roth IRA? How familiar are you with a Roth IRA? Is a Roth IRA even right for you? Determining whether you should be contributing to a Roth IRA takes planning and if you think taxes will be higher in the future, that’s another reason to take a good look at a Roth IRA in your financial plan.
I’m going to take you through a simple scenario that will show you how a Roth could solve some tax problems, starting now and into retirement.
Let’s take two people both 25 years of age, we will call them Marv and Harry. (Yes, that’s a ‘Home Alone’ movie reference, since it’s getting closer to Christmas). Marv and Harry both start contributing $5500 per year and both are in the 22% tax bracket. (We will keep the $5500 contributions and 22% tax bracket throughout the example for simplicity). Marv wants to maximize his tax deductions today, so he stuffs money into a Traditional IRA. Harry, on the other hand, feels like taxes will be higher in the future and is planning for retirement tax consequences, so he contributes to a Roth IRA.
Fast-forward 20 years down the road. Both Marv and Harry have been making their $5500 contributions on an annual basis while earning 7% per year on their investments. Both accounts have grown to $241,258. By contributing to a Traditional IRA, Marv has received a tax deduction of $1,210/year and over the course of 20 years he saved $24,200 in taxes. On the flip side, Harry didn’t get a tax deduction for his Roth IRA and he paid the $24,200 in taxes over those 20 years.
Marv and Harry no longer want to continue contributions to their retirement accounts. The accounts continue to grow at 7% per year for another 25 years. Each account now has a value of $1,309,411. However, Marv is still in a partnership with the federal government, so that full amount isn’t his. Harry, by making Roth contributions owns every penny of his account.
Since they have reached age 70 ½, Marv must begin taking required minimum distributions from his account, but Harry does not because Roth IRA’s do not have required minimum distribution rules. After calculating the RMD’s for Marv’s account, by age 75 he would have paid just over $56,000 in taxes, and well over $100,000 in taxes after age 80. Remember, Harry paid only $24,200 in taxes and can take the income as needed, TAX FREE! If Marv has other sources of income, he still must take his RMD’s whether he needs the income or not. Possibly pushing him into a higher tax bracket, in which the amount of taxes paid will be even higher!
Next time you think about your financial plan and taxes in the future, learn how a Roth IRA might help. A Roth can be a useful tool for saving and tax planning your retirement. Look at the possibility of using a combination of pre-tax (IRA, 401k, 403b, etc.) and Roth contributions as well. Keep in mind, Roth IRA’s have income limits . If you no longer can contribute to a Roth, there are other ways to get money into a Roth IRA, such as backdoor Roth’s or a Roth conversion. We will save those topics for another day. If you need help using a Roth to plan your financial future, we are here.
For 2018: The Traditional and Roth Limits are $5,500 and $6,500 if you are age 50 or older
For 2019: The Traditional and Roth Limits are $6,000 and $7,000 if you are age 50 or older