When it comes to saving for retirement, smart investors often choose Roth IRAs over traditional IRAs. That’s according to a 2012 study from Texas Tech University, which revealed that people with high IQs were most likely to own a Roth IRA, regardless of their education, income or net worth.
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).
Expecting a Higher Tax Rate in Retirement? It’s the Main Reason to go Roth.
Both Roth and traditional IRAs have tax advantages. So why go Roth?
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 going Roth and paying your taxes now instead of later. (NB: If you do the math, you’ll note that if your tax bracket does not change between now and retirement, there may be little difference in a Roth versus a traditional account. The main difference is paying your taxes now or later).
So how do you know if your tax bracket will change? Unfortunately, you don’t. The government could increase or decrease taxes. Or, you could be making a lot more or less in retirement then you imagine.
But you can make some educated guesses: if you’re 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.
Is There Any Other Reason to Go Roth? Yes – More Flexibility.
Another key Roth feature is flexibility. Unlike a traditional retirement account, 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).
Second, Roth IRAs are not subject to the same Required Minimum Distribution (“RMD”) rules as traditional requirement accounts. In plainspeak, 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?
When you look at the figures, 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.
Here are a few potential reasons:
- Roths have limitations on eligibility. As shown in the chart below, Roth IRAs have income limits (NB: these limits don’t exist for Roth 401ks)
- Roths are relatively new. Roth IRAs first came to be in 1997, and Roth 401ks have only been available since 2006.
- Individual investors can fall victim to inertia. The NBER study referenced is great example of inertia among 401k participants in Roth decision-making.
So What Are Your Next Steps?
We believe that the reason for the Texas Tech study finding that “smart people” choose Roths more is because asking more questions about your financial life will lead you to consider the Roth option (not because they’re right for everyone!). Here’s a list of questions that can help you lead a more examined financial life.
For your 401k plan:
- Are you currently participating in your employer’s 401k? Refresh on the plan’s details if you are – or start contributing if you aren’t.
- Does your company offer a “match” program? Make sure your contributing enough to earn all the free money your employer is offering.
- Is the Roth option available? If so, it’s time to think about whether a Roth makes sense.
- 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.
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.
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