The Future of Roth IRAs

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If you’ve ever spent any time on a personal finance blog, you’ve likely come across one, or two, or twelve articles comparing the Traditional IRA to a Roth IRA.  (If you haven’t, congratulations on finding more interesting things to read about!)  At the time of this posting, for example, a Google search for “traditional vs Roth IRA” yields approximately 94,600 articles.

So rather than walk through the usual IRA material (although we do provide a quick summary to get you up to speed), in this post I wanted to discuss future potential changes to the tax treatment of Roth IRAs.  Over the years, I’ve had several people raise concerns about contributing to Roth IRA accounts, fearing that the “tax free” treatment of the accounts may be taken away in the future.

Long story short, I think it’s unlikely that Roth IRAs will be taxed in the future, and it shouldn’t stop you from contributing to one today.  While it’s certainly possible that some of the details will change over time, Congress has very little incentive to change the tax treatment of these accounts.

What is a Roth IRA, exactly?

I know the legal and tax structures of retirement accounts isn’t the most fascinating topic (at least for some of us!), so I’ll keep this short and sweet.  If you’re looking to save for retirement outside of your 401(k),  you have two account options to choose from: a traditional IRA and a Roth IRA.  What’s the difference between the two?

  • When you pay tax on your savings-  all retirement accounts have some tax advantages built into them, but you need to know how the taxes work to make the best choice.  With a traditional IRA, you receive tax advantages in the beginning; the money you contribute to the Traditional IRA isn’t taxed this year, and it grows tax-deferred in the account until you retire.  But, since you didn’t pay taxes on the money now, you’ll pay income tax on all the money you withdraw from the IRA when you retire.  Roth IRAs have the exact opposite tax advantages; you pay income tax on the money you contribute to the account now, but the growth and withdrawal of money in the account is tax free when you retire.
  • Income limits- There are a few restrictions placed on both types of accounts.
    • If you make “too much money”, you can’t directly contribute to a Roth IRA.  The IRS website is the best place for a complete list of details on these limits (and the other bullet points on these lists), but as a starting point, your ability to contribute to a Roth IRA in 2018 starts to phase out when your income exceeds $122,000 for single taxpayers and $193,000 for married (filing jointly) taxpayers.
    • This limitation isn’t in place for Traditional IRAs, but your ability to deduct your contribution may be reduced or eliminated if you or your spouse have a 401(k) (or similar) plan at work.  Again, you can refer to the IRS website for the complete set of details.
  • Flexibility– The Roth IRA is a more “flexible” account to work with than the Traditional IRA.  For example, while most early withdrawals from a Traditional IRA are taxed and penalized, you can withdraw your contributions (as opposed to the investment earnings) of your Roth IRA without penalty.
How to Decide if You Would Be Better Off With Roth

When deciding between these two types of accounts, the main driver of your decision should be based on your tax rate.  Simply put: if your tax rate now is higher than you expect your tax rate to be when you retire, a Traditional IRA is probably the right choice for you.  Take the tax deduction now while your rate is high, and pay taxes at the lower rate when you retire.

On the contrary, if your tax rate is relatively low right now, paying taxes right now and getting the tax free income in retirement is likely the better deal for you.  This makes the Roth IRA a particularly compelling choice.

Remember, though, it’s not enough just to look at today’s tax rates to make this decision.  You need to think through how you expect the tax rates themselves to change over time.  Just because you expect to have lower income when you retire than you do now doesn’t mean that your overall tax bill will be lower if Congress raises the tax rates over the next few decades.

Ultimately, this is a decision you need to make based on your overall financial situation.  But in my view, given that tax rates are at historically low levels right now, I think it’s likely that tax rates will rise between now and when we retire, making Roth IRAs a good deal for most low- to middle-income millennials.  (Keep in mind, though, that I don’t think the same way that Congress does – thankfully! – so this is purely my opinion, and not a specific recommendation.)

Will Congress Kill the Roth IRA?

Roth IRAs are fairly popular (as far as financial topics go…) with people in our generation.  Nevertheless, I often get questions about whether or not the Roth IRA will actually be tax free several decades from now when we retire.  Will Congress really honor the promise of the Roth IRA?

In my opinion, yes, they will.  I completely understand the concern that the Roth IRA may be taxed in the future, but I think it’s highly unlikely. Here’s a few reasons why:

Politically, it would be extremely difficult. The people who would be affected the most by a tax on Roth IRAs are the elderly and the retired, who also happen to statistically be the most dedicated voters in this country.  There’s a reason that proposed changes to Social Security and Medicare almost always fail; retirees vote, a lot.  The AARP is one of the most well-organized lobbying groups in the country, and any law change that negatively affects retirees will be met with strong resistance.  Simply put, this isn’t a winning issue for Congress to take up. 

Congressional math is silly.  I probably shouldn’t pick on Congress as much as I do in this post… but they just make it so easy.  Because here’s the thing: the way Congressional legislation is reviewed, taking away the tax benefits of Roth IRAs will actually decrease the amount of taxes collected.

Intuitively, this doesn’t make sense.  Why would taxing a tax-free account decrease tax revenue?  Because of the system that Congress uses to evaluate budget bills.  The Congressional Budget Office uses a 10 year future projection to evaluate the tax impact of the bills it passes.  And in a relatively short time period like ten years, eliminating the Roth IRA would decrease the amount of tax revenue the government collects for two reasons:

  • People don’t take a lot of money out of Roth IRAs every year, so the overall projected tax increase is relatively small.
  • On the other hand, a lot of people contribute to Roth IRAs today… and remember, you’re taxed on the income that you put into a Roth IRA.  If Roth IRAs are eliminated, this savings will be redirected to tax-deferred accounts like the Traditional IRA or 401(k), which will decrease the amount of taxes the government collects now.

Over the long run, eliminating the Roth IRA would increase the amount the government collects in taxes.  But, Congress only evaluates the effects of tax legislation on a ten year time horizon… which means that if they were to pass a bill eliminating the Roth IRA, they’d be passing a tax cut bill, not a tax increase.

Silly?  Absolutely. Good for the Roth IRA?  Yes.

It is much easier to use Roth IRAs now than it ever has been before. Not only has Congress not made moves to eliminate the Roth IRA, they’ve technically made it easier to contribute to a Roth IRA.  Indeed, over the past several years, Congress has passed legislation allowing you to “convert” your traditional IRA into a Roth IRA, potentially allowing people over the income limits mentioned above to contribute to a Roth IRA indirectly.  This is a good strategy for certain individuals, but it’s a complicated process that shouldn’t be attempted without consulting a financial planner or tax professional.  But, it goes to show that Congress isn’t making it harder for you to access a Roth.  On the contrary, it’s easier now than ever before.

If we look at all of these factors, it becomes pretty clear that taxation on Roth IRAs is not a likely scenario in the near future. If you think a Roth IRA is the right choice for you, don’t let fear of future tax law changes hold you back.

Planning For the Future

That being said, there are a few different possibilities of legislation that could feasibly happen in the coming years affecting Roth IRAs, but none of them are reason enough to deter you from using the accounts.

The first possibility is the implementation of some sort of required distributions on Roth accounts in the future. Under the current tax law, you need to start taking distributions from a Traditional IRA when you turn 70.5 years old (because making it an even “70 years old” would have made too much sense…), but you don’t currently need to do this with a Roth IRA.  It wouldn’t surprise me if Congress implemented mandatory distributions from Roth IRAs at some point in the future… but that’s not a reason to not contribute to one.  

Another possibility is for Congress to implement a maximum amount of money that can be held in a Roth IRA. By restricting the amount that can be held in a Roth IRA, the government could prevent you from contributing to a Roth IRA in the future… but as I mentioned before, Congress doesn’t have a strong incentive to do so.  And again, this isn’t a reason to avoid contributing to a Roth IRA today.

Making a Contribution

Once you decide which account to use, it’s time to put money into your IRA of choice.  And if you happen to be reading this article between January 1 and April 15th of any given year, you have an additional choice to make.

Currently, there are caps on how much money you can put into IRA accounts – both traditional and Roth – each year. These caps were relatively steady for a few years, but there’s been an increase from 2018 to 2019; last year you could put $5,500 per year into an IRA, and now you can put $6,000 starting in 2019.  (Once you turn 50, you can add an extra $1,000 to your IRA each year).

But, you have until Tax Day (April 15th, or the next business day if it falls on a weekend) to make your contribution for the prior year.  So, as I mentioned, if you are reading this article at the beginning of the year, know that it isn’t too late to make an IRA (Traditional or Roth) contribution for last year!

If you want help figuring out which type of IRA is right for you, or need retirement savings advice in general, don’t hesitate to reach out! I would love to set up a free introductory phone call with you to walk you through what you need to know.

Solving the Millennial Retirement Savings Challenge

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Last week was a big week in the financial world — America Saves Week! From February 25th through March 2nd, the finance community came together to help impact the lives of Americans through motivating, encouraging, and supporting them to save money, reduce debt, and build wealth (particularly through automated savings).

Now, there is an important distinction to make here; “saving money” doesn’t just mean adding money to your bank account, it means paying down debt as well. When working with clients, there are two main metrics I like to focus on:

  • The first is Net Worth. This is the concept of how much money, investments, and “stuff” you have, minus how much debt you owe. As you grow through life, this number should continue to increase every year, which can be achieved by either saving money or paying down debt.
  • The second, and more relevant metric is a little bit harder to describe and calculate.  To boil it down, it essentially summarizes “What is the likelihood you will be able to retire at a decent retirement age and not run out of money?”  There are a lot of factors to consider when running this sort of calculation; I use advanced statistical software to run this type of projection.

I want to talk about both of these metrics in this post.  Because while many millennials are doing a good job saving in general – either by adding to their bank accounts or paying down debt,  statistics show that many of us are “behind” when it comes to retirement savings.  

Why Retirement Will Be a Challenge for Many of Us

Currently, we are saving significantly less for retirement than previous generations did, for several reasons:

  • Student loan payments. Many millennials are directing their would-be retirement savings to pay off student loans in a way that our parents and grandparents did not have to do.
  • Rising cost of housing. When our parents and grandparents were our age, buying a house was much more affordable. For a typical family, the cost of a home was only around 2 times their average annual salary. In today’s economy, purchasing a home on average costs about 4 times their average annual salary — and that is not even considering that most of today’s jobs are in large cities, where the cost of housing is even higher.
  • Lower company retirement benefits. Most of our grandparents had pensions through their jobs. Some of our parents even did too. Because of the rise in independent contractors and the gig economy, it is becoming harder and harder to come by solid retirement benefits — even 401(k)s are harder to come by than they used to be. Average employer contributions have fallen, too, which is putting more pressure on the individual to save on their own.
  • Relatively flat wage growth since the financial crisis. Since around 2008, there has been very little wage growth across the country, meaning that while prices have gone up, our incomes haven’t necessarily. We have less spendable money than previous generations, making it harder to allocate a significant portion of it to retirement savings
  • Social Security and Medicare are expected to cut benefits in 15-20 years. Having these programs to fall back on when we retire might not even be a possibility for a lot of millennials. If these programs are cut, it will mean that much more pressure is put on the individual to completely financially support themselves through retirement.

Simply put, we face a greater set of challenges in preparing for retirement than our parents and grandparents.  Which means that unless we prepare accordingly, we will either need to delay retirement or partially sacrifice one of the most beneficial strategies we can use to help save for retirement…

Compound Interest

 Compound interest is often described as “magic” or “a miracle” for people trying to save up money over time. The idea that the we can keep our money invested — and the return will exponentially increase over time — is a very appealing one to investors of any age. Consider the graph below.  If this year we invest $1,000 at an 8% rate of return, next year we will have $1,080, in 10 years we’ll have $2,200, in 20 years we’ll have $4,600, but in 40 we see this number grow all the way to $22,000. In the simplest of terms, earnings go from $0.80 in the first year, to $1,750 in the 40th year (that’s a pretty significant increase!).

This looks amazing — and it is! — but there is one key takeaway you should note — you need to keep your money invested and untouched for a very long time to see the “magic” of compounding happen.  Compound interest is a beautiful thing, but we lose most of the benefit if we don’t start investing early enough.

(And, of course, the chart above assumes a constant, consistent 8% investment return each and every year.  While the long-term annual return in the stock market is around 8%, we know that it can vary drastically from year to year!)

As we’ve already discussed, as a generation we are putting more and more money towards student loan payments and housing costs.  Which, in turn, means that less and less money is being put towards savings that will compound in retirement accounts and we begin to lose the impact of the compounding, making it harder for us to have enough money to retire at a “normal” age.

Retirement Shouldn’t Be Your Only Priority!

This isn’t entirely a bad thing.  One of the major criticisms I have of the financial planning industry is the degree to which we focus on retirement.  I started Pacesetter Planning back in 2016 because I believe that financial planning should be about more than just saving for retirement.  Short-term goals, such as buying a house, planning a career change, and paying down debt are important too!  The key is finding the right balance between your short- and long-term financial priorities.

Ultimately, you shouldn’t be putting all your money aside for retirement.  Too many people in this world work as hard as they can, in jobs that they hate, saving as much as they can for 40 years so they can “retire”… and then abruptly change everything about the way they life their lives. Instead, you should create your dream life right now so that you won’t be in a rush to retire in the first place!

Saving for retirement is important… but I’d rather have you create a fulfilling life, balancing your short- and long-term goals, and work in a job that gives you energy, doesn’t burn you out, and is something you won’t be in a rush to retire from.  But, of course, you will want to retire at some point… so how should you approach retirement savings if you feel “behind” in your long-term savings?

The Answer is Surprisingly Simple

To be prepared for retirement, the key is to continue to save more — even if you’re not directly saving for retirement.

Remember, paying down debt is an entirely valid form of saving, including your mortgage debt if you have it (although buying a house is NOT a way to save…more to come on that next week!).  So while you may not be doing a lot of “traditional” retirement saving at the moment, that doesn’t mean that you aren’t saving at all.

This brings up the question — How can short-term saving help you if the money isn’t going into retirement accounts? Well, there are two primary inputs into the calculation we use to determine how much you need to save for retirement, and short-term saving can have a big impact on one of them.

  1. How much do you have saved? This is pretty intuitive, and what we usually focus on. Once you have enough money in your retirement accounts, you can retire.  This input includes the amount of money you are currently saving for retirement, and how much you expect your cumulative savings to be worth by the time you retire.
  2. How much do you spend each year? The second component doesn’t have anything to do with savings at all… or at least, it doesn’t have anything to do with savings directly.  In order to know how much money you need to retire, we need to know how quickly you’re going to spend your money in retirement.   The more you spend, the more you’ll need to have saved for retirement.

The last sentence above hints at the key link between how your short-term savings and debt paydown can help you retire earlier.  The more you spend, the more you’ll need to have saved for retirement.

The problems holding our generation back from saving for retirement largely aren’t related to spending at all!  We’re saving… but the savings is being redirected elsewhere.  Which means that if you continue saving at the rate you’re saving, even as you pay off your student loans and accumulate enough money to make a down payment on a house, you’ll need less money set aside for retirement to begin with because your spending is low!

That’s worth repeating: If you lower your spending today, and build the habit of saving so that you continue to save once your loans are paid off, the less you will need to save for retirement in the first place. Saving money – even for short-term goals – helps you retire earlier because it decreases the amount of money you need to retire in the first place.

Think of retirement savings as filling a bucket with water. Over the course of your career, you’re putting money into your retirement savings “bucket”. When you retire, you start spending that money you’ve saved – for the sake of this metaphor, let’s say that when you retire, you poke a hole in the bottom of the bucket so water starts to leak out of your “retirement savings”. How quickly the water flows out of the bucket is critically important. If you spend a lot, you better make sure you have a TON of water in that bucket before you poke the hole in it, because the water is going to flow out of the bucket really quickly.

On the other hand, if you only poke a small hole in the bucket, the water inside will flow out of the bucket very slowly.  Which means that you don’t necessarily need a huge bucket of water to begin with!

If you want to spend a lot of money during retirement, you need to make sure you save enough to be able to retire comfortably.  The more you spend, the more important compound interest is to you. But if you keep your spending in check, the water will leak slower, meaning that the bucket has to be less full in the first place.

Big Idea: There is a “Double Benefit” When it Comes to Increasing How Much You Save:

Increasing your retirement savings will fill up the retirement savings “bucket” faster, which will certainly help you retire earlier.  But, filling the bucket is only half the equation.

If you’re spending less money, you’re slowing the the speed at which the water flows out of the bucket in the first place, which means that the water level does not need to be as high. If you are able to do both of these things, you can maximize your potential savings and have much more flexibility in when you can retire.

The key, though, is to be able to maintain this over time. Once you student loans have been paid off, redirect this type of saving to saving for something else. Even if you can’t save for retirement right now to fully benefit from the “magic” of compound interest, you can still put yourself in a great position to retire. By following these saving tips, and assessing what you would like retirement to look like for you — you can easily put yourself in the position to get where you want to be!

If you still have questions, or would like help walking through a savings plan, please contact me and we can set up a free introductory call!