Home>Video>Roth Advantage May Be Bigger Than You Thought

Roth Advantage May Be Bigger Than You Thought

Tue, 13 May 2014

Even if your tax bracket doesn't change, using a Roth can mean 20% or more aftertax income in retirement versus a Traditional IRA, says T. Rowe Price senior financial planner Christine Fahlund.

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Video Transcript

Adam Zoll: For Morningstar, I'm Adam Zoll.

The Roth IRA can be a versatile retirement savings tool for investors, especially younger investors. Here to talk about that is Christine Fahlund, senior financial planner for T. Rowe Price.

Christine, thanks for being here.

Christine Fahlund: Thank you, Adam.

Zoll: This new research found that, among other things, the amount of spendable income in retirement really increases for most people with a Roth IRA, but it particularly has an appeal for younger investors. What can you tell us about that?

Fahlund: Yes. Actually what we're finding is that younger investors are now tending to invest in a Roth instead of a Traditional IRA. That's very exciting because our research is showing that after tax, if you let that compound for years and you withdraw in retirement, even if your tax bracket is the same as it was before when you retired, it can be 20% or more after-tax income than the Traditional IRA would be.

Zoll: This has a special appeal for younger investors because they have a much longer time horizon, their money can compound over time. So, I take it that you would recommend a Roth as the first place to look for most younger investors?

Fahlund: Absolutely. The other thing is, presumably you are in a lower tax bracket than you're going to be in later. So, if you need a tax deduction, you are not going to get very much for your money if you're younger and you are not paying that much in taxes anyway.

Zoll: Another advantage of the Roth IRA aside from the fact that you get the tax-free withdrawals is that you have a lot more flexibility. For example, if you did need the money before you retired, you can take some of that money out without being taxed.

Fahlund: That's right. You could take contributions out at any time, because you've already paid the taxes on those, and they come out first. After that, there are some exceptions to the rules where a young investor would have to pay a 10% penalty for withdrawing early. Those exceptions include, for example, withdrawing money for first-time homebuyers. So there are some nice exceptions that way.

Zoll: We're still relatively early in the year. Your research also showed that a lot of investors are contributing to their Roths earlier in the year, which makes sense down the road, doesn't it?

Fahlund: It really does. And what we are seeing and encouraging people to do is, if you were one of those who just [recently] contributed for 2013 [before the deadline], why don't you see if you can also do 2014 at the same time? What you want to do eventually is get a jump on this, so that you're always making your contributions for that calendar year in January.

Zoll: Some of your research has also shown that investing early in the year tends to outperform waiting until the very end of the year to invest in an IRA.

Fahlund: Yes, over 10-year rolling periods, using the S&P 500, we found that it outperforms 96% of the time.

Zoll: So another lesser publicized advantage of a Roth IRA is that you are not required to take RMDs, whereas with a Traditional IRA you are. And those RMDs can actually have a ripple effect on your other financial decisions.

Fahlund: They can, because a lot of investors today have a significant sum in a traditional IRA or rollover IRA. If you're required to take 4% out in the first year, which is roughly what happens with a required minimum distribution, that can be a significant sum. That may be raising your taxes, raising you into a tax bracket that's higher than you'd wanted.

What happens also when you go into a higher bracket? Your Medicare premiums may go up, the percentage of your Social Security that's included in taxable income may go up; there are a lot of consequences. So if you could move some of the money into a Roth IRA, so you didn't have those anymore, that's a nice setup.

Zoll: So considering the flexibility you get with a Roth IRA, the tax bracket equation that we talked about, it sounds like it makes a lot of sense for younger investors to look at the Roth first and understand what that account is going to allow them to do as they plan for their retirement.

Fahlund: Absolutely.

Zoll: Thanks so much for your time today, Christine.

Fahlund: Thank you Adam.

Zoll: For Morningstar, I'm Adam Zoll. Thanks for watching.

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