Delayed Gratification: The Case for the Roth IRA
By Tony Allison, March 31, 2005
Once in awhile it’s important to remove your nose from the grindstone of the here and now and seriously consider the world at the time of your retirement. For most people that time may be years, if not decades from now. However, the actions you take now may have a significant impact on your retirement plans.
The future is impossible to predict with certainty, but the economic fundamentals are ominous, and without obvious solutions. With a Total Debt load (over $37 trillion) now measuring roughly four times America’s GDP, and growing like crabgrass (28% in the last three years), our ability to repay what has been borrowed becomes virtually impossible. Higher inflation looks more and more attractive to a debt-burdened government. The Roman Empire was not able to overcome this dilemma. We have the electronic printing press and reserve currency status on our side. Will that be enough ammunition? With unfunded Medicare and Social Security mandates spiraling off into the $50 trillion range, the alternatives looking ahead seem limited.
Without historic, society-disrupting change, the debt service bills will continue to spiral upward, the manufacturing base will continue shrinking, and government spending will just keep growing. At some point the piper must be paid. Even a much lower dollar will not solve these problems. The government will ultimately face the stark reality of raising taxes, cutting spending or inflating the currency to decrease the impact of the debt load. With the demographically powerful Baby Boomers soon to retire in numbers, and politicians desirous of staying in office, it is unlikely that significant spending cuts will occur. The inevitability of higher taxes and higher inflation becomes overwhelming. Taxes may come in many forms and disguises, but the tax revenue must go up, and taxpayers’ wallets are the primary source. The Total Debt load (see charts) will also necessitate that the Fed continues to print money to lessen the burden of repayment through inflation. In 10 years, 2015, there are likely to be many new and exciting inventions, discoveries and opportunities in the United States. But it is naive to believe that we won’t also live in a time of higher inflation and taxes.
A Road Map to future inflation – an accelerating money supply chasing the same goods and services. Given time, inflation and taxes will consume nest eggs like a pack of wolves.
The Roth IRA Strategy
Despite the economic storm clouds and general gnashing of teeth, there are ways to prepare and protect one’s golden nest egg, which brings us to the Roth IRA. Of all the retirement vehicles, it is the only one that allows all savings and investment earnings to be withdrawn (after age 59 ½) totally tax-free. No income tax. No capital gains. Zippo. That may not seem like a big deal today, when you can get a tax write-off with a regular IRA, but it could be a huge deal in 10 or 20 years from today.
If present trends continue, or worsen, those retirement dollars will emerge in a world with considerably higher tax rates. The retiree with a conventional IRA or a 401-k may end up paying more tax on his/her withdrawals than on income during the working years.
The 401-k may prove to be a major concern for Baby Boomers looking out 10-20 years. The forced savings aspect of the 401-k is a positive, especially if the employer matches contributions. However, for most 410-k owners, their savings can only be invested in a very limited spectrum of choices, usually plain vanilla stock and bond funds and company stock. In an environment of rising rates and inflation, bond funds will get battered. In an IRA, one can own an individual bond and ride it out, or buy shorter-term maturity bonds or CD’s. 401-k’s don’t offer this flexibility. This lack of choice leaves most 401-k holders without the ability to direct their savings into sectors that can weather inflation and retain purchasing power. Growing inflation, brought on by government spending and printing excesses, will unfortunately ravage the value of broad-based stock and bond funds.
At retirement, the 401-k, the vehicle of so many hopes and dreams, may yield bitter fruit. By 2015, the typical million dollar 401-k portfolio will have lost significant purchasing power through years of inflation, only to suffer the slings and arrows of high tax rates when the money is withdrawn. Millions of Baby Boomers are likely to suffer this fate, and indeed many will be unable to retire at all without drastic changes in quality of life.
Investment Flexibility and No Taxman
The Roth IRA is not a magic wand, but it can make a significant difference over time. Higher income people are unable to qualify for the Roth (your AGI must be below $150,000 for married joint filers and $95,000 for individuals) (UPDATE) but those who can contribute should not hesitate. Additionally, any 401-k contributions above the employer-matching level would be better served in a Roth. The Roth contribution limit went up from $3,000 to $4,000 in 2005, with an additional $500 “catch-up” provision for those over 50 years old (UPDATE). Another excellent aspect of the Roth is that you can withdraw your contribution amount any time, at any age, without penalty or taxes due. Only the earnings must be left in a minimum 5 years and not withdrawn before age 59 ½.
While miracles can happen (and are gratefully received) the future appears to be inexorably moving toward an environment of higher inflation, higher interest rates and ultimately higher tax rates. The iron laws of nature and economics are not likely to change any time soon. Any retirement vehicle that allows for both investment flexibility and no tax consequences is a unique safe-haven, especially in a high-tax environment. Investors who save and compound their growth tax-free over time will ultimately reap the benefits of this delayed gratification strategy.
No strategy is without risk however. There are those (including some in this office) who believe that the U.S. government will unceremoniously pull the rug out and renege on the Roth’s tax-free withdrawal status at some point down the road. That threat will continue to exist, but consider the alternative of the 401-k. Would you rather have the flexibility to invest in the Central Fund of Canada (gold and silver bullion) or be stuck in stock and bond mutual funds if our “manageable” inflation rate suddenly accelerates into hyperspace and beyond? The Roth IRA is not the complete answer, but its obvious benefits make it an important investment tool in a very uncertain world.
© 2005 Tony Allsion