Shout out for the Roth IRA

Written by Rory Dorman, ACA

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…

Disclaimer 

All of the material published on MASECO LLP’s website or via social media is protected by copyright law.  You may view the material for your own personal use and you may share the material where it is indicated that this is permitted to other parties for their personal use only.  None of the material nor contents may be used for commercial purposes.  You may only share articles in the form in which they appear on our website.  You are not permitted to take an extract from an article and distribute the extract, for example, by cutting and pasting content into an email.

Use of information: 

•    Nothing in this document constitutes investment, tax or any other type of advice and should not be construed as such. 
•    The investments and strategy noted in this document may not be suitable for all investors and making available the information in this document is not a representation by MASECO that any investment strategy is suitable for any particular client. 
•    This document is provided for information purposes only and is not intended to be relied upon as a forecast, research or investment advice. 

Risk Warnings: 

•    All investments involve risk and may lose value.  The value of your investment can go down depending upon market conditions and you may not get back the original amount invested. 
•    Your capital is always at risk. 
•    Although the information is based on data which MASECO considers reliable, MASECO gives no assurance or guarantee that the information is accurate, current or complete and it should not be relied upon as such. 
•    The levels and bases of, and reliefs from, taxation is subject to change.  The tax treatment depends on the individual circumstances of each client and may be subject to change in the future.

Performance: 

•    Past performance is not a reliable indicator of future results. 

MASECO LLP (trading as MASECO Private Wealth and MASECO Institutional) is a limited liability partnership registered in England and Wales (Companies House No. OC337650) and has its registered office at Burleigh House, 357 Strand, London WC2R 0HS. The partners are Mr J E Matthews and Mr J R D Sellon; Mr D R B Dorman, Mr H Q A Findlater, Mr T Flonaes, Mr N B Tissot, Ms A L Solana. Telephone calls may be recorded for your protection.

MASECO LLP is authorised and regulated by the Financial Conduct Authority for the conduct of investment business in the UK and is registered with the US Securities and Exchange Commission as a Registered Investment Advisor.