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Retirement: Can These Roth IRA Strategies Work ?

iraNew investors who anticipate paying higher rate taxes upon retirement might find Roth IRAs appealing but also to seasoned investors eager to generate more retirement income than with a traditional retirement account (401K), even if future taxes paid have a lower rate.

While these strategies can work in certain situations, there is no guarantee of benefits when saving with a Roth IRA, which can be quite small. Essentially, Roth IRAs are the same as traditional IRAs and 401Ks, all of them designed to increase retirement assets over time by investing in stocks, bonds, and other types of investments.

Investors in both a traditional IRA and 401K are provided a tax deduction or can invest pretax dollars upfront. Once the money is withdrawn at a later date, taxes are paid on contribution but also investment gains. In comparison, an investor contributes after-tax dollars with a Roth IRA and contributions, as well as any gains in retirement can be withdrawn tax free.

Someone who invests in a Roth IRA and expects to pay a higher marginal tax rate in retirement benefits by avoiding higher taxes down the road. According to research findings by T. Rowe Price Group, a large Maryland-based fund manager, investors in their 50s and even into the early 60s who pay low rate taxes during retirement can do extremely well in a Roth.

As an example, a 55-year-old investor paying taxes at a 28% rate that drops to 25% in retirement could end up with 8% additional after-tax income throughout a 30-year retirement period by contributing to a Roth IRA opposed to a more traditional type account.

Over a shorter-term period, the advantage of a Roth is not as impressive. If the same investor contributed $6,500 to a Roth IRA, the maximum allowed for someone over 50, and that money saw an annual increase of 7%, earnings after 10 years would be $12,786 but also withdrawn completely tax-free.

If that same investor contributed $6,500 to a traditional IRA, as well as used a separate taxable account to invest the tax savings, the gain over 10 years would be $12,566, $220 less than earned with the Roth IRA. Paying annual taxes on the separate account is what gives the Roth an edge.

There are two critical aspects of taking advantage of a Roth IRA or 401K over a traditional account. A Roth investment typically takes years to develop a significant edge over a traditional account if moving to a lower tax rate during retirement, again because the advantage is quite small.

First, the investor who maintained a Roth IRA for 10 years prior to retirement earned an 8% increase in after-tax income but then 30 years after at age 65, 6% annually, withdrawing money on a gradual basis. As stressed by Michael Kitces, director of planning research at Pinnacle Advisory Group, people should never count on strategies that require extreme limits in order to get ahead.

Second, in order for an investor to pay a lower tax rate and take full advantage of the boost provided by a Roth IRA, the maximum allowable amount needs to be contributed. If a 55-year-old man invested $4,000 in a Roth IRA rather than the $6,500 maximum allowed, the after tax income over a 30-year period during retirement would be 4% less.

A better decision for this investor would involve an investment of $5,556, the equivalent amount of pretax dollars at a 28% rate, into a traditional account although the Roth could still be a good option. In a Roth IRA account, unlike a traditional IRA, an investor does not need to take the minimum distribution after 70.5 years of age or pay the associated taxes.

The bottom line – a Roth can be useful even if the tax rate is unknown. By investing in both a Roth and traditional account, an individual might have the opportunity to diversify tax exposure. That way, not all of the retirement savings would be taxed according to what Congress ultimately sets the rate for pertaining to ordinary income.

Additionally, taxes on Social Security benefits are not triggered by tax-free Roth distributions, something that can occur when withdrawing money from a traditional IRA or 401K. Of course, investors should never expect the tax-free status of assets for a Roth to produce a dramatic gain if the rate drops during retirement.

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