This is a question I’m asked nearly everyday. I think it’s great that people are becoming more knowledgeable on their investment options. However, I have no clue where the idea that investing in a Roth IRA became “THE GREATEST INVESTMENT EVER.” It’s a much more complicated question than a simple yes or no, and I see many in the financial arena throwing out a blanket statement that everyone should invest in a Roth. That may be great to draw people to your website, but as far as providing true, personalized advice I think it falls very short. So, in response I’m going to detail the origins of the Roth IRA and who it is and isn’t made for.
Let’s do it!
So, lets start at the base. I’m constantly speaking on building a solid foundation, and the foundation for understanding whether you should do something typically starts with having knowledge on what that thing is, and how it began.
A long, long time ago in 1997 (okay, not that long ago but in the internet age 1997 might as well be a century ago) the Roth IRA was birthed as part of the Taxpayer Relief Act of 1997. The name of the act that introduced the Roth should be nearly enough to tell you what it’s purpose is, to provide tax relief.
The name is in honor of its chief legislative sponsor, William Roth from Delaware. You can see this good looking guy right here:
That’s the face of a guy looking to help taxpayers
Mr. Roth sought to provide relief for those under a certain income threshold ($191,000 for married filing jointly in 2015) by allowing those who save to contribute after-tax income to an IRA and then withdraw the income from the Roth IRA later tax-free.
Basically, this means that any interest earned by the Roth IRA is effectively TAX-FREE.
People love the words tax free!
So, now that you have a general idea of what the Roth IRA is, let’s look at a few of the main advantages and disadvantages of the Roth IRA vs. Traditional IRA.
- Interest Earned by the Roth IRA is effectively tax-free
- Direct contributions to a Roth IRA (principal) may be withdrawn tax and penalty free at any time.
- If you decide purchase a new home, and it is your principal residence, Up to a lifetime maximum $10,000 in earnings withdrawals are considered qualified, also known as those lovely words tax-free.
- Unlike distributions from a regular IRA, qualified Roth distributions do not affect the calculaiton of taxable social security benefits. This calculation is known as the Provisional Income Threshold and determines how much of up to 85% of your social security income will be taxed. In other words, it’s a big advantage for the long term thinker.
- If you make too much, you may not be able to contribute to the Roth IRA due to income limitations. Now, most tax deductible employer sponsored retirement plans have no income limit for contributions.
- You may never actually experience the tax benefits of the Roth IRA. I.e. if you pass away before retirement.
- The Government is constantly changing it’s mind. Therefore, congress could change the rules that allow for tax free withdrawal of Roth IRA contributions. You never really know.
So to get down to brass tacks let’s give examples of who may benefit from the Roth IRA, and who would not.
John and Jane Doe (That’s actually my Wife and I but shhhh…)
Both are 30 years old.
Their combined income is $80,000 and they plan on working till their 60 years old.
They have enough cash reserves to reside on without working for many years.
They’ve maxed out their contribution limits at work and are looking for an investment to put some money away on the side.
They decide on a Roth IRA because…
- They plan on withdrawing the contributions sometime in their 50’s to build a home.
- They are going to wait more than 5 years to withdrawal from the Roth.
- They are under the income contributions.
- They are already maxing out their contribution limits at their workplace.
- They are relatively young and have a long time horizon.
- They don’t want to be forced to withdrawal an RMD at 70 1/2.
In this example based on the facts presented, a Roth IRA may certainly be a great investment.
Now lets look at a couple who may not benefit from a Roth IRA.
Sam and Susan Sassafras
Both are 60 years old
Make a combined income of $500,000
Both plan on working only 1 more year.
They are not contributing to their employer sponsored plans where they receive a hefty match.
Have only a small amount of money in their cash reserves.
Plan on making withdraws starting in 2 years.
They should forgo the Roth IRA because:
- They plan on withdrawing in 2 years, which is before the 5 year seasoning period is complete.
- They aren’t contributing to their employer sponsored plans.
- They plan on retiring soon.
- Finally, they wouldn’t even be allowed to contribute because they are over the income limitations.
So, is the Roth IRA “The Greatest Investment Ever.”
It depends who it’s for, and what the goals are.
These are the reasons Advisors are in place to help you look at the whole picture and making a decision.
Deciding to invest in something simply because some guy on YouTube told you to is not an investment strategy I would suggest.
There are many advantages and some disadvantages to the Roth IRA just like anything else in this world. Seek knowledge on the issue, meet with an expert, and figure out if it’s right for you.