Smart investors choose Roth IRAs over traditional IRAs, according to a recent study by Texas Tech University. The researchers determined that people with high IQs were the most likely to own a Roth IRA, even after controlling for education, income, and net worth.
"When the government creates a tax incentive, it creates an advantage for people who have the sophistication to be able to figure out the value of that incentive," says Michael Finke, an associate professor of personal financial planning at Texas Tech University and coauthor of the report. "With a Roth IRA, you are not getting any immediate advantages. You are essentially locking up your money with the threat of a fee in order to get a long-term benefit."
The study used data from a random sample of 12,686 young adults who participated in the National Longitudinal Survey of Youth beginning between ages 14 and 22 and who were between 43 and 51 in 2008. Those who scored the highest on the Armed Services Vocational Aptitude Battery, a series of 10 tests related to intelligence, were the most likely to own a Roth IRA. Some 14.3 percent of people in the highest IQ quintile owned a Roth IRA by 2008, compared with 3.8 percent of all the study participants and just 0.9 percent of people with the lowest IQs.
There are many logical reasons to select a Roth IRA over a traditional retirement account. Here's a look at why sophisticated investors are choosing Roth IRAs:
Lower lifetime tax liability. Traditional IRAs allow you to defer paying taxes on money you save for retirement until you withdraw the funds from the account. Roth IRAs permit you to pay the income tax upfront, and distributions that are made after age 59 1/2 from accounts that are at least five years old are tax-free. To decide whether you should put your retirement savings in a traditional or Roth IRA, compare your current tax rate to what you estimate you tax rate will be in retirement. If you expect to be in a higher tax bracket in retirement, it makes sense to pre-pay the tax now using a Roth account. If you think your tax rate will drop in retirement, you might want to defer paying income tax until later using a traditional retirement account. "A Roth IRA is really designed for the person who is starting out or in their younger years," says Lisa J.B. Peterson, a certified financial planner and president of Lantern Financial in Boston, who is not affiliated with the study. "Someone at their peak earning potential would probably do better with a traditional IRA."
Retirement flexibility. Withdrawals from traditional IRAs become required after age 70 1/2. The penalty for failing to withdraw the correct amount is 50 percent of the amount that should have been withdrawn. Roth IRA account owners are not required to take withdrawals, which gives them more flexibility to time withdrawals or pass on tax-free money to heirs. "You don't get an immediate tax advantage with the Roth IRA, but the money that you take out during your retirement years comes out tax-free," says Russell James, a certified financial planner and Texas Tech associate professor. "You are giving up current consumption for higher levels of future consumption. It requires a lot of cognitive ability to do that."
Easier access to funds before retirement. Roth IRAs give you more flexibility to make withdrawals before retirement. While traditional IRA distributions before age 59 1/2 result in a 10 percent early withdrawal penalty and income tax on the amount withdrawn, Roth IRA distributions charge the income tax and early withdrawal penalty only on the portion of the withdrawal that comes from earnings. Penalty-free withdrawals are also allowed from both types of IRAs for a variety of reasons, including college costs, significant unreimbursed medical expenses, and a first home purchase.
Leave more money to heirs. You heirs will need to pay taxes on money you leave them in a traditional IRA. However, your beneficiaries may be able to receive tax-free distributions of money left to them in a Roth IRA.
Roth IRA conversions. In 2012, individuals earning less than $125,000 ($183,000 for couples) are eligible to make Roth IRA contributions. The maximum amount you are allowed to contribute to a traditional IRA, Roth IRA, or combination of the two is $5,000 in 2012, or $6,000 for those age 50 and older. The maximum possible Roth IRA contribution amount is lower for individuals earning more than $110,000 ($173,000 for couples). However, traditional 401(k) and IRA accounts can be converted to a Roth if you pay income tax on the amount rolled over. The IRS removed the $100,000 income limit for Roth IRA conversions in 2010, which means almost everyone now has the ability to open a Roth IRA by doing a rollover. "You can shift money that you have in a traditional IRA over to a Roth IRA, but you have to pay taxes on that shift," says Russell. But if you make the switch, "All the growth happens tax-free, and you get to take it out tax=free."
Tax diversification. Saving in both a traditional and Roth IRA adds tax diversification to your portfolio and allows you to be prepared for future tax-rate changes. "It allows us to essentially hedge against the risk that capital gains rates or income tax rates are going to go up in the future," says Finke. "We are taxed once on it when we put the money away and then we are allowed to defer additional taxation essentially forever."