E*TRADE Seminar #6: “Roth IRAs: Beyond the Basics”

This seminar is perhaps the one that I looked forward to the most today.

Defined contribution plans, like Roth IRAs, are how people will retire in the future. If you are younger than, say, 48, you shouldn’t rely on Social Security, and you should control your retirement goals using defined contribution plans.

Here is a summary of parts of the presentation. I summarize the basics of Roth IRAs and the appeal for it. The presenter also went over unique tax consideration and how conversions work; I will not summarize these topics.

The Basics

Roth IRAs have grown in popularity over the last several years. Based on Vanguard’s data from its accounts, about $2 out of every $3 contributed are to Roth IRAs. The other $1 is contributed to traditional IRAs, of course.

Contributions to a traditional IRA are tax deductible. You will be taxed at retirement when you withdraw funds from a traditional IRA. Contributions to a Roth IRA, on the other hand, are made with after-tax dollars. Withdrawals at retirement are not taxed, since you’ve already paid the taxes.

That is the key difference between the two and is the cause of the biggest dilemma for investors. Which do you pick? Do you want to pay your taxes now or do you want to wait until later?

Some other differences include:

  • You can contribute to a Roth IRA at any age. With a traditional IRA, you cannot contribute after age 70 1/2.
  • There is no lifetime required minimum distributions with a Roth IRA. That is, you’re not told when to start withdrawing your money. With a traditional IRA, you must begin withdrawing at age 70 1/2.
  • Your contributions to (but not your earnings from) a Roth IRA can be withdrawn at any time without penalty. With a traditional IRA, you will be penalized if you withdraw your contributions before age 59 1/2.

The Appeal

The presenter asked the question before, but finally answers it: “Which (the traditional or the Roth) do you pick?” The rule of thumb is this: Compared to the tax bracket you’re in now, consider a Roth IRA if you think you’ll be in the same or a higher tax bracket at retirement.

But here are two other reasons to consider a Roth IRA regardless of your tax brackets now and in the future.

One: If you contribute to a tax deductible retirement savings account, like a 401(k) plan, you get tax diversification by also using a Roth IRA.

Perhaps, you don’t want to guess what you tax bracket will be in the future, or you are unsure how the government will change tax laws, Tax diversification helps because you are putting some of your savings into tax deductible accounts and some into after-tax accounts.

Two: You can technically save more in a Roth IRA than a traditional. Since it’s after-tax contributions, $5,500 (the contribution limit for 2014) into a Roth IRA is more than a $5,500 tax deductible contribution into a traditional IRA.

To think about it another way: Suppose you contribute the max limit to a Roth IRA yearly for several years, and your friend contributes the max to a traditional IRAs for the same amount of years. You both invest in the same mutual funds. At retirement, you both have $1,000,000. Well, your Roth IRA doesn’t get taxed, and his traditional IRA does.

The counterargument: You are using more of your money to contribute to a Roth IRA. So, your friend (who has a traditional IRA) could invest the difference (his tax deduction) and be as well of as you.

My response: Really? Will you really contribute the tax deduction? And if so, where else will you contribute it to get the same tax advantages?

My Thoughts About This Seminar

My general thoughts are in line with the summaries above. I personally use a Roth IRA, and here are my reasons:

  • I believe that I will be in a higher tax bracket when I get older. I am relatively young now, so I fully expect my income to grow over the years.
  • I have a hard time convincing others, but I really am contributing more to a Roth IRA since it’s after-tax money.
  • Do you really think that the government will lower the tax brackets? Changes will be made to keep up with inflation, but I sincerely doubt we will get taxed less in the future.
  • I have a 401(k) at work, so I’m tax diversified,

As always, personal finance is personal and about being intentional. If you have strong gut feelings for a traditional IRA, then use it! If you are being intentional about how you invest and what you invest in, then who cares about a few tax dollars here and there. The key thing is that you are doing something!

I like Roth IRAs, and I recommend everyone use them. But if you decide to use a traditional IRA, I am okay with that as well!


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