The Roth individual retirement account turns 20 this year, and it’s a birthday worth celebrating. The Roth IRA gives investors not only another way to save for retirement but also new strategies for managing withdrawals and taxes in retirement.
Introduced as part of changes in the tax code in 1997 (which went into effect in 1998), Roth IRAs allowed investors to use after-tax dollars to save for retirement, with earnings and withdrawals tax-free after age 59½. That’s different from traditional IRAs, which are funded with pre-tax dollars in exchange for withdrawals that are taxed in retirement.
[Read: Consider the Tax Rate on Your Investments.]
Thanks to the Roth, financial planners can make tax diversification part of a portfolio. “It really changed how we look at retirement,” says Timothy Steffen, director of financial planning at Baird in Milwaukee. In addition to using different asset classes, financial planners also diversify a portfolio based on the tax treatment for where the investments are held: taxable, such as brokerage or savings accounts; tax-deferred, such as 401(k)s, 403(b)s and traditional IRAs; and the tax-free Roth IRA, Steffen says.
An incentive to save. The Roth IRA is named after former U.S. Sen. William Roth, a Republican from Delaware, who wanted Americans to save more for retirement, says Jack Towarnicky, executive director of the Plan Sponsor Council of America.
Traditional IRAs had been around since the 1970s and allowed pre-tax contributions for people who didn’t have an employer plan. But changes in the tax code in the 1980s made traditional IRAs less desirable for investors, he says, and fewer people were using them. From about the 1980s to the 1990s, Congress considered how to reinvigorate retirement savings without adding tax deductions, Towarnicky says.
“One of the challenges is that we really don’t have a true retirement strategy in terms of policy” in this country, he says. “What we have are how the retirement incentives shift within the tax code.”
Other ways Roth IRAs differ from traditional IRAs include income restrictions, with the option to contribute gradually phasing out at $120,000 for single earners before ending at $135,000. For married couples filing taxes jointly, the income limit is $189,000 and phases out completely at $199,000. The Roth doesn’t penalize early withdrawals of contributions and has no required minimum distributions once the owner is age 70½, which financial planners say is a key part of the Roth’s flexibility.
Nevertheless, investors were reluctant to embrace the new savings vehicle 20 years ago.
“When it first came out, it had a little bit of the, ‘it’s too good to be true’ aspect to it, that the government is going to let this money grow and they’re not going to tax me,” says Rich Ramassini, senior vice president at PNC Investments in Pittsburgh. As time passed, he says, people started trusting the Roth more and saw that it had real tangible benefits.
A hedge against changing tax rates. The Roth IRA eventually spawned the Roth 401(k), Towarnicky says, and now about 60 percent of retirement plan sponsors offer it in addition to a traditional 401(k).
[See: 11 Steps to Make a Million With Your 401(k).]
Steffen says Roth IRAs may still be slightly underused by investors because the lure of a tax break today often overrides the desire for tax-free withdrawals in the future. That instant gratification is a compelling argument against the Roth, he says. “Why wait 30 or 40 years for this tax break? Why can’t I get it right now?”
Experts recommend Roth IRAs for younger investors who are more likely to be in a lower tax bracket early in their careers, making the traditional IRA’s tax break less advantageous. Roths are generally best for investors who expect to pay higher taxes in retirement.
Although Congress recently lowered tax rates for individuals last year, those reductions aren’t permanent and are scheduled to sunset after 2025 unless Congress intervenes. “It’s reasonable to think that the next big move on tax rates would probably be an increase,” Steffen says. “If that increase happens when you’re taking money out of a plan, then the Roth becomes more valuable to you.”
Top marginal tax rates have been a moving target before and in 1986 fell to 28 percent from 50 percent. In 2018, the top marginal rate is 37 percent. “Our history is that those marginal rates can and do change,” he says.
Of course, income limits can prevent higher earners from contributing to a Roth IRA, but they can put money into Roths by converting traditional IRAs, says Neil Krishnaswamy, a certified financial planner at Exencial Wealth Advisors in Frisco, Texas. Depending on when the conversions occur, they can give investors more flexibility in retirement, although the standard penalties and taxes can apply. Converted funds are taxed as ordinary income the year the conversion takes place, and if an investor is younger than 59½, the money could be subject to a 10 percent penalty depending on how the taxes are paid. Using money from an IRA to pay the tax is considered an early withdrawal. To avoid the penalty, investors must use savings outside of a retirement account to pay the tax.
Krishnaswamy believes Roth IRAs should be part of an investor’s plan, especially because they have no required minimum distributions, unlike traditional IRAs and traditional 401(k)s. Those traditional options are still relevant, too. With the demise of pension plans and the need for people to take control of their retirement, any vehicle for retirement savings becomes important, Ramassini says.
[See: 7 Things That Can Derail Your Retirement Investing.]
The Roth IRA just gives retirees more options for managing withdrawals and limiting their taxes. “You could control which bucket or pot of money you want to pull from, whether it’s the taxable or the tax-free bucket,” he says. The beauty of the Roth is that by letting you control your income, you have more control over your tax liability, too.
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Happy 20th Birthday, Roth IRA originally appeared on usnews.com
