Wall Street Steward Blog

Drop It While It's Hot

A friend of mine recently asked me to write a piece about Roth IRAs.  This is no ordinary friend, so I decided to partake in the endeavor.  But, in my typical rebel fashion, I promised myself that my contribution to the Roth IRA network of articles would be neither status quo, nor boring.  Search #RothIRAMovement on Twitter if you want the play by play…that’s what all the cool kids are doing.

If you are reading this article, your goal is to NOT be able to contribute to a Roth IRA.

Shocked?  Good, now let’s roll…

For those that have no idea what a Roth IRA is, allow me to bottle feed you the details in 20 words or less:  it’s for retirement.  You contribute after-tax money.  It grows tax FREE, and when you withdraw it to live in retirement, it remains tax FREE.

If you noticed that I used 24 words and thought “that is more than 20,” I hope you enjoy your career as an Engineer or a CPA.  Just playin’…I love you guys too. 

Pretty simple, right?  Of course, there are caveats and special disclaimers, but I will save that heavy lifting for your advisor.  Suffice to say that these suckers are good, and you should consider having one.  I grew up in the South, so please pardon the redneck dialect.

Allow me to run a few figures for you showing the differences between a Traditional IRA and a Roth IRA.

Assumptions:  Married couple, both 25 years old, with household income of $70,000.  They do not participate in employer sponsored plans such as a 401(k).

Traditional IRA (each person)
Max annual contribution:  $5,000
Assumed annual growth:  8%
Assumed 2012 tax bracket:  max 15%

After 40 years, with an annual contribution of $5k, earning 8% per year, the account would be worth $1,295,282 at retirement (age 65).  Not too shabby!  However, when the family decides to withdraw some of that money to pay for Mr. Rubio’s Viagra, it will be TAXABLE as ordinary income.  Why is that you ask?

Each year that the $5,000 was contributed, the taxpayer received a dollar for dollar tax deduction.  So, instead of a joint income of $70,000 each year, the couple only had to show an income of $60,000 per year (assuming both husband and wife put in the max $5,000).  Since they are in the 15% tax bracket, this represents an annual value (tax savings) to them of approx. $1,500.  Because of that benefit, whenever the money is withdrawn, they will pay ordinary income tax on it.

That being said, they should have over $2.5 million to live off of at age 65.  How much will they need to withdraw to be able to maintain their current lifestyle?  My guess is about $175,000 per year.  They make $70,000 now, and I think they will need 75% of that income in retirement to maintain their lifestyle, so they need $52,500.  But, they are not retiring for 40 years, so we need to account for inflation.  At 3% per year, it will take $171,256 in year 2052 to buy what $52,500 buys today.

No problem, you say….we will just take out the $175k and enjoy life.  The big issue is that the tax brackets on $175k rises to 28% (based on 2012 figures). 

Summary:  you didn’t pay 15% taxes on the money going in, but will now pay 28% in tax when it comes out.  Congratulations, you paid a dear price for that “tax deferred” growth.  Saved $60,000 (1500 bucks for 40 years) in tax money, only now to owe around $700,000 (2.5 mill times 28%).  How’s that feel?

Even if you do not need to withdraw the funds in retirement, the IRS makes you start taking RMDs at age 70 ½ so get those 1040 forms ready.  You gonna owe sump’in.

WHO KNOWs where tax brackets will be in 40 years??  Congress decided in December 2011 what the tax brackets would be for 2012!  If tax brackets are 5% in 2052, then the traditional IRA beats the Roth.  For those that believe that tax brackets will be 5% in 40 years, please consult your blue alien “special friend,” as I’m sure he can talk some sense into you. 

Same example, using the Roth IRA instead.

Roth IRA (each person)
Max annual contribution:  $5,000
Assumed annual growth:  8%
Assumed 2012 tax bracket:  doesn’t matter….no deduction

Same math as before….the account grows to $1,295,282 at retirement (age 65).  However, when Mrs. Rubio needs more Viagra for her husband and pulls some money out, there are NO TAXES due! 

The reason is that each year that the Roth was funded with $5,000 was contributed, there was NO tax deduction.  This means that after tax money was contributed and it did not help them at all on their annual tax returns.  They essentially gave up the $1,500 annual tax savings.

Was that a smart move?  Well, now when they withdraw their $175k per year to live, it is tax free.  They owe not a penny on that money.  I ain’t no smart man, but “not a penny” is less than 28% in my infantile mind.    

Summary:  You decided to pay the 15% taxes on the money up front, and contributed after tax money to a Roth.  But now, you can take as much out in retirement as you want to, and do not owe a single dime in taxes.

Also, those RMDs I mentioned above do not exist with a Roth!  Yee-haw!!  Leave the funds in to grow tax free for as long as you’d like.

The mathematics behind this argument depend 100% on how your current tax bracket compares to your retirement tax bracket.  Again, Congress decided what our brackets would be for this year about a month before we celebrated New Years….so who knows where they will be in 40 years?

If you are in a higher tax bracket now than you will be at retirement, the Traditional IRA is better.  If you are in a lower tax bracket now that when you retire, the Roth IRA is better.  If you are in the same exact bracket, it is a wash. 

More important question:  if you can accurately predict where tax brackets will be 5/10/40 years from now, you are a soothsayer, so please tell me who will win March Madness!  I could stand to win a few extra dollars….errr, wait…..IF I were hypothetically in a bracket pool of some sort.  Of course, gambling is illegal, so I do not partake in such an event.  wink wink

WHY did I start this article out by saying that “if you are reading this article, your goal is to NOT be able to contribute to a Roth IRA?”

Roths are great, but they have income limitations.  If you and your spouse make over $183,000 this year, you are ineligible to contribute to a Roth IRA because you make too much money.  You may be thinking, “my wife and I are WAY beneath that, so we will never have to worry about that,” and you would likely be mistaken. 

If you are diligent enough to (1)do the research on the Roth, and know what it is, (2)read a blog entry that is 1,300 words long, and (3)begin investing when you are young….you are very intelligent and will likely have a high paying job one day.

Because of that, my Roth example above could never happen because eventually you will crossover the threshold of being too successful to use a Roth IRA.  What money you have in there will remain tax free, but each year you “crush it” and make 200k, sorry but “No Raf for you!”  So, you won’t be able to contribute for 40 years, which blows up my entire example.

For that reason, stock away what you can now, while you can.  Or, as Snoop Dogg would say,  take that Roth IRA contribution, and  “Drop It While It’s Hot!”

Important Disclosures
Traditional IRAs (Individual Retirement Accounts) are accounts funded with tax deductible contributions in which any earnings are tax deferred until withdrawn, usually after retirement age. Unless certain criteria are met, IRS penalties and income taxes may apply on any withdrawals taken from Traditional IRAs prior to age 59 1/2. RMDs (required minimum distributions) must generally be taken by the account holder within the year after turning 70 1/2. Please see your tax advisor for details pertaining to your specific situation.
The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 1/2 may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.