Thursday, February 19, 2009

The Power of the Roth IRA

As Washington continues to print and spend billions of dollars, two things are certain in the future:

1)Inflationary pressures will increase at some point. You can't flood the market with new dollars and not expect a buying frenzy to occur at some point. Supply and demand will change and higher prices will unfold.

2) The Roth IRA is going to be the retirement vehicle of choice (some investors will also turn to the Roth 401K plan as well). The plethora of money currently being spent by Congress is borrowed from future generations and sooner or later will have to be repaid. Budget cuts & economic reform may recoup a small portion of what is owed, but the vast majority of repayment will come from higher tax rates.

As an investment with 'after tax' dollars, the growth of a Roth IRA is tax free. Not tax deferred, but rather tax FREE. Don't confuse the two. Most retirement plans (401k, 403B, Traditional IRA's and SEP/IRA's), use pretax dollars and offer tax reductions upfront. However, when funds are distributed, the government will tax the proceeds at that time. Depending on future income tax brackets, this could be expensive.

The old school of thought was simple: Defer your income until you retire and then take distributions at a lower marginal tax rate. This will afford less taxes are paid upfront AND less taxes will be paid in retirement as your household income decreases.

This sounds great in theory, but I think the game has changed with the current economic situation. Borrowed dollars are going to dictate higher taxes across the board (tax brackets, capital gains, dividends, etc.). It may not happen this year or next, but higher rates are coming from the current administration. This is where the true value of the Roth IRA will come into play.

Let's look at an example: Pat and Rose both save aggressively for retirement. After investing for a number of years, they both accumulate a cool $1 million. Pat uses her 401k plan to amass this money and Rose uses a Roth IRA account. Once retired, Pat elects to take a one time lump sum distribution of $1 million to travel the world and play tennis. If tax brackets remain where they are today (probably unlikely), Pat will owe about $360,000 (36%) in income taxes and pocket the remaining $640,000. Rose on the other hand elects to cash in her Roth IRA and move to Aruba to look at Dive-Dive trees all day. In her case, she walks away with a cool $1 million as NO income taxes are due.

The power of the Roth IRA is undeniable.

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