Why Fear of Tax Hikes Is Fueling a Roth IRA Boom

Roth IRAThe economic prognosticators have spoken: Tax hikes are coming -- soon. And that means you may want to adjust your retirement planning to compensate.

It wasn't that hard to do the math: Thanks to tax cuts, wars, the recession and our growing population of retirees, the federal government is spending more than it takes in -- a lot more -- and will have to increase revenue to make up the difference. That this will be necessary has been obvious for years, but politics and our ongoing economic malaise have postponed the inevitable.

In 2013, experts say, the fiscal strain will hit critical mass and the delays will end. The top income bracket will go from paying 35% to almost 40%, with surtaxes expected in 2014. After that? They could even go higher.

Which is why future retirees looking for savvier ways protect their money in the long term are flocking to Roth IRAs, according to Doug Lockwood, CFP at Hefty Wealth Partners in Auburn, Ind.

What is a Roth IRA?

The Roth Individual Retirement Arrangement is a retirement plan that allows you to withdraw money tax-free in retirement. That contrasts with traditional IRAs and retirement plans, that let you deposit pre-tax funds, but tax your withdrawals.

Now, in a traditional IRA, you can deduct your contribution (up to $5,000 annually) from your taxable income. But let's think about the future.

There's an old business school trick called the Rule of 72 for estimating how many years it will take for an investment to double: Divide 72 by your average return on investment percentage, and you have a rough answer. So, if someone earns 8% on a Roth IRA, -- 72/8 = 9 -- their money will double every 9 years. Thus, $5,000 invested at age 30 will become $10,000 at 39, $20,000 at 48, $40,000 at 57 and $80,000 at 66. If that were a traditional IRA, the investor would then have to pay income taxes on the $80,000.

With the Roth, you don't get a deduction for your contribution, so you pay the taxes on the initial $5,000 you put in. Your investment grows the same way, but when you take money out, it's tax free. Basically, you're choosing between paying taxes on the seeds or on the crops.

The crux of the matter comes down to people's belief that taxes will continue to increase. Based on that premise, it's better to pay the taxes on your initial investments now, while rates are lower, than to wait and pay a higher rate on your total returns when you remove the money at retirement.

The Roth's Rise

IRA's are the most popular type of retirement savings product, holding $4.7 trillion in assets as of the end of 2010, according to Mintel Market Research. And according to the Investment Company Institute's 2008 IRA report, as of May 2008, 41% of U.S. households had an IRA. Back then, the great majority of IRA owners had a traditional IRA (89.6%), while a modest 4.2% had a Roth (and 6.1% had another type, such as a SEP or SIMPLE). But it was Roths that were experiencing the most growth -- the number of accounts increased 47% from 2000 to 2008.

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And the Roth has gained continued momentum throughout the recessionary period: In 2010, 38.5 million U.S. households had traditional IRAs, and 19.5 million had Roth IRAs.

"Now all of sudden, the Roth makes a whole lot more sense or at least makes people take a view at its benefits over the traditional IRA," Lockwood said.

The advantage of a Roth is that it's never going to be taxed again, it has capital appreciation as long as it grows and you get it back tax free. "That's a huge, huge benefit for people worried about government manipulation and the IRS," Lockwood said. "Inside an IRA, you don't know what you're going to get back."

Much of the growth in IRAs comes from rollovers from other types of retirement plans as people try to protect their assets from future tax hikes. The majority of assets are held in Traditional IRAs, but more of the new money coming in is going into Roth or other types of IRAs, according to the Employee Benefit Research Institute.

It's also no coincidence that more companies are offering the Roth option to their employees. In 2000, the Roth IRA assets were $78 billion but $160 billion in 2005 and $265 billion in 2010. Overall, the percentage of companies offering Roth IRAs has grown from 19% in 2007 to 24% in 2009-2010.

Not everyone can open a Roth, but most people can: The Roth IRA is an option for singles making less than $110,000 annually or couples making less than $173,000 annually.

"Conversion [to Roth IRAs] is getting a lot of traction," Lockwood said. "Next year, our tax brackets are going up. The amount of money going to a Roth will grow exponentially."

Looking Forward

As younger workers have gotten the message that Social Security benefits are unlikely to be as generous when they retire as now, they've begun to get more serious about retirement plans, according to Mintel Market Research. That increasing prudence about retirement preparation is adding momentum to the trend toward IRAs in general, and Roth IRAs specifically.

According to the ICI, IRA assets increased 81% from 2000-07. The ICI's report, The Role of IRAs in U.S. Households' Saving for Retirement 2008, found that in the early 1990s, IRA assets accounted for 4% of all household financials; that year, they represented 10%.

"It's a bird in the hand for the traditional IRA versus two birds in the bush for the Roth," said T. Doug Dale, CIO at Security Ballew Wealth Management in Jackson, Miss. As tempting as a tax break today might be, the savvy personal finance planner might do well to be patient and avoid potentially painful taxes down the road by joining the Roth trend.

The Big Retirement Myth: You'll Spend Less
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Why Fear of Tax Hikes Is Fueling a Roth IRA Boom

By Selena Maranjian, The Motley Fool

There's a persistent assumption going around about what happens after one retires: Pundits, financial planners and even retirees often claim that your spending shrinks after you leave the 9-to-5 world.

Sure, your house may be paid off by then, and you may be able to ditch the expenses of commuting and buying clothes for work. That's not the full picture, though.

In good and not-so-good ways, many people end up spending more than they expect during their golden years.

For lots of folks, retirement means finally getting around to doing things you've been putting off for years. And those things cost money.

You may finally do some traveling in Europe, for example, or explore the U.S. in an RV. Want to get serious about your love for curling? Joining a league costs some money. Looking forward to overhauling the garden or taking up woodworking? That'll cost you, too. Even just traveling to visit and spend time with the grandkids can add up -- in travel costs, dinners to treat the family, and gifts and ice creams for the young ones.

Of course, you don't have to bear these costs. You can let the children and grandchildren come to you and can spend more time in public libraries than on golf courses. But the early years of retirement, in particular, are when folks tend to have significant energy and lots of plans.

Unfortunately, many expenses in retirement are not so discretionary.

Health care, for example, can take a huge bite out of your nest egg. Fidelity Investments recently estimated that a 65-year-old couple retiring today can expect to pay, on average, about $230,000 on health care. That's just an average, so you might spend far less -- but you could also spend much more.

Medicare probably won't provide sufficient coverage, so you might need to buy supplemental insurance, which isn't usually cheap.

Meanwhile, though a lower income level will probably mean your income taxes will decrease, you'll still be on the hook for property taxes. And those will probably keep growing over time. If your annual property tax is $3,000 and it grows at 3% each year, it will hit $5,400 in 20 years.

Your home insurance costs will rise, too, along with your car insurance premiums, the cost of heating and cooling your home, groceries, and most other items.

And finally, whereas you might expect retirement to be a time when you're no longer raising children and supporting those dependents, you might still find yourself occasionally -- or routinely -- helping your loved ones out financially.

Still, the news isn't all bad. While you might spend more than you expected to once you retire, you probably won't keep it up. As we move into and then out of our 70s, people tend to slow down and be less active. Less travel, less eating out, and fewer hobbies can mean lower spending.

Throughout most of our retirement, we'll enjoy discounts on various expenses, too, such as movie tickets, meals, and even property taxes.

What to do

Don't let your retirement plan end up designed by assumptions you never questioned. Take some time to map out what your expenses may be in retirement, and to make sure you're saving, investing, and accumulating enough to support them.

If it looks like you're not quite where you should be, you have options. You can ramp up your saving and invest your money more effectively. (Yes, you can become a millionaire on a minimum-wage salary.) You might work a few more years before retiring, too, which can do wonders for your nest egg by boosting your Social Security benefits.

Another possibility is working part-time through part of your retirement, which can add income and possibly some useful benefits as well. It also keeps many retirees happier, giving them a social setting to belong to. Downsizing to a smaller home or moving to a less costly town or region can also make a difference.

Spend some time planning now, and you'll thank yourself later.

Learn more:

AOL DailyFinance Retirement News

The Motley Fool Retirement Nook

The Social Security Administration Retirement Planner

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