How much benefit does a Roth IRA really give you?

[Pointedstick]

I was crunching some numbers this morning and I ran into a quirk of US tax law regarding the Roth IRA that I found rather odd, if I'm correct about it. I thought it might be worth it to bring up here for discussion.

As of this year, the long-term capital gains tax rate for people in the 10% and 15% brackets is 0%. If I'm reading things right, this means as long as you take long-term investment profits while remaining in one of those tax brackets (even easier if you're married to a non-working spouse), then your "taxable" investments are basically tax-free like a Roth IRA, but without any of the restrictive rules of a Roth!

If hypothetically I retired tomorrow as a 60 year-old married man with a non-working spouse, doesn't that mean that my retirement income would have to exceed $70,700 (thus putting me in the 25% bracket and kicking me out of the 0% long-term capital gains tax rate) before having the investments in a Roth IRA would actually provide me any benefit? And on top of that, if I took the standard deduction of $11,600, the actual investment income can be $82,300! Assuming my only retirement income was from investments, wouldn't I need a truly titanic portfolio of $2,743,333 (@ 3% withdrawal per year) before that income threshold was crossed and the Roth started to give me any benefit? That's a crapload of money to accumulate in a Roth. I don't know how you even could with a $5,000 yearly cap.

I have to be calculating this wrong. Because keeping retirement income in or below the 15% bracket seems to me like it would be the easiest thing in the world with my current level of frugality. And in retirement, I can have even less income since I won't have to save as much/anything. I know that congress can change the rules at any time, and the Bush tax cuts that ushered in these nice tax rates for low-to-middle income people might expire very soon, but someone tell me I'm wrong and that a Roth IRA actually provides a benefit!

[KevinW]

I didn't check your figures, but AFAIK this is true in principle. The tax burden on low-income investors is very low.

I think I worked out once that, due to this rule and the standard deduction, someone who makes about $25k/year, lives on $5k/year, and maxes out a 401k and traditional IRA every year, could retire after about 8 years and never pay income tax their whole life.

[Greg]

This does seem like an interesting idea but I'm going to play devil's advocate if I may (for funzies)

1.) It is true at current laws that 10 and 15% tax brackets pay no capital gains. If this changes however between now and when you would want to retire, if tax brackets go up, then you'd be wishing you had put money into a Roth when you had the chance. It's more of an insurance against rising tax brackets in the future.

2.) Does Social Security count towards your Income? If so, then your portfolio wouldn't need as much capital gains increase before you'd go over the threshold and then you'd be paying whatever that bracket of tax is.

At least in my mind, I don't see a problem getting into the higher tax brackets. If I have more money than I need when I retire, I can either give it away to children, or other sources for when I die.

That being said, I think that there is a higher than not probability that tax brackets will raise in the future but that's just an opinion. I'd want to get into a Roth now and lose some flexibility of pulling the money out for the insurance that if brackets do raise, that I'll be covered.

[moda0306]

You still have to pay state taxes of between 5-10% depending on the state.  Further, If you're in the 15 and likely to someday be in the 25, you'll want to be conscious of that and not sell after you're out of the gold zone. Plus, with our portfolios in 3/4 non-stocks, all of which are difficult to get in a 401k.

[notsheigetz]

As of this year, the long-term capital gains tax rate for people in the 10% and 15% brackets is 0%.

I had no idea this was true. Planning on a budget of around $70k in retirement this might change my perspective.

I wasn't able to contribute to Roth accounts due to income restrictions until they loosened them up a few years ago but I have been doing so for both me and my wife for the past few years (and I am able to contribute the max of up to $21,500 into a Roth at work in addition to my personal limit of $6k). I thought I would do this for a few years just to seed the accounts for future growth and give myself some tax free money that I won't spend until my twilight years (or pass onto the kids if I don't need it). Having suspicions similar to yours I just discontinued my Roth contributions at work and went traditional 401K only. Will probably still do the yearly personal contributions for a while however.

My thinking is you never really know what's going to happen with taxes in the future so like the PP I've got myself covered from all angles, including Roth, Traditional and taxable savings.

[dualstow]

Pointed,  ("P-Stick" sounds rather indelicate. ;-) )

You've brought up something incredibly important to me. While your hypothetical amounts are larger than my real ones, I think the situation you're describing is mine. I have a rather large portfolio, especially for my age, but my income is a modest 60K (US$).
# I think I was in the 20% bracket once or twice, but last year I was in the 15% group.
# My wife earns very little, but neither of us has an extravagant habit or expensive hobby.
# I paid zero taxes on dividends, although I have a lot of pre-PP individual stocks in my taxable account.
# I don't usually take large capital gains in taxable.
# State tax is only about 3%
# City tax is actually large. I'll spare you the details.

I've been throwing excess cash into a Roth IRA and a solo 401(k) for the past several years. Although the contribution limits of the latter are dictated by income, I cannibalize the taxable account. If I used my income, I wouldn't have enough left to spend. That's why I have posted questions like, "Is it possible to put too much in tax-deferred?" I thought I was doing the right thing letting wealth accumulate tax-free for now, but maybe my tax burden is low enough that I should reconsider all this.

[WildAboutHarry]

A handful of states do not tax income, so the value of a Roth is reduced if you live in (or retire in) a no-state-income-tax state.

Having funds in a regular IRA and a Roth IRA does allow for future tax planning.  Remember you have RMDs on regular IRAs, and that could bump you into a higher tax bracket. 

For example, you could fund early retirement (either before or after claiming social security) from traditional IRAs (doing Roth conversions along the way if possible) and keeping your income in the lowest bracket possible.  This would reduce the value of the traditional IRA and consequently the RMD after age 70 1/2.  You can then withdraw from the Roth.

[TripleB]

You guys heard about the "Bush Era Tax Cuts" that Obama is so vehemently against because it only benefits the rich at the expense of the middle class? This is one of them. It expires at the end of 2012. The long term capital gains tax rate goes up to 10% for people in the 15% tax bracket starting in 2013.

However, let's assume it does get extended indefinitely. Here's why the Roth is still better:

Roth IRA is protected against creditors. The money in your Roth is essentially "immune" and yours for life. Any money you have in a taxable brokerage account is fair game if someone wants to drum up a bullshit liability claim against you.

There's certain government benefits (aka welfare/handouts/socialism) that you can use whereby your IRA assets may not be counted against you. I can't speak too intelligently about this because the ones I looked into all factored in personal vehicle ownership into your assets, so I wouldn't have been eligible anyway. Interestingly, I could sell my car and lease a BMW and qualify for foodstamps because I could shelter all of my assets against the qualification test and not "own" a car. In all seriousness, going forward, there may be significant government handouts in the near future regarding health insurance that factor assets but ignore IRAs.

In taxable brokerage account, you get dividends spit off each year. Those are taxable. So you do wind up paying taxes on those each year, which reduces your principal and thus your long-term growth rate.

If you're using the PP, which I will assume you do or at least are interested in trying, otherwise you wouldn't be here, then only 25% of your money is in stocks. Considering the low annual contribution maximums for a Roth IRA, and the strong desire to stuff cash or bonds (both of which spit off taxable interest payments) into a tax shelter, mean that you should max out your Roth (or Traditional IRA if that makes more sense based on tax planning) if only to keep non-stock assets sheltered in it.

Here's why the Roth IRA isn't as restrictive as you may believe it is:

You can pull out your contributions at any time, for any reason, without penalties/taxes. So if you put in $5k/year for the next 10 years, that's $50k worth of contribution that you could pull out for emergencies if you needed it.

You can pull a SEPP withdrawal that lets you take out a chunk each year, tax/penalty free, for the rest of your life. There's downsides to it, but if you plan it out correctly, it is a useful tool to leverage your IRA.

[TBV]

1) Asset protection in a Roth IRA is not as ironclad as a 401K or pension plan.  However, it all depends on which state you live in.

http://www.latimes.com/la-ira-story3,0,6977190.story

2) @Notsheigetz: Roth IRA contribution of $21,500 plus $6,000???  How is that allowed? The stated limits are much less, unless you're rolling over money from an existing 401K or qualified pension plan.

http://roth-ira-contribution-limits.com/

[moda0306]

TBV,

Those numbers appear to be the 50+ catchup numbers of both 401k and IRA, whether Traditional or Roth.

I do honestly feel there's very little to lose and very much to gain by defaulting to maxing out that Roth contribution before building up other forms of monetary wealth or maybe even paying down lowish interest debt.

[TBV]

TBV,

Those numbers appear to be the 50+ catchup numbers of both 401k and IRA, whether Traditional or Roth.

I do honestly feel there's very little to lose and very much to gain by defaulting to maxing out that Roth contribution before building up other forms of monetary wealth or maybe even paying down lowish interest debt.

Couldn't agree with you more, Moda, on the benefits of a Roth IRA.  However, folks should be aware that assets contained within one are not immune from lawsuits, and the most a 50+ married couple can contribute each year (subject to various limitations based on income) is $6,000 per person.