The IRA/401k or ROTH is a great type of individual retirement account (IRA) that grows tax free. When you retire, you can then take the money out tax free. And, you can choose to withdraw or not. Of course, any time money is put into a Roth it is “after tax” money. You pay the tax at the beginning. Everybody says the Roth is the way to go, but you may or may not want to Roth.
There are a number of reasons why you would or wouldn’t want to invest in a Roth. Understanding those reasons and then looking at the long term tax trends will help you plan your retirement. The reality is that understanding these trends could help you make more money in every aspect of your financial life. The table below shows you the difference between investing in a Roth IRA vs. a Traditional IRA.
IRA / 401k vs Traditional IRA
As the table demonstrates, if there is no difference in tax rates, the earnings results for the Roth are the same as with the traditional IRA. This means that the primary question for deciding whether to use a Roth is, “What’s the tax?” The second question is, “How long can I let the money grow?” Wouldn’t it be nice to have a crystal ball?
History helps some. When income tax was introduced in 1913, it came in at 8.5% and jumped to 75%. Then it came back down to 25% in the 1920s. You might remember that they called the 20s the “roaring 20s,” because the economy went nuts. There was a huge spike in taxes in the early 30s and that threw the nation into the great depression. In the 50s and 60s if you made a million dollars, you paid over $900,000 in tax. Reagan is responsible for the big tax drop in the late 70s and early 80s. It was called Reaganomics, and everybody said he was nuts. Note that the tax was very low in the 90’s through about 2005. During those years there was huge economic growth.
Believe it or not, taxes are near historic lows right now (2009). They have been higher than they are now most of the time in the past hundred years. With the current drunken spending binge Congress is on, where do you think tax rates are going? Up or down? When you take your IRA funds out in 10 or 15 years, it is almost a sure bet that tax rates will be higher. So, why not Roth? However, it’s not that simple. When you retire and start taking out your IRA money, you’ll have lost a lot of your earned income, and you may be in a lower tax bracket. But, you could be in a lower tax bracket and still be taxed at the same rate you are today. The arguments go around in a circle. You’ve got to follow your gut, because nobody knows.
Why IRA / 401k because Taxes are Going Up
The reality is that it’s a safe bet that taxes are going up in the future. Knowing that taxes will go up should help you plan lots of the financial aspects of your life. Always ask the tax question first. What is the tax result of the financial move I am making? That question is far more important than the question most people ask, “What is the return?” If you know taxes are going up, you’ve got to factor that into all of your decisions. For example, maybe you should pay the tax now and not do the 1031 exchange.
Now that the tax issue is fully settled, the timing has to be considered. You’ve got to have the money in the Roth long enough to “offset” the cost of the taxes. There is a time value of money that can be placed on the taxes you’ll pay for the transfer. If you are under 59½ you have to keep your money in the Roth for 5 years, or the IRS will charge a 10% penalty if you withdraw any of the money. Therefore, the younger you are, the better sense it makes to Roth.
Retirement plans are taxed very heavily when the owner dies, and the heirs usually mismanage them horribly. I can easily show you scenarios where the family in some states can lose 105% of the value of the IRA or 401(k). Yes, they lose it all and pay more. An IRA can be the most valuable thing you leave to your family, and a Roth IRA in the hands of your heirs is double or triple the value of a traditional IRA. But the heirs have got to understand that and not spend it.
Let’s assume you’re not going to spend all of your IRA money to live on. Your rental income can carry you and the IRA is just a back up fund for you. (Good position to be in!!) In a traditional IRA, you have to take required minimum distributions after you hit 70½. That lowers the amount in the IRA that will ultimately be passed to your heirs, and it may throw you into a higher tax bracket, so you lose taxes on all your income. A Roth IRA does not force you to take required minimum distributions, so the Roth IRA can grow without any withdrawals – more goes to your heirs.
Yes, all of the retirement funds will be equally subject to estate taxes when you die. There may or may not be an actual estate tax owing, based upon your total estate value. Once your kids get their split of the IRA, they will withdraw the money and go to Vegas or buy real estate. STUPID!!! It is important to know that they have the opportunity to “stretch” the IRA over their lifetime. That money growing in the tax-free environment of the IRA is a HUGE advantage. There is no investment in real estate that would be worth taking the money out of the IRA. The child will have to take required minimum distributions out of the IRA based upon their life expectancy, but it gets to grow tax free. With a traditional IRA, they will have to pay income tax when they take money out (required or not). With a Roth IRA, there isn’t any income tax for the heir to pay. That’s huge. Everything being equal (investment returns, taxes, etc.), if the heir plays their inherited IRA right, the Roth will deliver between 3-5 times more spendable dollars than a traditional IRA would deliver over their life. Anybody that is going to inherit IRA money needs to carefully study what they should do.
IRA / 401k and Asset Protection
There’s a little PS here. 401(k)s are almost bullet proof asset-protected funds. IRAs are subject to state laws, so whether or not you can lose them depends on the state. Many states have protected them like 401(k) plans. We do know that the IRAs are protected in federal bankruptcy cases (Supreme Court ruling), but for common lawsuits, the protection isn’t absolute in some states. I am sure that some day the Supreme Court will extend absolute protection to all IRAs in all states. Bottom line: not only do the IRAs, 401(k)s, and other retirement vehicles give you a great tax advantage, they are the best asset protection you can get. In my book, Protecting Your Financial Future, I cover the basics of creating a great retirement estate plan.
By Lee R. Phillips, JD
US Supreme Court Counselor
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