22nd Apr 2021 by Rory Dorman, ACA

Shout out for the Roth IRA


Rory Dorman, Partner and Senior Wealth Manager at MASECO, shines a proverbial spotlight on the Roth IRA and shares why he is such a fan of this particular tax-wrapper. In his article, Rory discusses the basic mechanics, numbers and less likely known key nuances of the Roth IRA. In his words, 'what's not to love'. 

It has felt to me for some time that the Roth Individual Retirement Account ‘Roth IRA’ is under-loved, under-whelming and under-appreciated.  This might be because the contribution limits are on the small side, or because the nuances of the Roth are not widely known.  For whatever reason, I thought it worth spending a moment shining the proverbial spotlight on this particular tax-wrapper.  I’m a big fan!

Let’s start with the basic mechanics.  The big difference between a Roth IRA and a Traditional IRA is that the former grows completely free of tax, and distributions out of the plan are also free of tax (provided the distributions are considered qualified).  The latter, in contrast, grows tax-deferred, but distributions are subject to income tax.  Both are generally locked up until the beneficiary hits the age of 59½, so no difference there.

Now let’s consider the numbers.  In my view, an American citizen/taxpayer is never too young to start contributing to a Roth IRA.  Even if an individual’s earnings might prohibit them to make a direct Roth IRA contribution, they may have the opportunity to contribute via what is colloquially known as the “back-door” (but obviously dependent on individual liquidity and cashflow requirements).  In real-speak this means contributing after-tax dollars into a Traditional IRA, and then immediately converting into a Roth IRA.  As there has been no growth during the 5-minutes that the contributed cash sits in the Traditional IRA, moving it into the Roth does not present a tax-event.  In terms of the contribution limits, an American taxpayer can currently (2021) contribute $6,000 per annum to a Roth IRA via the back-door up to age 50, and $7,000 from age 50, provided they have the earned income of at least this amount.  This may seem like small potatoes, but if an investor contributes to the maximum every year from age 21 to 81, with a growth rate of 4%, this computes to a whopping $1,602,406 (!!!!) at the age of 81.  Ah the beauty of compound returns (what Albert Einstein famously quipped was the most powerful force in the universe). 

However, this is only half the story… 401(K) accounts (or the majority of US employer sponsored pension plans) can also be rolled into a Traditional IRA or also have the opportunity to be converted into a Roth IRA.  To be clear, this does present a taxable event, in that it effectively accelerates all the tax due on the historic (untaxed) growth while the assets were within the 401(K) and/or Traditional IRA wrappers.  This can be expensive from a cashflow perspective but for anybody with sufficient liquidity to be able to swallow the tax bill, even if at a higher marginal tax rate, it should make mathematical sense, as from that moment on the Roth IRA grows completely free of tax, again with distributions also free of income tax.

And then let’s talk about a key nuance which does not seem to be widely known.  Traditional IRAs and Traditional 401(K)’s, or their equivalent, are subjected to Required Minimum Distributions (RMDs) from age 72, which are designed to whittle down the value of the plan as the beneficiary approaches their mortality.  In contrast, and in my view one of the most delightful features of a Roth IRA, is that there is no RMD obligation at any point, which means the Roth IRA can continue growing entirely free of tax until mortality.

Which brings me onto my final point regarding estate and inheritance tax planning.  While the Roth IRA is assessed as part of an individual’s estate for US estate taxes, the plan can be passed onto the individual’s heirs as a tax-free saving vehicle, whereby the beneficiary of the inherited or Bene Roth IRA is obliged to take tax-free distributions from the plan over a 10-year period, but can still enjoy the tax-free growth of the corpus during those 10-years. 

In short, what’s not to love about the Roth IRA…


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