As a financial planner, I find people are pretty predictable about their feelings on income taxes: hardly any of them want to pay more than is absolutely necessary, and they feel like other people don’t pay enough! The US tax code has incentives and rules meant to encourage us to do specific things like buy a home, make charitable gifts and save for retirement. But is there any value in actually paying taxes up front rather than put them off if you can?
In practice, I’ve found funding Roth accounts to be one of the ways where short term pain actually can result in long-term gain. Since the Roth IRA was created by legislation sponsored by Sen. William Roth Jr. (R-De) in 1997, adoption of the Roth has been relatively slow to catch on, with Roth’s making up only about 8% of total IRA assets. If you haven’t considered the Roth IRA yet, it really is time to give this most generous of long-term tax breaks a second look.
First, a little background – traditional IRAs and Roth IRAs have a sort of inverse relationship. With a traditional IRA, the contributor might get an up-front tax deduction for the contribution if their income falls within certain limits, but in the end, all or part of the IRA must be taken out as taxable ordinary income. With a Roth IRA, the contributor doesn’t get a tax deduction up front, but if left to grow until 1) age 59 ½, death or disability and 2) at least 5 years pass, the growth is completely tax-free. What’s more, Roth IRA contributions (not the growth) can be pulled back anytime without tax or penalty if the contributor needs the funds for any reason.
This added flexibility and the power of compounding returns over the long haul make the Roth IRA especially attractive to Millennials and those in the early stage of their career. Assuming future earnings go up over one’s career, milking the up-front tax break of a traditional 401(k) or IRA makes less sense the less you earn. A rule of thumb: if most of your earnings are in the 0-15% tax bracket now, contributing to a Roth 401(k) or Roth IRA likely makes the most sense, even if your tax bracket falls back down in retirement.
Why? Remember, any matching funds you get at work are pre-tax (and by all means get all of those matching funds you can), so you’ll have a pre-tax part if you stay in the plan. It’s the tax-free growth in a Roth over a long period that really adds up.
This calculator can show you how a traditional and Roth IRA will compare over the long haul. The longer the wait to take out the funds, the better the Roth IRA looks unless you have almost no tax liability in retirement. But if you’re successfully saving at work or in your Roth IRA, that seems pretty unlikely.
How about if you’re later in your career and considering a Roth IRA or 401(k)? Generally, if your tax rate now is higher than you think it will be in retirement, use your 401(k) contribution limit towards pre-tax contributions and use a Roth IRA for additional saving if you’re under the income limits to contribute. (If you’re not, the “back-door Roth” technique might work for you, but beware: the Obama Administration has made this technique a target for elimination.)
Finally, if you think tax rates are going up due to the US fiscal situation, consider Roth funding as a hedge. Income tax rates now are near their lowest levels since WWII, so think about where you stand on the likeliness of tax increases. With a Roth account, you can avoid those future tax rates.
When it comes to tax planning, it usually makes sense to defer tax until later. But as you can see, there are reasons when it might make sense to pay taxes now instead. The Roth 401(k) and IRA offer us a solution worth another look.