Why do people care to invest in a Roth account?
For the majority of investors, decisions about whether to invest in a Roth account or not come down to your current tax bracket, compared to your tax bracket in retirement. If you expect to spend more per year in retirement than you’re making now, invest in Roth. But there are other considerations.
To answer this question, we need to first define Roth accounts and consider their advantages and disadvantages vis-a-vis taxable accounts. Did you miss my post on taxable account investments? If so, read these two posts (part 1 and part 2) first.
Roth accounts allow you to invest post tax money (money from your paycheck that has already been taxed) and withdraw both the contribution and its growth tax free in retirement. In other words, the money you contribute is not tax deductible in the year of contribution.
Don’t underestimate the seemingly subtle difference between Roth and taxable account investment: the majority of your assets in retirement will likely be growth from your initial investment principal. As a result, being able to withdraw the growth tax free makes Roth investments very remunerative.
There are two major types of Roth accounts: a Roth 401k account and Roth IRA account. Some employers offer Roth 401k accounts and some do not, but Roth IRA accounts are available to everyone. Notably, the availability of direct Roth IRA contributions phase out for individuals with income higher than $118k in 2017 ($186k for married file jointly) but there is a loophole “backdoor” Roth IRA, which allows higher income individuals to contribute to Roth IRA (I’ll write about this in a future post). Roth IRA contributions max out at $5,500 ($6,500 if you are 50 or over) per individual every year.
So who benefits the most from investing in a Roth account? Here’s what I think:
- People in their 20’s should buy Roth. People in their 20s usually haven’t reached their peak earning potential yet. Chances are that their income is less than or equal to what their yearly need will be during retirement, which means their tax bracket is lower than what they can expect in retirement. So contributing to Roth in one’s 20’s is good deal.
- People who are expecting a large salary hike should buy Roth. The best examples are medical residents (physicians in training) who should absolutely invest in a Roth account. Medical residents will expect a substantial salary increase once residency is complete. For the rest of their career they are likely to stay at a higher tax bracket than their tax bracket during residency. It is also safe to assume that their yearly need during retirement will be higher than their income during residency. So paying that tax at the front end and allowing the investment to compound free of future tax burden is a great deal.
- High incomers maxed out 401k should consider Roth. For high incomers, a traditional 401k should always be the first priority investment to max out every year. It lowers your taxable income and potentially lowers your marginal tax bracket. After maxing out a traditional 401k (and HSA if qualified), you are going to have to choose between a taxable account and a Roth account. I would max out Roth IRA before investing in a taxable account for the benefit of tax free withdrawal of the growth in retirement.
- Medium income super savers should consider Roth. Jenny is a good example. Her current income is at a fairly low marginal bracket but because she is a super saver and a disciplined investor she will have a large nest egg in retirement. Investing in a Roth account will provide her with more freedom from taxation in retirement. Even if only a portion of her investment is in Roth, she can still lower her tax bracket in retirement by diversify her income source. Plus having funds in Roth IRA has decisive advantages on estate tax for her heirs when she dies.
I was in residency when I figured out how a Roth IRA can benefit me. It sparked my interest in personal financial management, but it also made me want to kick myself in the rare for not paying attention to it sooner. Despite years of interest in investing in the stock market, I had not paid attention to retirement planning or personal tax management. It seems almost inconceivable now that I had invested in a taxable account all those years when I should’ve put my money in a Roth IRA.
What do you think? Are there other advantages to Roth that I can add to this list? Are you taking advantages of a Roth account?