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Roth IRAs can be an excellent tool for retirement savings in certain situations. A Roth IRA has the unique feature of tax-deferred growth and income tax-free distributions. But, are there any drawbacks to Roth IRAs, and is there an alternative to the Roth IRA that could serve as a good substitute or addition to your current retirement portfolio?
Since a Roth IRA is a qualified retirement plan, it must follow certain IRS rules for the account owner to receive the benefits. So, what are the rules you ask?
Roth IRA Income Limits
For starters, you must have earned income to contribute to a Roth IRA. This does not include pensions, social security, disability, and annuity payments. Basically, you must have income from a job (W2), a business, or other active work (could be 1099 income from self-employment such as off duty).
Once you have your “earned income,” there are contribution and income limitations. What this means is that some higher-income earners may not be able to contribute to a Roth IRA due to the amount of money they earn per year.
For 2020, individuals cannot have a modified adjusted gross income (modified AGI) of more than $139,000. If an individual’s modified AGI is over $124,000, their Roth IRA contribution limits are reduced. For those filling jointly, the modified AGI limits are $206,000 and reduced contributions at $196,000.
Roth IRA Contribution Limits
If your income limits meet the eligibility requirements, there are contribution limits for the year. Those that are eligible to contribute are capped at contributions of $6,000 per year ($7,000 if you are over age 50) in 2020.
You can make your contributions up until April 15 of the following year. For 2020, this deadline has been extended to July 15. This means that you can make 2019 Roth IRA contributions up until July 15, 2020.
When You Have Access To Your Roth IRA Money
Now for some good news about your Roth IRA. The three main eroding factors of any retirement account are taxes, volatility, and account/management fees. Therefore, the Roth IRA eliminates the eroding factor of taxes, provided that the Roth IRA owner is at least 59 ½ years of age AND has held the account for a minimum of 5 years.
This is a huge perk.
Additionally, there are NO required minimum distributions (RMD’s) like with a traditional IRA. This means that you are not forced to withdraw any money from your account at age 72 if you do not want to.
In theory, you can let the money sit in your Roth IRA for as long as you’d like.
Roth IRAs And Taxes
Your Roth IRA is funded with after-tax dollars. With a traditional IRA, you receive a tax deduction in the year you contribute and kick the tax bill down the road until later in life.
Personally, I like to get my taxes out of the way now. This is because right now we are experiencing some of the lowest tax brackets we will see in our lifetime. Also, there is no guarantee you will be in a lower tax bracket when you retire, and this is especially true for public employees.
This is partly because you may not be receiving many of the deductions you get while working (i.e., pension & deferred compensation plan contributions, healthcare, etc.). As we can see, the Roth IRA can provide some tax-free money later in life, which is huge!
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However, beware that withdrawals that do not follow these rules are subject to a 10% penalty tax and, in some cases, income tax on your gains.
Roth IRA Drawbacks
Now we have established the rules of the Roth IRA, who is eligible, and what the major benefit is. But what are some of the potential drawbacks of a Roth IRA?
Remember, a Roth IRA is not an investment in and of itself. A Roth IRA is essentially a tax code, so the IRS knows how to treat your money when you withdraw it later. It is the investment(s) within your Roth IRA account that determine how your money will grow and appreciate over time.
A potential drawback is that many Roth IRA accounts are usually tied to stock market investments, which can be volatile and risky. These investments can include high fees that may erode a large portion of earnings.
A Real World Retirement Example
Imagine you open a Roth IRA at age 25 with $1,000, and you contribute $6,000 per year until age 59. Now we will pretend you earned 5% per year for those 34 years. This would give you an account value of $515,655.13 at age 59.
If we factor in a 1% annual fee each year for 34 years, this brings your account value down to $414,688.11.
This means that a tiny 1% fee each year ended up costing you $109,967.02! That is $109,967.02 that YOU could have had in your pocket, totally tax-free for your retirement.
Also, one last note on the drawbacks is that we must remember that Roth IRAs are included in the gross value of an estate, which may increase state and federal taxes paid upon your passing by your heirs or beneficiaries.
A Good Alternative Or Addition To A Roth IRA?
Now don’t get me wrong, when it comes to qualified retirement plans, the Roth IRA is probably one of my favorites. However, there is a very effective alternative or addition to a Roth IRA to help achieve the same objectives as the Roth IRA.
This alternative possesses all of the same benefits of a Roth IRA, but it has far fewer rules and restrictions. Plus, it is something that has been around, in some form, for over one hundred years. It is whole life insurance. Now bear with me for a moment, and let’s see exactly how this works and compare the pros and cons of whole life insurance to a Roth IRA.
For those that are unfamiliar with what a whole life insurance policy is – it is merely a life insurance policy that has a death benefit and an internal cash-value account. Why life insurance, you say? Because it provides tax benefits and guarantees that are not available in any other investment or financial vehicle.
As long as a whole life policy is funded correctly and follows IRS guidelines, it will fall under section 7702 of the U.S. tax code. What this means is that whole life insurance provides tax-deferred growth AND tax-free use of your money just like a Roth IRA.
Sheltering Investments From The Stock Market
However, it is not tied to the volatility of the stock market, and there are no age restrictions for liquidity. This means that you can access your money at any age, for any reason, and with no penalties. If you remember, there is a 10% penalty plus applicable taxes for Roth IRA withdrawals that do not follow the IRS rules.
Additionally, unlimited contributions can be made to a whole life policy (within MEC guidelines) and there is a guaranteed growth rate tied to the policy’s cash value (usually around 4%). The death benefit in a whole life policy can also pass tax-free to your heirs. This isn’t always true of a Roth IRA, and the value of a Roth IRA upon the account owner’s death will depend upon the market value of the internal investments.
Unlike a Roth IRA which has a 10% penalty for accessing cash before the age of 59½, the cash value in a whole life policy can be accessed prior to age 59½, without a penalty.
Time-tested, whole life insurance has played a role in retirement plans for over 130 years. And, it can simultaneously be used as a legacy planning tool wherein the death benefit can be passed to heirs’ tax free and usually with a fairly high rate of return in comparison to the contributions.
We must not forget about the role of legacy and estate planning as part of our retirement plans. A lack of proper planning will cause us to limit spending in retirement, which in turn limits the quality of life and enjoyment, and isn’t that what retirement is all about?
Takeaways And Key Points
Overlooking whole life insurance in your retirement portfolio could cost you more than you realize. I am not saying that a whole life policy should completely replace your Roth IRA. However, it can certainly be a solid addition to your current retirement portfolio with its own set of unique financial benefits; and can be a great tool for those that may not be eligible for a Roth IRA.
Since much of our retirement income will be fully taxable for many of us, it is important to add as many tax-free “buckets” of money as possible to limit that tax burden in retirement when we need income the most.
On a side note, if you had to guess, what would you think the largest asset holding for most large banks is? Would it be real estate? Or perhaps mutual funds or corporate bonds?
Rich People Hide Their Money In Life Insurance
Believe it or not, whole life insurance is one of the largest asset classes of big U.S. banks such as Bank of America and Wells Fargo, to name a couple. This is because it is a safe way to store tax-free, liquid cash. You can view a breakdown of asset holdings on the FDIC website here. You may be surprised to see how many billions of dollars banks have invested in whole life insurance policies.
Forbes and other economic researchers and professors concluded that those who integrate cash value whole life insurance into their retirement plans and utilize this tool with other retirement investments realize more growth and income in retirement than those who do not. A retirement income study concluded that “For retirement income, we must step away from the notion that either investments or insurance alone will best serve retirees. More emphasis is needed on the basic forms of insurance products, and how they may behave as part of an integrated retirement income plan.”
So, stop for a minute and think about this question, if there was a way to have a solid foundation within your retirement plan, with guaranteed growth, virtually no restrictions, and tax-free benefits, would you want to add that financial vehicle to your portfolio?
To Your Retirement…