Ever wondered if a Roth IRA is right for you? If you have one, you may reconsider.
|Taking the murkiness away from an IRA (Individual Retirement Arrangement)
First, let's get the terminology down. An IRA is simply an account, similar to a savings or checking account. But this account just holds an investment, instead of just cash. Further, the advantage is when the investment earns interest, dividends, and capital gains it is not taxed on your current tax return. Additionally, this money is intended for your retirement. So withdrawing money before the age of 59 ½ will cost you a 10% penalty on whatever you withdraw plus your regular marginal tax rate. Federal tax rates currently range from 10% to 39%. In the environment we find ourselves, those rates are likely to edge higher. Whatever your marginal rate (the tax rate which you would pay on your next dollar of income) you will add a 10% penalty onto it. Also, don’t forget those state and local taxes.
A simple analogy for the lay person:
So, you still don't understand? Perhaps an analogy will help. Are you sitting at a desk? Well if you aren’t, go sit at one. Is there a pencil holder on it? For this purpose, I’m going to assume that there is.
Take all the pencils, pens, markers, scissors, and whatever else out of it and just leave the cup. Take a good look at that cup. (Pause for effect) That cup – a container – is an IRA. It just holds something else instead of pens, pencils, markers, etc. – in this case investments. Take your pens and pencils and start dropping them into that cup. Your first pen could represent a certificate of deposit (CD) that most any bank offers. The next pen could be a savings bond. The next pencil could be P&G stock. The next one could be a GE corporate bond. The next could be a mutual fund that invests only in domestic growth stocks. The point of this exercise is: It is not the cup that is the investment. The cup is just a holder – an account – that holds the investment vehicle.
What’s so special about the cup then? Why all the hoopla about an IRA? Again that is a simple answer. As long as the investments (those pens, pencils, markers, etc.) stay in the cup, taxes are not assessed on them, nor any income that they throw off. Now take out a pair of scissors. The scissors represent taxes. (I usually get a few giggles on this. Go ahead… I know you want to. Take the scissors and circle the cup. Just waiting for those innocent pens and pencils to emerge.) The tax “shark” can not get inside the cup. But what it can do is take a chunk out of anything taken out, or withdrawn. So, when you take your fingers and lift a pen out of the cup, the shark will take its bite. Just take the cap off -- that's taxes. Of course, this is a financial discussion and it’s never that easy. Typically speaking, this analogy is only for a Traditional IRA and other taxable buckets (which I’ll describe later), but elements do apply to a Roth IRA as well.
What are investments?
That’s pretty simple. Investments are things (I use the word vehicles) you put your money into where you expect to gain value. Does that mean gambling is an investment? Absolutely not. You do not expect to gain income from gambling. The odds are stacked against you. Investing is more of an educated judgment. The expected result of all investments is positive, not negative like in gambling. Can some forms of investing be considered gambling? I would have to say yes, but those are typically frowned upon by regulatory agencies, and as such are either banned or highly scrutinized. Understand that taking risk is an integral part of investing. The level of risk taken is completely up to the investor. When risk becomes so high that the net expected result is a loss, you have pushed over into gambling. Remember though that it is the investments (those pens, markers and pencils) that hold the risk -- not the cup.
Common forms of investments are: Certificates of Deposit (CD’s), stocks, bonds, real estate, art work, coins, commodities – such as wheat, gold, cattle, etc. As you can see, the variations are nearly endless. But keep in mind that all investments contain risk. The lower the risk taken typically shows up in the form of a lower yield. For instance, a savings account is considered a very safe investment. The bank’s financial status initially backs the account and if that isn’t sufficient the federal government backs it as well through FDIC insurance. However, the yield is often paltry to “buy” that safety. Yields currently are under .25%.
The two ideas I want you to walk away with here is risk vs reward and inflation risk. Savings accounts are safe, but will lose you money in the end. Savings accounts are really only necessary as a safety net. They are quick cash for the unexpected events in life. As an investment they are simply bad. Inflation usually ranges from 2-4% annually. That means that .25% is not even keeping pace. In other words, you are losing purchasing power. The $10,000 that you start out with would buy more goods and services than the $10,025 you have one year later. Risk, therefore, is not bad if it is managed within your risk tolerance level. Keeping pace with inflation is paramount to gaining wealth.
Wealth is another term that gets thrown about that most people have a misconception about. Wealth comes down to a person's net worth not their annual income.
Two types of IRAs:
Traditional IRA. Generally, a traditional IRA creates a deduction on your tax return for whatever you put into the account. For instance, if you put $1,000 into a traditional this will be deducted on your tax return and increase your Federal and State refunds. However, some people are not able to contribute to a traditional IRA. They must have earned income, be less than age 70 ½, and stay under the annual limitation. Further, even though someone does meet these rules, some can not take the deduction.
There are other types of retirement plans that work very similarly. These are what I call taxable buckets. You put something IN the bucket and you get a tax deduction. The benefit of which depends upon your margin tax bracket and certain credits you can obtain dependent upon income level. A brief, but not all inclusive, list of taxable buckets might include -- 401(k), 457 plan, Profit sharing plan, 403(b), 501(C)(3) Plan, etc. The idea here to understand is there is a tax benefit up front, but when you begin drawing on these funds, hopefully at retirement past age 59 1/2 the withdraws are taxed. Again this tax is figured at your marginal rate and can be 0%.
Roth IRA. In contrast, a Roth IRA works a bit differently. A Roth IRA is never deducted on your tax return. Sometimes you can garner a tax credit, but that will be discussed later. Think about this: What that means is you are putting after tax dollars into this tax advantaged account. That’s important to understand. The original contribution money inside a Roth has already been taxed. So, why would anyone want to do that? That answer is simple: Any earnings (once a five year waiting period is met) from interest, dividends, or capital gains is never taxed. This can become huge money over 30 to 50 years, and it’ll be tax free upon withdraw. You don't pay tax on the withdraws, but get no immediate tax benefit going in.
Discussion of IRAs:
When perusing the mountain of information in the marketplace which outlines IRA’s you will get basically what I have written above. I have just put it in simple language and took off the hype. IRA’s are difficult to get your facts straight. There are many rules to them, especially in the tax area. No less important, however, is the determination as to who and when each type of IRA is a fit. While not a lot of the hype is centered on fit, this understanding is the most important decision that any individual can make. They talk a good game, but they’d rather cookie cutter the discussion and push you mostly toward a Roth. I will make this statement now: A Roth is a bad idea for about 85% of all Americans. Shocked? You should be if you have read all the brochures and looked at the graphs. You would think a Roth is the investment and retirement savior. It isn’t. That's because I don't just look at the IRA "cup" from just an investing standpoint. My point of view is larger than that and yours should be too.
I’m not only an investment adviser, I am a tax adviser as well. I understand that the common Joe does not have hundreds of thousands saved up for retirement (or anything else for that matter). At best most of them are skimping by on their paychecks and putting 2-3% away. They are also hopelessly stuck in the 15% tax bracket or below. In retirement, they are going to rely upon a combination of three things: Social Security, Investment income (interest/dividends), and Pensions/Annuities/IRAs/401ks and the like.
This section will use my own lay-person term to describe a certain concept. That term is a “bucket”. I use this term as it’s easy to visualize. Everyone knows what a bucket looks like. There are two types of buckets – taxable and tax-free. The tax free-bucket is limited to Roth IRAs and some single-purpose accounts such as 529 Plans or Health Savings Accounts. Almost all of the rest are taxable buckets.
A taxable bucket is one in which you put pre-tax dollars into (in other words you get an immediate tax benefit on your current tax return), the earnings grow without being taxed currently, and when you reach into the bucket and grab cash out, those withdraws are taxed at that time. Sometimes, they are even penalized should you not meet an exception to that penalty.
A non-taxable bucket is one which you put after-tax dollars into, the earnings grow tax-free, and when you ultimately reach into the bucket and grab cash out those withdraws are not taxed. There is no pair of scissors circling this bucket. In short, as long as you meet a five year rule the earnings in a non-taxable bucket will never be taxed.
Taxable buckets – Traditional IRA’s, 401k plans, 403b plans, money purchase plans, profit sharing plans, SEP’s, SIMPLE plans, 457 plans, and many others. We have a long list under the taxable bucket definition. Remember: You get a tax benefit up front on all of these. There are elections you can make to not receive the tax benefit, but that’s beyond the scope of this discussion.
Non-taxable buckets – Roth IRA’s, 529 Plans (for education only), health savings accounts (for medical only), and medical reimbursement plans (for medical only). Only a Roth is not limited by the type of expenditure a withdraw can be used.
Why do 85% of Americans not want to set up a Roth IRA?
This answer lies not in the definition of an IRA, nor in the type of investment that you choose. It lies in the tax code.
I would urge you to get out your tax return at this point. Yep, that thing that’s likely stuffed in the back of a drawer somewhere, or scattered, torn, and mangled at the bottom of your in box lying next to the denied request from the bank at your latest attempt at refinancing.
Once that’s in front of you, I want you to look at a few lines. First, is what is called the standard deduction (about line 40) . This is a tax free amount that the government gives you. In other words, your first ‘X’ number of dollars are not taxed. These amounts vary based upon your filing status. We’ll concentrate on married ($11,400) and single ($5,700). In addition, you receive $3,650 for each exemption (about line 42). Again, this is a tax free amount that the government gives you per person claimed. So, we get to add another $7,300 for a married couple onto the standard deduction and $3,650 for single. Further, once age 65 is reached the government gives an additional $1,100 for married, and $1,400 for single. Finally, if you own a home the real estate taxes get added, up to $1,000 for married and $500 for single. Add these together and you get $21,900 for married ($11,400 + 1,100 + 1,100 + 3,650 + 3,650 + 1,000) and $11,250 for single.
Now the question becomes: How much would it take withdrawing only the earnings from a taxable bucket to equal these amounts? Earnings must assume a particular rate and is dependent upon risk and the investment you choose. At 6% you’d have to accumulate $365,000 ($365,000 x 6% = $21,900 or $187,500 for single). The smaller the rate assumed the more you must accumulate. At 3% the amount would be double for instance. Quite a daunting number for the vast majority of people. But that’s not all because as anyone knows who is paying attention in tax law, ALL of these numbers for standard deduction, exemptions, additional amounts for age and real estate taxes rise over time with the rate of inflation. When planning just remember that most things double in 20-25 years. So that $365,000 just became $730,000 if you are 40 years of age.
Example time: Let's say you have $100,000 in a traditional IRA at age 50. Let's also assume you put in $3,000 per year into that investment that yields 6%. By age 67 you would build up about $378,000. Standard deduction and exemptions should double to $43,800. This means you would drain the account by age 80. That said. An actuary will tell you that you can use all $378,000 and spend your last dime on your last day. I just like a little more security in case I live to 150 or have medical issues. The more you save, the better off you will be and the more flexibility you'll have. In 25 years, $43,800 will not be a lot of money -- due to inflation.
In conclusion, it makes no sense to push money into a Roth IRA when you can have the best of both worlds. Take the tax deduction up front and draw money out in retirement tax free if you are disciplined enough to draw the money out over the rest of your lifetime and keep within the framework of the tax law.
Imagine if you receive $32,000 jointly from social security and draw $40,000 from a taxable bucket. A total of $72,000 and you pay no tax. It can happen. All you need is planning.
By Bryan Scholl
Tax and Investment Adviser
Bachelor’s degree at Miami University (Oxford) in Finance
Twenty-nine year tax professional
Fourteen year registered investment representative
Series 6 and 63 licensed