What I am Seeing

I am a CPA and this time of year my days are filled with preparing and reviewing hundreds of tax returns. A tax return is largely a summary of the prior year’s financial activities and can be a window into opportunities to improve those financial activities. One common theme I have seen lately is the underutilization of ROTH Individual Retirement Accounts (IRAs). This article is my take on why the ROTH IRA is so underutilized and why it should be a more prevalent account among savers of all ages.

The Tollway Always Gets Its Tolls

There are two flavors of IRAs and 401(k)s available, traditional and ROTH. Both the traditional and the ROTH vehicles were designed by Congress to provide assistance with saving for retirement. Imagine two vehicles about to head on a long road trip. The ROTH vehicle pays its tolls just to get on the tollway before the trip even begins. The traditional vehicle pays all its tolls when it exits the tollway. Now imagine, halfway through this road trip an unexpected event occurres and both vehicles need to exit the tollway before reaching the destination (retirement age of 59½). The traditional vehicle must settle up with the toll authority upon exit and there is a penalty for exiting early. The ROTH vehicle already paid tolls up front at the on-ramp so exiting can be primarily toll-free at any time, even before the destination.

ROTH IRA as a Savings Vehicle

The most common feedback I hear to retirement account contributions is, “I am not sure if I will need this money before I turn 59½”. This is a great point as traditional 401(k)s and IRAs are structured with penalties to prevent raiding retirement accounts before age 59½.  The concern is that medical expenses, college education funding, vehicles, homes, and vacations will be difficult to fund when too much of the family’s savings is in a retirement account that cannot be tapped until 59½ without tax and penalty unless one of the few exceptions allowing penalty free withdrawals is met. This concern is legitimate and finding the right balance between long-term and short-term savings is a delicate tightrope balancing act.

Steve and Jill contribute 10% of their paycheck to their 401(k) at work. This money is set aside for retirement and they do not plan to tap into it until then. Each year Steve and Jill save an extra $10,000 that they put into a taxable investment/savings account yielding an estimated 4.0% each year. Steve and Jill do not want to put this $10,000 a year into their 401(k) for fear they will need access to it prior to 59½. As a result, Steve and Jill must pay tax on the $400 (4% of $10,000) of income in the first year and as the account balance grows by $10,000 each year the tax on the earnings grows as well.

What if they each put $5,000 into two ROTH IRAs each year instead of the $10,000 into the brokerage account? What would this change? The $400 of income would no longer be taxable in year one. Over the course of 15 years with no withdrawals, the brokerage account value would be an estimated $188,739.72 compared to the estimated ROTH IRA balance of $200,235.88. The below chart is a depiction of the projected earnings for the 15 years between the two accounts.

This difference is often called tax drag. Eliminating the tax drag for 15 years by utilizing the ROTH IRA Steve and Jill essentially get an extra $11,496.15 “contribution” to their account by Uncle Sam.

But wait, Steve & Jill’s whole concern was they might need the money before 59½ and in the above example they never took a withdrawal. Exactly, a ROTH IRA allows withdrawals of prior contributions at any time for any reason. So, if in year five Steve and Jill had a cash need, they could take out up to $50,000 from the ROTH IRA with no tax or penalty. The projected $6,329.75 of earnings up to that point would need to stay inside the ROTH IRA until 59½ to avoid any potential tax or penalties.

To sum up the decision Steve and Jill face. If the $10,000 a year in savings is going to be used for a specific future need and the earnings on the $10,000 will be needed to fund the expenditure then the ROTH is not the way to go as the earnings will generate tax and a 10% penalty upon withdrawal. However, if the $10,000 a year is “safety-net” savings that might or might not be needed down the road I would suggest taking a long look at the ROTH IRA as a tax efficient vehicle to hold that “safety-net”.

Contribution Limits

ROTH IRA contributions are limited to the lesser of earned income or $6,000 per person in 2019 and 2020. If one spouse has at least $12,000 in earned income and the other spouse does not work the IRS considers both spouses to have met the earned income requirement to each fully fund ROTH IRAs. The annual limits do not carryforward so Steve and Jill cannot look back in year seven and wish they contributed to a ROTH over the previous seven years and make up for it. If a year goes by without a ROTH contribution that potential contribution is lost. Those who are at least age 50 at year end are able to make a $1,000 additional catch-up contribution bringing their maximum contribution to $7,000. IRA contributions are typically allowed to be made through April 15th of the following year. Taxpayers may be able to make 2019 IRA contributions through July 15th of 2020 due to the Treasury’s postponement of the 2019 original individual income tax filing deadline. The IRS has not made it clear whether the postponement of the filing deadline has postponed the IRA contribution deadline so stay tuned for more information in the coming days.

Direct ROTH IRA contributions are only fully allowed for married filers with adjusted gross income (AGI) less than $196,000 or single filers with AGI of less than $124,000 in 2020. I refer to these direct ROTH contributions as contributing through the front door. For those with AGI in excess of these thresholds there is a way to still contribute to a ROTH IRA but it must be done through the back door which is a two step process. If AGI is in excess of the above thresholds taxpayers can contribute to a traditional IRA, not deduct the contribution, and subsequently convert that non-deductible traditional IRA to a ROTH IRA. This works wonderfully in many situations however, if you have pre-tax traditional IRA dollars the back-door contribution method will trigger taxable income and is likely not a good solution for you.


Last, the fact that this article is of interest to you means you have savings, congratulations! This is no small feat and spending less than you make, while difficult, is crucial to a healthy financial life. As you decide where to allocate those savings at least consider the ROTH IRA as it can function as a tax saving chameleon more so than most people give it credit for.