Why are Roth IRAs (and 401ks, if your employer offers them) sometimes a smart choice?
They offer a unique benefit – your money is tax-free in retirement. You contribute to your Roth account with funds that you’ve already paid income taxes on, and then you never have to think about taxes again.
In contrast, in traditional IRAs and 401ks, you pay no tax on your contributions (i.e., you take a “deduction” in the year of the contribution) and then you don’t pay tax until you withdraw the funds in retirement. (Want to look at your existing retirement accounts while you read? Link them to your Personal Capital Dashboard
to be able to view them all in one place).
The Main Reason to go Roth: You Expecting a Higher Tax Rate in Retirement
For many investors, the question to go Roth boils down to whether you expect your tax rate to increase in retirement. If you do, you have an arbitrage opportunity – all things equal, you grow more wealth by paying your taxes now instead of later. If you’re very early in your career, it’s likely your taxes will be higher in retirement. If you’re closer to retirement and plan to live off a similar income, your tax rate may still be higher if some of your deductions – like interest payments for your mortgage – disappear.
Another Reason to Go Roth? Flexibility.
You can generally remove money from a Roth without penalty (be careful – there are exceptions to this rule, and you can only remove contributions, not earnings or growth). Roth IRAs are also not subject to the same Required Minimum Distribution (“RMD”) rules. For traditional requirement accounts, once you hit 70 ½, if your account has an RMD, you need to withdraw a specified minimum amount or face paying a 50% penalty. With Roth IRAs, on the other hand, you withdraw funds on your own schedule. It’s only when you pass along your account to your heirs (tax-free!) that RMDs kick in.
So, Why Don’t More People Go Roth?
Only about 17%
of American households have a Roth IRA, compared to the 33% with a traditional IRA. For Roth 401ks, these figures are lower; less than 9% of people who with employer-sponsored Roth 401ks use it, according to a National Bureau of Economic Research (“NBER”) study. But those low figures might be because Roths are relatively new. Roth IRAs first came to be in 1997, and Roth 401ks have only been available since 2006.
So What Are Your Next Steps?
If you think a Roth might be right for you, here’s a list of tips and questions to help think about your retirement picture.
For your 401k plan:
What are the investment options in your 401k? And when’s the last time you brushed up on them? Try our Personal Capital ⦁ Investment Checkup
tool to see if those investments are right for you.
⦁ Have you maxed out your 401k? If you’re able to contribute more to your 401k, consider doing so. Because of the employer match, it’s generally the most attractive for your savings. If you haven’t maxed out your contributions this year, you may have until your tax return deadline to set up and make contributions for the previous tax year.
⦁ Is the Roth option available? If so, it’s time to think about whether a Roth makes sense.
For your IRAs:
⦁ Don’t have an IRA yet? Time to consider your current and future tax situation to see whether Roth or IRA is right for you. If you have no idea, it might be worth consulting a tax professional. Or if you expect the brackets to be close, “tax diversifying” is a way to avoid guessing by putting some money in a Roth and some in a traditional.
Are already in a traditional IRA? You might consider ⦁ converting your traditional IRA to a Roth
if you expect your income to rise or are concerned about tax rates increasing. However such conversions warrant some strategic planning since they can incur a hefty, one-time tax bill.
Have further questions or want some professional advice? That’s what your Personal Capital advisor is there for. For Personal Capital users, log into your account
and select the Advisor or Investing tab to schedule an appointment to speak to an expert.
Disclaimer: Personal Capital Advisors is an SEC registered investment advisor. Any reference to the advisory services refers to Personal Capital Advisors. SEC Registration does not imply a certain level of skill or training. This communication and all data are for informational and educational purposes only.. You should not rely on this information as the primary basis of your investment, financial, or tax planning decisions. You should consult your legal or tax professional regarding your specific situation. Third party data is obtained from sources believed to be reliable. However, PCAC cannot guarantee that data's currency, accuracy, timeliness, completeness or fitness for any particular purpose. Past performance is not a guarantee of future return, nor is it necessarily indicative of future performance. Keep in mind investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.
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