When we look at a dollar bill, there doesn’t seem to be anything special about it. It just seems like a piece of paper we might be able to buy a stick of gum with.
But in the world of personal finance, not all dollar bills are equal. Some are special and have tax advantages while others don’t. We’d be wise to employ as many special dollar bills in our personal situations as possible.
This is where Roth dollars come into play.
I referenced Roth IRAs in this blog post as a great vehicle for young professionals to utilize as we get started on our retirement savings path. But what exactly are Roth accounts and why are they so great?
The 3 reasons:
- Access to contributions, tax-free withdrawals
- We have to pay taxes, but we can decide when
- Eliminate Uncle Sam from our future
- Reduce taxable retirement income
- Reduce chances of paying higher premiums for Medicare Part B
- Reduce chances of paying more taxes on Social Security benefits
- Tax advantages to future beneficiaries
Access to contributions, tax-free withdrawals
Whenever you see the word “Roth” in the finance world, think “taxed today, mine in the future.” A Roth account has after-tax contributions in it, enjoys tax-free growth while it’s invested and, if certain rules are met, all the contributions and the growth come out tax-free.
So what do we get in compensation today for paying taxes up front? Something rare in the qualified accounts world: access to the money.
We have to pay taxes, but we can decide when
The dollars we contribute to most retirement accounts (think Traditional IRA, Regular 401(k) or a pension) are not taxed today because we get a tax deduction for taking care of our future selves. This is a great incentive for us to save for retirement, but it comes at the expense of not having access to those savings today (unless stringent criteria for limited exceptions are met).
However, since we’ve already paid taxes on the money we put into a Roth IRA, Uncle Sam no longer cares what we do with that money. If I contribute $2,000, I can always access that $2,000 until the end of time. However, just because we can access it doesn’t necessarily mean we should: we want to avoid taking contributions out too soon as we will not get the opportunity to put them back into the Roth to realize further tax-free growth.
The Roth IRA is a game changer for young professionals as we get started in our careers (go here to learn about the income and contribution limits for a Roth IRA and other accounts like it). Once we turn age 59.5 and the account has been open for five years, then we have access to every single penny in the account…completely tax-free!
Eliminate Uncle Sam from our future
There’s century-old arguments about the merits of Uncle Sam and the reach of his powers, but I think we can all agree that we tend to not like him very much when he reaches his hands into our paychecks.
With our Roth IRA, because we use after-tax dollars up front to save for retirement, we can take these dollars out in retirement and they are not taxed again. This is beneficial if tax rates are higher in our retirement years, since we would pay the lower tax rate today. And at $31 trillion in debt, I strongly doubt U.S. tax rates will be lower in 40 years.
Reduce retirement income for tax purposes
With most qualified accounts like the aforementioned Traditional IRA and Regular 401(k), the government mandates us to take a Required Minimum Distribution (RMD) once we reach a certain age (age 73 in 2023), whether we want to or not. Since Uncle Sam hasn’t gotten his tax revenue on these accounts yet, he makes us take money out every year after age 73 so he can tax it. These distributions are considered ordinary income, getting taxed at our marginal rates.
But with a Roth IRA, there are no RMD’s. Uncle Sam already got his tax revenue up front so he doesn’t get any on the back end. And when we take money out of the account in retirement, it is not considered income. Theoretically, we could take out $1 million from our Roth IRA at age 73 and recognize $0 of income and pay $0 in taxes!
Roth IRA distributions not being considered income has a domino effect on other aspects of our financial lives, as well. These aspects are not something we tend to think about in our 20s or 30s but if we take advantage of Roth dollars when we’re just getting started, we’ll really be thanking ourselves down the road.
Reduce chances of paying more for Medicare in retirement
When we turn 65 we become eligible for government healthcare, called Medicare.
While Medicare is primarily funded by the U.S. government, individuals also pay premiums for specific portions of the coverage, namely Part B (doctor visits) and Part D (prescription drugs). The base premiums are based off our Modified Adjusted Gross Income (MAGI) and surcharges are added if the MAGI reaches certain thresholds.
These surcharges are called Income Related Monthly Adjustment Amounts (IRMAA). Hopefully the first two words in the acronym tell you where I’m going with this.
If we have a Traditional IRA, a Regular 401k or a pension in retirement that we’re drawing from, then that increases our MAGI. These distributions could bump us into higher IRMAA thresholds which can increase our monthly Medicare premiums by up to $472/month in 2023.
The bottom line: The more income we have in retirement, the more we’ll pay for healthcare coverage. Roth IRAs help to avoid this.
Reduce the tax on your Social Security income
The story with Social Security rhymes with the Medicare story.
When we file for Social Security in retirement and begin receiving benefits the government uses the following formulas to determine if our monthly check will be subject to taxation:
Income + 50% of Social Security benefits < $32,000 = 0% of benefits are subject to tax
Income + 50% of Social Security benefits > $32,000 = 50% of benefits are subject to tax
Income + 50% of Social Security benefits > $44,000 = 85% of benefits are subject to tax
*Note: these are married filing jointly 2023 numbers and the numbers are not indexed to inflation.
As you can see, the more income we have while we’re collecting Social Security, the higher percentage of our benefits will be taxed. Again, Roth IRAs help to avoid this potential tax hit in retirement.
Tax advantages to future beneficiaries
The “income in retirement” problem doesn’t stop with us: it can affect our beneficiaries too.
We discussed that while we’re alive, we do not have to take RMDs from our Roth IRA because Uncle Sam has already collected his tax revenue. But when we die, the rules change a bit.
The rules are very complicated and beyond the scope of this post, but the important thing to know is that our beneficiaries who inherit our Roth IRA must take distributions. But because we’ve already paid taxes (and the account has been open for five years) our beneficiaries enjoy the same tax-free withdrawals that we do!
This means that our heirs (likely family members) can avoid the income problem related to Medicare and Social Security for themselves as well. In special cases, if our heirs have special needs and they inherit a non-Roth account with RMDs, this could seriously affect their ability to receive government benefits (read more about this here), making the Roth dollars that much more valuable.
The Big Takeaway
Roth this, income that…I get that it’s a lot of fancy Congressional financial jabber. But it’s really important to understand the basics today so that we can make good decisions that will benefit both our present selves, our future selves, and our future inheritors.
“A bird in the hand is worth two in the bush” is the old saying and I think it applies nicely here: if we act on the knowns today (tax rates), we eliminate the unknowns in the future (tax rates). In other words, the big takeaway is this: we pay a known tax today to invest in a Roth IRA and we avoid Uncle Sam’s tax hands in retirement. This gives us maximum flexibility today (access to the money) and in the future (tax-free withdrawals) that allows us to adhere to the seventh ingredient in a healthy financial plan…Keep It Simple, Stupid!