You probably know the conventional wisdom: Tax-free Roth IRAs and 401(k)s—a relatively new and fast-growing breed of retirement account—make the most sense for young investors.
But a growing chorus of advisers, backed by new research, indicates older investors can benefit from Roths, as well.
Even for many in their 40s, 50s and 60s, "Roths should be the rule and traditional 401(k)s and IRAs the exception," says Stuart Ritter, a senior financial planner at T. Rowe Price, the Baltimore-based mutual-fund company.
The classic candidates for a Roth are those convinced their marginal tax rates will be higher in retirement, a description that fits many younger workers. By paying income tax on their contributions now, these workers can avoid paying Uncle Sam at a higher rate on their withdrawals. (In contrast, with a regular IRA or 401(k), investors receive upfront tax deductions and pay income tax on their withdrawals.)
But those who expect their marginal tax rates to remain the same in retirement can also benefit from a Roth—or more specifically, from the tax-free withdrawals they can take from these accounts when distributions from a regular 401(k) or IRA would push them into a higher tax bracket.
Moreover, workers in their 40s, 50s and early 60s who want to contribute the maximum to a tax-advantaged retirement savings account can accrue more wealth with a Roth than with a traditional 401(k), even if their marginal tax rates actually decline by as many as 10 percentage points in retirement, according to Mr. Ritter, whose research on Roths was published in March.
"The power of tax-free compounding in a Roth can offset even a significant drop in tax rates between when the investor made an IRA or 401(k) contribution and began retirement withdrawals," Mr. Ritter says.
Roths come in two flavors: the Roth 401(k) and the Roth IRA. Now offered by half of large employers, up from 11% in 2007, a Roth 401(k) can be a boon for high earners and big savers. While contributions to a Roth IRA are off-limits to individuals with modified adjusted gross incomes above $129,000 a year and couples with annual adjusted gross incomes above $191,000, the Roth 401(k) is open to anyone whose employer offers these accounts.
To see how a Roth account might benefit an older investor, consider a 50-year-old worker who—after years of saving diligently—has amassed enough in his tax-deferred retirement accounts that he is confident he will remain in the same tax bracket when he retires.
At first glance, contributing the same amount to a Roth or a regular 401(k) will get the same result. For example, if he contributes $5,000 of pretax income to a regular 401(k) that earns a 7% annual return, he will have $38,061 before tax in 30 years. After paying tax at a 28% rate, he will net $27,404—the same amount he would amass in a Roth after paying a 28% upfront tax on $5,000 of pretax income and investing the remaining $3,600 at 7% for 30 years, according to Fidelity Investments.
So why favor a Roth?
For one thing, with a Roth, he will have greater flexibility to manage his future tax bills. If in retirement he has to withdraw a large amount from his IRA or 401(k) to pay for, say, a new car or a child's wedding, he can take a tax-free distribution from his Roth without inflating his taxable income and potentially subjecting himself to a higher tax bracket or higher Medicare premiums.
Moreover, because our worker typically contributes the maximum the Internal Revenue Service allows to his 401(k), he comes out ahead with a Roth. The reason: While the rules allow him to put $23,000 before taxes into a regular 401(k), he can put as much as $23,000 after taxes into a Roth 401(k). As a result, while for someone in the 28% tax bracket the IRS effectively has a claim on 28% of a $23,000 contribution to a regular 401(k), it has no claim on any of the $23,000 of after-tax money that goes into a Roth. (Roth money grows tax-free, provided an account owner has the account for at least five years and is 59½ or older when he starts withdrawals.)
This allows someone in the 28% bracket to "effectively put 28% more in a Roth," says Rob Austin, director of retirement research at Aon Hewitt.
Finally, even if our worker were to contribute the $23,000 pretax maximum to a traditional 401(k) and then take the 28% upfront tax deduction he'd receive for that contribution and invest it in a brokerage account, he'd still likely come out ahead with a Roth. The reason: As this investment accrues dividends, interest and realized capital gains, those profits are taxed. The Roth, in contrast, grows tax-free.
The upshot, according to T. Rowe Price, is that someone 50 years old planning to retire in 15 years who expects to remain in the same tax bracket is likely to amass 11% more in a Roth, versus a regular 401(k) and a brokerage account, assuming 30 years of withdrawals. The Roth will come out ahead even if this person's postretirement tax rate declines by as much as eight percentage points.
For someone planning to retire immediately, the Roth will accrue 6% more wealth and maintain a performance edge unless the account owner's postretirement tax rate declines by more than five percentage points.
Ms. Tergesen is a staff reporter for The Wall Street Journal in New York. Email her at firstname.lastname@example.org.
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