The Roth IRA: Trick or Treat?

With Halloween just a day away, I thought it would be fun to get into the holiday spirit (or is it spirits?) by answering a question I frequently get asked by my young physician and young married clients: should I start a Roth IRA?

Unfortunately, just like Halloween costumes, there’s no “one-size-fits-all” answer.

To determine whether or not a Roth IRA is for you, the main question that you need to answer is, “will my income tax bracket be higher now or in retirement?” If it is projected to be higher in retirement, then a Roth IRA will probably be an ideal retirement account for you.

To understand why this is true, I present you with a simple Trick-or-Treat analogy. 

If you’re anything like me, when you were a kid you probably spent a good three or four hours on Halloween night trucking it from one house to the next until your legs went numb, all in a quest to have enough candy to last until at least Thanksgiving. Every year, once I had completed my candy-filled marathon, despite being completely exhausted, I would race home and dump out my treats on my bedroom floor and count them one-by-one.

Unfortunately – and I would always forget about this – waiting for me at home was the most intimidating creature I would see that night: Mom, the candy-snatcher.

Now mom wasn’t there to steal my candy for her enjoyment (although I’m sure she found a way take a little bit of “mom tax” here and there). No.  My mom was mainly concerned about my well-being, and would sift through each and every one of my candies before I could devour them, to make sure they were safe to eat.  And without fail, every year, a handful of my treats would be thrown into the trash – a necessary loss to be able to enjoy my overall gain.

And this is exactly how a Roth IRA works. Roth IRA contributions are taxed before they go into your account.  Uncle Sam confiscates a portion of your contribution before you can invest and let it grow. The benefit is, these contributions and all their future earnings never get taxed again. 

Yes, you read that right: The contributions AND ALL THEIR FUTURE EARNINGS never get taxed again.

It’s just like my trick-or-treating experience. Mom confiscated my “questionable” treats, before I could touch them. All the candies that were left over though, were Grade-A, mother-approved treats that would satisfy my sweet tooth but not sour my stomach (unless I ate too many, which unfortunately always happened that first night).

The sacrifice I had to make up front was well worth the long-term benefit! The same is true for a Roth IRA.

 

The trouble is, how do you go about determining whether your income will be higher in retirement or lower (and accordingly, whether or not a Roth IRA is right for you)?  Here are a few questions/thoughts to consider:

1)   What tax bracket are you in now?

a.    If you’re in the 15% tax bracket or lower, you should fund a Roth IRA because chances are this is the lowest tax bracket you will ever find yourself in. You probably fit in the 15% bracket if your gross income is $50,000 or less as a single filer or $100,000 or less as married filing jointly.

b.    If you’re in the 25% tax bracket, maybe fund a Roth IRA.  This is always the gray zone.  Your tax bracket may or may not be higher in retirement.  You probably fit in the 25% bracket if your gross income is between $50,000 and $100,000 as a single filer or between $100,000 and $180,000 as married filing jointly.

c.     If you’re in the 28% tax bracket or higher, don’t fund a Roth IRA. You probably don’t qualify to make a direct contribution anyways.  However, if you have maxed out all your tax-deferred options, it makes sense to make a back-door contribution to a Roth IRA, versus using a taxable brokerage account or variable annuity.

d.    Remember, the above are generalizations that ring true most of the time. Nothing is guaranteed and can only be appropriated projected and analyzed with your particular situation in mind.

 

2)   Are federal income tax rates going to go up in the future?

It’s highly probable.

Just compare the trend of our marginal income tax rates to the federal debt owed per person.  You start to realize that the path we are on is unsustainable.  We can make as many cuts in expenditures as we want, but sooner or later, we’re going to have to raise taxes to pay for all we’ve spent and plan to spend in the future.

If future tax rates are going up, that is another compelling argument in favor of using a Roth IRA.  Why put it to chance how much income tax rates will go up in the future? As the old saying goes, “one in the hand is worth two in the bush.”

 

3)   If you are in a high income tax bracket (most physicians and married couples with two incomes), even though it probably makes sense to make all your retirement contributions to tax-deferred accounts, you will be eliminating all tax flexibility in retirement if you do so.

For example, if you find yourself in a year where you’d like to take a couple long trips to Europe or somewhere else exotic, you might need an extra $50,000 of spending money that year.  If you are pulling from your tax-deferred retirement accounts like a traditional IRA, you might have to withdrawal anywhere between $70,000 and $90,000, to be left with $50,000 after income taxes are withheld. That could push you into the next tax bracket, which would be a negative event. 

Contrast that with someone who funded a Roth throughout their career, despite being in a high tax bracket.  When that unusually high spending year in retirement comes along, they can just withdrawal the exact amount ($50,000) from their Roth, because it won’t be taxed.  Thus, they aren’t pushed into a higher bracket and taxed an exorbitant amount. Another win for the Roth IRA holder.

 

So consider these ideas when determining whether or not a Roth IRA is the right retirement account for you. And remember to always take advantage of the match in your employer-provided retirement plan before you fund a Roth IRA. Because that’s basically free money.

 

Happy Halloween everyone!