Smart Money?
Contents
According to an article in The Wall Street Journal, an academic study has concluded that the smarter you are, the more likely you are to own a Roth IRA, and the earlier in life you are likely to open it. In the paper The Impact of Cognitive Ability on Roth IRA Ownership, researchers at St. Joseph’s University and Texas Tech University stated:
…we find that cognitive ability is positively related to Roth IRA ownership and adoption.
This is a very fascinating conclusion, because they make the further assertion that it is cognitive ability, i.e., IQ, and not formal higher education that is the biggest predictor of Roth enrollment.
This is quite a feather in the cap for long-time proponents of the Roth IRA. For years, the public has listened to the liturgy of the word from top financial advisers proselytizing that Roth accounts were smart money. Respected Certified Financial Planner Bob Fitzsimmons, of Omaha, Nebraska, says:
Younger people especially, I urge them to open a Roth. Being able to get tax-free withdrawals is very powerful, so the general notion is you should look to the Roth IRA right away.
It is one thing to hear such proclamations from financial professionals, but quite another thing to have academians in the social and economic sciences say, in essence, that early adoption of this retirement strategy proves how smart you truly are.
Tax Advantages During Retirement
Central to this assertion is a thorough understanding of the benefits of delayed gratification as it applies to retirement planning. Although contributions to the plan are not able to be used as tax deductions, the future withdrawals are tax-free at any time, and that is because the tax has already been paid. This distinction is important, because the ability to easily absorb the tax burden is greatest during the peak wage-earning years.
Famed financial guru Suze Orman states:
…since you invest in a Roth with money that has already been taxed, you are free and clear of Uncle Sam. You already gave the federal government its bite. So when you reach retirement and start making withdrawals, there will be no tax. Zero…Remember, withdrawals from your 401(k) and traditional IRA will be taxed at your income tax rate, which can be as high as 35 percent. That’s a big, big difference.
Planning Early
Although the findings have suggested that intelligence was more of a factor than education, the good news is that investors can still be taught to be smart. The lesson that teaches people that they can help secure their futures by opening a Roth IRA as early as possible is not going by the wayside. According to the USA Today, seventy percent of the under-30 who are eligible for their company’s retirement plan contribute to that plan. Almost half of all workers under the age of 30 state that retirement benefits strongly influenced their choice of jobs.
Said one public relations assistant account executive, aged 23:
I knew what a Roth IRA was at 17. I learned about it in economics class. My generation is much more realistic. We were in college when we saw the whole dot-com bust.
Advantages Over Traditional IRAs
One of the most attractive features about a Roth account is flexibility. You don’t have to be fresh out of college to reap lucrative benefits. Unlike traditional IRAs, there is no age limit for contributing. Likewise, unlike other IRAs, there is no set age dictating when you must start minimum distributions. Some people, based on their individual circumstances contribute to both a Roth account and a traditional 401(k). Charles Howry, a private wealth advisor and CFP out of New York, has been quoted saying
A Roth IRA with a 401(k) makes a lot of sense.
The reason that the combination makes so much sense is twofold. The first and most obvious advantage is diversification, in other words, protecting yourself and your retirement from the consequences of metaphorically putting all of your next eggs in one IRA basket. In a volatile business world, employees who focus solely on investing in company stock can lose their life’s savings should the company ever reorganize ala’ IBM in the 1990’s.
The second advantage lies in the ability to take advantage of the distinct benefits of each type of account. Says Don Boegel, a Minneapolis-based CFP:
On a pure dollars-and-cents basis, the difference is that with the traditional 401(k) you get the tax break now, while with the Roth 401(k) the tax break comes later.
It depends upon the age of the individual and the personal income tax situation, but I like the Roth IRA.
Flexibility is the key word concerning a Roth account. Ideally, you contribute to an IRA for financial security after you retire. However, if you come upon life’s unforeseeable hurdles, you may with draw from your contributed amount at any time, with no loss to taxation. Or, if you are retired, you can take or not take a distribution, at your discretion.
The fact that traditional IRAs hamper that choice is one more credit in the favor of a Roth IRA, in some people’s eyes. According to Tim Nolworth, a CFP in Chicago:
Some people need the discipline of the taxes and penalties of a traditional IRA to avoid the temptation to use the money too quickly in retirement.
Conclusion
The general consensus seems to be the younger an eligible earner is, the more a Roth IRA appears to be the smarter and superior choice over a traditional IRA, because of the future tax benefits and the flexibility it affords. It is perhaps said best and most succinctly by Ms. Orman.
I love the Roth IRA. Tax-free income in retirement is truly a Ms. Orman.
Love; That’s a strong word, especially coming from someone working in the financial sector. But when it comes to your hard earned money, the words “tax-free withdrawals” are about as close to an expression of heartfelt endearment as you are likely to get.
