The Incredible Roth IRA - Part 1 — Commonwealth Financial Services

In 1996, the federal government bestowed one of the biggest gifts to retirement savers. It is called the Roth IRA. Put money in on an after-tax basis, and the reward—when done correctly—not paying taxes on any of the earnings. Since then, we’ve seen the Roth expanded to 401k’s and other employer retirement plans. Today we illustrate the incredible power of Roth Accounts.

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Still Can't Believe it...

A late client of ours used to tell us, "I still can't believe our government created this for us!" And in our experience, it is one of the most impactful savings tools we have ever seen. The idea that, when done correctly, the growth in these accounts will not be taxed makes this an incredible tool for both retirement savings and multi-generational wealth transfer.

Looking at What is Possible...

Meet our couple, George and Jane Jetson. George is 42 and Jane is 38. They plan to retire when George turns 65 years old. Here are the details:

George's current earnings are $79,000 per year, Jane's $52,000
George contributes 5% of his pay to his 401k and receives a 4% match.
Jane contributes 4% of her pay to her 403b, and receives an employer contribution of 3%
George's current balance is $92,384, all of which is pre-tax money
Jane's current balance is $42,360, also all pre-tax money
Baseline assumptions.
- Pre-retirement growth rates - 7.3%
- Growth rate in retirement - 5.1%
- Inflation - 2.3%

Let's do some math!

Continue Pre-tax Contributions

Using our assumptions for investment returns and wage inflation, we estimate the Jetsons will have accumulated $1.2 million for their retirement nest egg. All of which will be taxed as ordinary income when it is withdrawn. In addition, both will be required to take minimum distributions when they reach age 75.

Their kids, Elroy and Judy, might inherit the remaining amounts in the future. And they will get to pay the taxes on the remaining amounts.

Switch to Roth Contributions

The math doesn't change. At retirement, they will still have $1.2 million. But what changes is the different pools of money they will have. We project their pre-tax retirement savings will grow to approximately $750,000 and their Roth accounts will grow to $456,000

When money is withdrawn from the Roth accounts, no taxes will be due. There are also no required minimum distributions on that portion. And Elroy and Judy won't be taxed on that amount either.

Determining the "right" way to save...

Evaluating the "right" way to save for retirement is a complex problem for George and Jane. Switching from pre-tax contributions to Roth contributions means they will pay more taxes over their working years.

Looking at the Tax Bill...

The tax benefit for traditional retirement savings vehicles is immediate. You are reducing your taxable income each year you make the contributions. When you shift to Roth contributions, you no longer benefit from that deduction.

In The Jetsons' case, there is a modest impact each year. But, over time, small things can add up to a more significant amount. Based on our assumptions, George and Jane will pay more than $53,000 in extra taxes during their working years to shift their contributions from pre-tax to Roth.

If you only consider the current income tax impact, this could be a tough decision to make. We can estimate and compare the differences in taxes George and Jane will pay over their lifetimes under the two different illustrations.

Anytime the yellow line on the chart is below zero, it shows where George and Jane have paid more total tax by using the Roth contributions. And as they progress through life, they will eventually realize some significant tax savings. You can see this when the yellow line turns positive. But like many things in the world of personal finance, the reward happens if you live long enough.

Living Long Enough: Is it the Key to Making Plans Work?

Whether it is looking at a situation like this or evaluating when you should start your Social Security benefits living a long life makes a lot of the decisions look much more appealing. But like future investment returns, our own life expectancies are one of the great unknowns we all need to factor into our plans. If George and Jane were to die in their early 70's, does that make the decision to use the Roth contributions a bad one?

If you only evaluate their choice by only considering the tax impact on their lives, you can reach that conclusion. But it is far more complex than that.

Whack-a-mole

You may remember the arcade game Whack-a-Mole. A mole pops up in one spot, you hit it, and another one pops up somewhere else on the board.

Personal finance is similar. George and Jane's tax impact is one element. But then you look at how this impacts their overall success. What about the legacy they leave behind—which is better? Then you need to consider how it could impact Judy and Elroy. It gets complex in a hurry!

Probability of Success

Our planning software can simulate thousands of lifetimes for George and Jane, It uses a very simple definition of success. Do the Jetsons run out of money while they are living? If account balances are above zero, that is a success. Under the hood, the software uses risk and return assumptions for retirement savings to simulate what is possible. Think of this as the chance of good weather. The inverse of that number is the chance of rain.

Here is what we see for the Jetsons...

Pre-Tax Contributions

In both situations, their probability of success is strong. We generally aim for 80% or better. An 81% probability of success can help them be confident that they are on a good path for retirement.

But switching to the Roth contributions does improve their overall situation to an 88% chance of success.

Why? Taxes are an expense in retirement, that are not always at the top of your mind. Let's say you need to spend $1,000 on something. If you fund that expense from a traditional retirement account, your actual withdrawal might be $1,250—$1,000 for your expense + $250 for taxes. If your expense is funded from a Roth account, you just need $1,000.

Roth Contributions

Leaving with more...

It is also important to look at the overall impact on George and Jane's account values throughout their lifetimes.

At age 75, they will both be required to take distributions from their traditional retirement accounts—whether they need it or not! The Roth accounts do not have the same requirement. This can have a tremendous impact on their projected values.

The impact of Roth contributions makes a significant impact on the wealth they are able to accumulate. The projected results are substantially more than if they used only the traditional way of saving!

And we haven't even looked at the impact this would have on their children.

For illustrative purposes, we are assuming excess distributions are spent and not reinvested.

Key takeaways for you...

This is just a hypothetical illustration and doesn't represent a real family. But it does show some common things we as planners see every day. We also must realize things change as we move through life and that what we project today will not look the same over time. But we can take away some key concepts...

Paying more tax today is not a bad thing—nobody enjoys paying taxes, let alone more. But we are often shortsighted in how we look at it. When it comes to our tax bill our main concern is often next April 15th. But sometimes paying more today can result in substantial benefits over a long period of time.
Think in terms of VERY long-term—Financial advisors love to talk about a long-term mindset when talking about investments. The same is also true when thinking about how you save for the future. The benefits of Roth accounts may take decades to materialize, and you may not reap the rewards. But you are faced with making a choice between who benefits more—your family or the IRS.
Money decisions are complicated—This illustration shows how complex and entangled money is. The concepts can have some general application to our lives, but when you dial into specifics, you can throw the generalities out the window.
Money goes much deeper than investing—Investing is a component of any financial plan, but it may not be as important as many believe. Nothing in this illustration focused on the investments, yet the impact of the decisions made can be substantial. The value of creating a plan goes far beyond picking investments. Keep in mind, this also doesn't cover the multi-generational impact these decisions can have (that's in part 2).

You're not alone...

Our team of planners and advisors understand these complexities. We can help you evaluate and guide you to decisions that add significant value to your life. Connecting with us is easy. Fill out the form below and we can arrange a time to discuss how we can help you improve your real-life outcomes.

Appearing in this video...

Todd Kimpel, ChFC®

Todd is a financial advisor in Wheeling, WV.

Daniel Spurgeon, CFP®

Daniel is a financial advisor, in Parkersburg, WV

Neal Watson, CFP®

Neal is a financial advisor in Marietta, OH