Roth IRAs are great for some, but some don’t appreciate the benefits.
Q: Everyone talks about what a great product the Roth IRA is. But my belief is one is contributing after-tax money. That means you’re likely paying at least 40 percent in state and federal taxes on the cash.
Imagine if you didn’t pay that tax upfront? How much money would that additional 40 percent make over the life of the IRA? And then, when you take out the cash, all you pay is 18 percent.
So why does everyone love a Roth IRA, and is there a computer program that will calculate the benefits of putting more money away pre-tax rather than less money after-tax?
A: Here are a whole bunch of reasons why we like Roth IRAs:
First, you don’t know what the level of taxation will be in the future. Instead of paying 40 percent today, you might pay 50 or 55 percent in the future. A lot of that will depend on where our federal deficit is and whether we can get out of our economic malaise in this country. By putting cash away now in a Roth IRA, you lock in a fixed amount of tax. And, your money grows tax-free forever.
The next reason I really like Roth IRAs, is that if you decide to buy a first home or to construct your first home and if you have had your Roth IRA for five years, you can tap into your Roth IRA to the tune of up to $10,000 without paying any taxes (you’ve already paid them on this money when you contributed to the Roth IRA) and without a penalty even for earnings you have obtained while your money was invested.
Beyond that, Roth IRAs give you options about how you decide to spend money in the future. Twenty years from now, you might not want to pay taxes on every dollar you pull out. You might prefer to have some after-tax cash that allows you to weather a bad year in the stock market or make an investment you might not otherwise have cash for.
And, you can use the money penalty-free to pay for college tuition or medical expenses before you turn 59 ½. If you are blessed enough to have more cash to invest after maxing out your 401k, a Roth IRA or even a Roth 401k (if your company offers that) are great ways to go.
There are also some excellent inheritance benefits – your heirs with have more options with the money than with a traditional IRA.
If you don’t have a 401k option at work, maxing out a Roth IRA will at least give you the opportunity to salt away $5,000 ($6,000 after age 50).
I could go on, but I think that this gives you an understanding of why we think Roth IRAs have different, and for some people, better potential. For more details, please see IRS publication 590, Individual Retirement Arrangements.