Why You Want a Tax-Free Roth

by Paulette Miniter | Mar 9, 2009 | Comments

Key Stats

• Name: Roth IRA and 401(k)
• What is it: A retirement savings account that lets you invest after-tax dollars, which can grow tax-free and be withdrawn tax-free at age 59 1/2.
• Who can open one: Couples with modified adjusted gross income (MAGI) below $176,000 (singles below $120,000) can open a Roth IRA in 2009. Any employee whose company offers a Roth 401(k) can open one.
• How much can you contribute: As much as $5,000 per person (plus $1,000 if over age 50) to a Roth IRA in 2009. Roth 401(k)s have higher limits, the same as regular 401(k)s.

When it comes to investing for retirement, the old adage holds: It’s not what you make, but what you keep that counts. That’s why all retirement savings vehicles offer some kind of tax break. But for people like you — who don’t need to be convinced that saving is a good thing and who are realistic enough to expect higher taxes in the future — one kind of retirement account makes more sense than the others. It’s the Roth IRA or 401(k). In most cases, a Roth will let you save more and keep more than any other retirement plan.

Chances are, you’ve had other things on your mind in this market than Roth IRAs and 401(k)s. But there are two key reasons you should be thinking Roth now:

• 1. You’ve taken a pasting in the market and need to save more to get your retirement plan back on track.
• 2. Congress just passed a bill to spend $787 billion it doesn’t have. All taxpayers will be footing the cost tomorrow — except those who get their income from tax-free Roths.

Recent tax law changes make it possible to have a Roth no matter what your income.

The Roth Difference

At the risk of reminding you of what you already know, traditional IRAs and 401(k)s allow you to defer paying income tax on the money you save and the interest it earns until you withdraw it. It’s a good deal for both you and the tax man. “The government never gives you something for nothing. The reason it gives you the tax break for 401k(s) is because it knows that money will grow many times over. It’ll tax you on that larger amount later,” says Jake Engle, a fee-only certified financial planner in Seattle who is a big proponent of Roths.

In contrast, with Roth IRAs and Roth 401(k)s you save money on which you’ve already paid taxes, but the interest you earn is forever tax-free. By paying taxes up front at your current rate, you protect yourself against higher tax rates in the future. But what you may not realize is that Roths also allow you to save more in the long run.

Let’s Do the Math

Federal tax laws allow you to save the same maximum amount each year in Roths as in their traditional counterparts. For 2009, that’s $5,000 for IRAs, and $16,500 for 401(k)s.

But in reality, saving $5,000 after taxes in a Roth is not the same as saving it before taxes in a traditional IRA or 401(k). Because they lower your taxable income, the traditional versions save you taxes ($1,400 on a $5,000 ante, assuming a 28 percent marginal income tax rate). So, to make a fair comparison between Roths and regular IRAs, the standard formula assumes that you’ll invest that $1,400 savings.

But get real. Would you really do that? And even if you did, the math still works out in the Roth’s favor. After 20 years, the Roth winds up with $23,305, versus $21,998 in a traditional IRA. These numbers, crunched by the Schwab Center for Financial Research, assume an 8 percent annual return and that your tax rate is still 28 percent when you withdraw the money.

With the Roth 401(k), the advantage is even greater because the savings limits are higher. When everything nets out, after 20 years you’d have $76,906 in a Roth 401(k), assuming an 8 percent annual return and a 28 percent marginal tax rate. That’s $4,312 more than in a traditional 401(k).

“The Roth is an exceptionally important vehicle [because] it’s tax-free retirement income,” says John Carl, president of the Retirement Learning Center in New York, which provides consulting services to companies in the retirement business. “What you see in your Roth account is what you can spend. In traditional accounts, what you see in there is not what you will get to spend.”

The big variable in all of this is your tax bracket. If you expect your tax rate to be lower when you retire than it is now, a traditional IRA or 401(k) might be better. But planning for higher taxes is the smarter bet. After all, don’t you plan to work yourself into a higher tax bracket as your career progresses? And haven’t you heard of President Obama’s budget and its trillion-dollar deficit, or the budgetary black hole known as Social Security and Medicare? If you don’t think taxes will have to go up in the future to cover those shortfalls, you are truly an optimist.

Spotlight on 2010

Although not everyone can get a Roth IRA this year, that will change in 2010. For 2009, only couples with modified adjusted gross income (MAGI) below $176,000 can open a Roth. For singles, the ceiling is $120,000.

But starting next year, anyone, regardless of income, can convert a traditional IRA into a Roth IRA. You will have to pay taxes on the money you convert, but you’ll be able to pay your tax bill over a two-year period, in 2011 and 2012. So to get into a Roth, regardless of income, you need only to open a regular IRA and convert it after 2010. The 401(k) is more welcoming: There are no income limits to participating in a Roth 401(k). You just need to work for a company that offers one. If your company does, your after-tax contributions go into the Roth 401(k) account and your company’s pretax contributions go into a separate traditional 401(k) account.

A Great Way to Save for Your Heirs

In addition to all these timely benefits, Roths have a couple of other advantages. Generally, with a traditional IRA and 401(k), the IRS requires you to begin withdrawing money from the account when you hit age 70 1/2. These so-called required minimum distributions (RMDs) trigger a tax bill. With Roths, there are no RMDs. You can hold the money as long as you like.That’s why Roths are also a great way to save money for your heirs. If you don’t need the money during retirement, it can keep growing unscathed. Although your beneficiaries will have to take required minimum distributions from your Roth, they won’t have to pay income taxes on them.

If your employer doesn’t offer a Roth 401(k) yet, don’t worry: companies are slowly coming around. Last year, 22 percent of 186 employers who sponsor retirement plans and were surveyed by accounting firm Grant Thornton added the Roth 401(k) benefit. That’s up from 12 percent in the prior year. Another 19 percent said they were thinking about offering the Roth 401(k).

In a period of unrelieved gloom for retirement savers, that, at least, is good news.