Headline: Roth IRA might make you want to, JUMP!!

Date: 12/5/2020

Body: I just read an interesting article at Investopedia about the potential disadvantages of a Roth IRA.    The article (linked below) made me think.

Disadvantages of Roth IRAs Every Investor Should Know (investopedia.com)

Until now, all that I had read extolled the virtues of investing in a Roth IRA.   Perhaps not?

What is a Roth IRA?

A Roth IRA is a savings account for your retirement.    It is different from a Traditional IRA (largely) because you fund the account (make contributions) with money that has already been taxed.  So, when you go to withdraw it in retirement, neither your contributions nor your earnings are taxable.  I later learned that with a Roth IRA, there are never any dreaded “required minimum distributions” (explained later) like with a traditional IRA.    On this basis, I was always instructed that as long as you meet the requirements, (described later) you would be better off with a Roth.  (Especially if you expect to be in a higher tax bracket after you retire.)

What are these disadvantages?

First, this kind of account draws from money that was already taxed.   This makes the “pinch” on your wallet a bit harder, especially early in your life.  Were we more rational beings (think Dr. Spock from Star Trek) this would be less of a concern.   But, we are not Vulcan, and we are living through difficult financial times, so, this is a valuable point to make.

Second, you need to have the account open for 5 years before you take distributions.    This shouldn’t be a concern, as you should be at least thinking about retirement before this, but once again, Life rears its ugly head (or perhaps the reverse) and things happen.    So, if you don’t plan ahead far enough, this could potentially become a pitfall.

Third, there are income limits.   You might have heard about MAGI.   This is not a fictional figure who sells hair or watch fobs.  It stands for Modified Adjusted Gross Income, (The IRS is so creative.)  You might recall that there is a line at the bottom of p.1 of the 1040, and this is your Adjusted Gross Income.   MAGI simply adds some things back and deducts some others from adjusted gross income. (This is the number at the bottom of p.1 of your 1040, and the top of p.2 of your 1040.) The limitations are quite high, topping out at $140,000 for single taxpayers and $208,000 for married couples( these are 2021 tax year numbers.).  Excluding a few zip codes, incomes like these should not exclude many people, and if they do, it seems likely that they would already have the financial advisors to make needed recommendations to take advantage of the Roth, if they deem it advantageous for the client.

Fourth, your employer might offer a better deal.   For instance, they might offer a 401(k) plan that allows for a far more generous contribution limit.  But, at some point (hopefully) you will leave the workforce to retire, and if you have the IRA set up outside the company, it is a relatively simple matter (usually) to make a trustee-to-trustee transfer to the outside IRA.

Fifth, there are some people who expect to retire with enough money in taxable accounts that their retirement money will mostly be left to charities they like to support.  In this case, the charities already enjoy tax-free status as a 501( c) (3) and it would make little sense to give them money that has already been taxed.    I think this probably only applies to some very wealthy individuals, and the large majority of people (like me) will need most of their retirement money.  If this does apply to you, might I suggest giving some to me?

Sixth, if you currently have your retirement income in a Traditional IRA or a 401(k), when you do a rollover to a Roth IRA, you could face a daunting tax bill.  But, you can sometimes recharacterize only a piece at a time of your 401(k) to your Roth IRA.  This allows you to spread out the pain of paying taxes, over time.

The Verdict

Roth IRAs are often the right investment vehicle, but, in some situations, they might not be.    To my way of thinking, for most individuals and married taxpayers, they make sense, despite the potential disadvantages.  (And for each of these disadvantages, there is usually a “workaround” to mitigate the tax bite.)  Before you do make any of these changes, consulting a CPA or financial advisor could make sense, or perhaps many more dollars.

REFERENCES:

The Pros and Cons of a Roth IRA – NerdWallet

6 Reasons to Say No to a Roth IRA (fool.com)

The Disadvantages of a Roth IRA | Finance – Zacks

Opening a Roth or Traditional IRA (thebalance.com)

Editor’s Note: Please note that the information contained herein is meant only for general education: This should not be construed as Tax Advice.   Personal attributes could make a material difference in the advice given, so, before taking action, please consult your tax advisor or CPA.