How a Roth IRA Could Make You Rich
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For more than 10 years, a unique investment vehicle has given some people the chance to accumulate huge amounts of wealth. But until January of this year, many others didn’t have access to what may prove to be the most important investing tool you’ll ever find.
That tool is the Roth IRA, and although the name suggests that the Roth is primarily a method to invest for your retirement, it is flexible enough to serve a number of other purposes as well. From giving you a way to save for shorter-term goals to protecting your assets for future generations to come, the Roth IRA is so valuable that you won’t want to miss out on the chance to use it in your own financial planning.
Let’s take a closer look at exactly what the Roth can do for you — and why it’s getting so much attention right now.
What makes Roths great
Right now, it’s hard to remember when financial innovation didn’t automatically conjure up feelings of skepticism and distrust. But back in the late 1990s, when the Roth IRA was first created, it ushered in a new way to think about saving for retirement.
Until then, retirement investing was all about tax deferral. Traditional IRAs and 401(k) plans allowed savers to set money aside for the future, giving many of them a current tax break on their contributions. In other words, the government essentially paid you back for part of what you put into a retirement account in the form of a tax deduction. Depending on your tax bracket, that deduction could be extremely valuable as a current benefit, irrespective of whether saving for retirement was your primary goal.
The trade-off, though, was that when you actually used the money, you had to pay taxes on what you took out. From one perspective, then, the U.S. government shared in your investment gains and losses. If your IRA skyrocketed in value, then the IRS would collect more tax. Just look at some of these examples:
|
If You Invested $2,000 in an IRA 20 Years Ago in This Stock |
It’s Now Worth This Much |
And the IRS Could Collect up to This Much in Taxes |
|---|---|---|
|
Microsoft |
$117,231 |
$41,031 |
|
Home Depot |
$37,090 |
$12,981 |
|
United Technologies |
$31,266 |
$10,943 |
|
ConocoPhillips |
$15,564 |
$5,441 |
|
Apple |
$47,948 |
$16,782 |
|
Nordstrom |
$10,129 |
$3,545 |
|
Amgen |
$101,018 |
$35,356 |
Source: Yahoo! Finance. Assumes taxpayer is in top current tax bracket of 35%. Prices from January 1990 to January 2010.
Those tax figures represent a darn good return for the U.S. Treasury, especially when you consider that the upfront deduction on the original $2,000 only cost them $660 or less in tax revenue.
The Roth IRA turned that logic on its end. Rather than giving you a current incentive to save, the Roth pushed the incentive far into the future by making all the growth within your account tax-free. And if you decide to convert an existing traditional IRA into a Roth, then it’s even more obvious that the Roth is a different animal than traditional retirement accounts — because you have to pay tax on the amount you convert.
Opening the door
Until now, though, many investors have been locked out of the Roth IRA. Income limitations prevent many high-income investors from using a Roth IRA, either through annual contributions or by converting existing IRAs to Roths.
Now, though, those income limits on Roth conversions have disappeared. And although high-income earners may still not be able to make their $5,000 annual contribution to a Roth, anyone who has a traditional IRA can choose to convert now.
So the big thing that everyone’s asking right now is this: Should you convert to a Roth?
For the answer to this question, read our story Understanding Roth IRA Conversions.
This article was originally published as The Roth: An Amazing Opportunity on Fool.com
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7 Comments so far
leave a commentSigh. Sometimes the articles on the Mint blog make me cringe.
The article conveys the impression that a Roth IRA is a huge tax advantage for every investor, but totally misses the point that Traditional and Roth IRAs grow in exactly the same way: exponentially.
The same amount of money invested at the same tax rate will yield the same after-tax growth whether you pay the taxes up front or you pay when you withdraw.
The real question for the individual is to assess how your tax situation now will compare to your retirement. Will your tax rate be higher right now or when you are 65? Take into account what your annual income will be at age 65 and whether tax rates as a whole will move up or down between now and then.
“Rather than giving you a current incentive to save, the Roth pushed the incentive far into the future by making all the growth within your account tax-free.”
Traditional and Roth IRAs *BOTH* give you a current incentive to save. They wouldn’t be effective retirement programs if they didn’t. The incentive is that you don’t get double taxed: pay income tax now and then pay capital gains tax later.
These two types of IRA offer you a good trade off: do you want to pay income tax and get free capital gains, or vice-versa?
Again, the precise answer to this question is unknown due to the uncertainty of the future and the unique situation of each individual, but the best answer is that you probably want some of your money in both types of IRA to give you tax flexibility when you begin to withdraw.
I’m personally more heavily allocated towards the Roth because I anticipate my income will rise as I get older, and I also don’t expect prevailing tax rates to ever drop below current levels. But I also put some money in the traditional as a bit of a hedge.
Oops, meant to say, “The same amount of money invested at the same RATE OF RETURN will yield the same after-tax growth whether you pay the taxes up front or you pay when you withdraw.”
Mark, am I not understanding the difference between the IRAs?
Roth IRA – put $1000 in and get taxed on it. I do not pay tax on what I withdraw later.
Traditional IRA – put $1000 in, tax free. Then get taxed not only on that thousand when I withdraw, but also on the rest of my money.
* Of course this is the simplified version of each.
Now, even if I am in a lower tax bracket when I withdraw from my traditional IRA, I will no doubt pay more in taxes because I will have accumulated a lot more money. As a result, given that I am much more likely to be in a higher tax bracket and have a lot more money when I withdraw, the Roth IRA is the obvious choice.
If I am understanding what you are saying correctly, the only thing to consider is whether I believe I will be in a higher or lower tax bracket compared to where I am when I initially invest my money.
Please help me understand better,
– Joe
Joe, let’s assume there’s a flat tax of 25% with no tax brackets.
If you have $1000 pre-tax, you can get a $750 Roth or a $1000 Traditional.
If you buy $1 shares now and they are worth $10 when you retire you will have $7500 tax free dollars in your Roth or $10000 taxed at %25 for $7500 in your Traditional.
So only the tax rate matters.
Joe, the difference is that $1000 in pre-tax dollars is different from $1000 in after-tax dollars.
Let’s say you want to open a retirement account today and put in as much money as you can afford right this second. How much can you afford? It depends whether we’re talking about pre-tax or after-tax dollars. If you can afford to part with $1000 in after-tax dollars and you’re in the 25 percent tax bracket, that’s the equivalent of $1250 pre-tax dollars. The overall hit to your wallet is the same.
So, for your, putting $1000 in a Roth IRA is the same as putting $1250 in a traditional IRA. You have the same amount of money left in your wallet, no matter which transaction you pick. If you stay in that same tax bracket, when you pull out that money at retirement, Uncle Sam will take 25% of the traditional IRA and zilch from the Roth IRA. They’ll come out exactly the same.
If you’re in a higher tax bracket at retirement, the Roth IRA wins. If you’re in a lower tax bracket, the traditional IRA wins. Mark is correct. Now, Roth and traditional IRAs are different in other ways. But Mark is right about the tax implications.
Er, my basic point is right, but my math stinks. Listen to Doug! ($1250 in a traditional IRA is equivalent to $937.50 in a Roth, not $1000, in the 25% tax bracket. DUH.)
Doug and Matthew – Thanks!