Why Fear of Tax Hikes Is Fueling a Roth IRA Boom

Roth IRA
Roth IRA

The 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.