Advantages of Investing in a Roth IRA
Freedom and flexibility:One of the best aspects of Roth IRAs is the absence of a required minimum distribution (RMD). At 70½,Traditional IRAs require you to calculate all of your RMDs and take them as taxable income. If you miss anyor don’t withdraw enough, it will cost you a 50% penalty on top of your income tax. You also can’tcontribute savings after 70½ to regular IRAs, but Roths have no contribution age limit.
Tax-free growth and withdrawals:Contributions to Roths are made with after-tax dollars, so you don’t get a deduction on your tax bill thisyear. Instead, you pay zero taxes on growth or earnings and you can withdraw 100% of your contributionsany time for any reason without penalty or taxes.
Estate planning considerations:Estate planning is a complex process and it can be easy to overlook the negative tax impact of inheriting aTraditional IRA with RMDs. The additional taxable income might push your heir into a higher bracket. Rothsdon’t have RMDs and withdrawals are tax-free, but are best left to heirs with a higher combined state andfederal tax rate than you.
Tax efficiency:Minimizing your income tax liability in retirement is easier when you have multiple retirement plans to pullfunds from. Adding a Roth to your plan lets you take income from tax-deferred account as well as a tax-freesource to stay within a target bracket. Roths also decrease your exposure to the new Medicare surtax onnet investment income because your withdrawals don’t count towards modified adjusted gross income,which triggers the surtax. Paying taxes up-front hedges you against rising income tax rates from Congress orhigher earnings levels too.
2014 requirements and limits:Withdrawals are only tax-free after you turn 59½ and have owned the account for at least 5 years, butthere’s a first-time homebuyer exception worth $10,000. The 2014 income limit phases out between $114-129K for single filers and between $181-191K for married couples. The annual contribution limit is $5,500 or$6,600 if you are 50 or over. If your income exceeds the threshold you can still convert savings already in atax-deferred account, but paying for the costs out of the account you’re rolling over almost negates thebenefits the conversion provides.
Adjusting Withdrawals and How Often.
Withdrawal Strategy:The 4% rule is to withdraw 4% of your savings annually when you retire, adjust for inflation and you shouldhave enough money to last 30 years. Let’s say two investors each have the same birthday and $1M insavings invested identically. One retires when he turns 65 and the other waits one year until he turns 66,but the market drops over the course of that year. Both portfolios fall by the same amount, but the investorwho retired first also withdrew 4%, or $40K. The second investor begins retirement with $900K, so his 4% isonly $36K. The second investor has smaller withdrawals, but is actually better off because he did not take adistribution during the year and is spending less than his counterpart. If the first investor only expected tolive until 89, he might boost his rate to 5.3% or $53K because it doesn’t have to last as long.
Timing Retirement:Adjusting your monthly spending is the most effective way to add time to your portfolio. Timing the marketby buying and selling in anticipation of price movements is by far the least successful.
The Possibility of Adjustment (POA):The POA is the likelihood that a retiree will ran out of money based on a portfolio’s value and spendinglevels. The first investor who retired at 65 would normally account for 3% inflation by boosting hiswithdrawal rate and taking $41,200 the following year, but his savings took a beating and he might adjustdown to $3,900 in order to stay on track to last 30 years.
Spending Expectations and Wealth Preservation:We all have different risk tolerances and exposure, but one common trend is that when we make moremoney, we can spend more money. If we correlate retirement spending to the value of our portfolio, thenone approach to manage expectations is to keep POA constant. If we maintain the position that there willnever be more than a 10% chance that we outlive our money, then if our stocks lose value we have todecrease our spending as well and vice versa.
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