TAX ADVISOR

Joseph B . Darby III

Roth IRAs offer clear tax advantages , but the behavioral issues might surprise advisors .

High taxation makes it challenging to create and accumulate wealth . However , there is one specific tax-reduction tool widely available to all U . S . taxpayers — namely , the Roth IRA and its kissing cousin , the Roth 401 ( k ).

Let ’ s start by belaboring the obvious and note that high taxation makes it challenging to create and accumulate wealth . Sure , everyone should contribute a fair amount toward the functions of government , but even the most patriotic Americans could feel just as patriotic while paying a whole lot less . Unfortunately , it is generally difficult to escape the long reach of the ( tax ) law ; fortunately , however , there is one specific tax-reduction tool widely available to all U . S . taxpayers — namely , the Roth IRA and its kissing cousin , the Roth 401 ( k ).

The sales pitch for a Roth IRA is compelling : Money is contributed to the account on an after-tax basis , meaning that people do not get a current income-tax deduction for the contribution . But once the money is invested it can go into almost any investment activity you please ( subject to the limitations imposed by the account custodian ) and all income earned from those investment activities — whether it ’ s interest , dividends or capital gain — is excluded from current federal income tax ( and typically state income tax ) at both the IRA level and at the taxpayer level . Moreover , when it comes time to distribute funds from the Roth IRA in the future , these distributions are likewise fully exempt from federal ( and usually state ) income taxation . Thus , the Roth IRA allows taxpayers to enjoy a tax-free investment that earns a full market rate of return . All in all , a very sweet deal .

A Roth IRA ( like the regular IRA ) is generally limited to passive investments , and only a very limited amount of income each year can be derived from an activity characterized as trade or business ( for example , the IRA must earn less than $ 1,000 per year of taxable income from public limited partnerships or other active businesses or else it must file a tax return and pay income tax ). But this is an easy problem to avoid , and the opportunity to enjoy full market-rate tax-exempt investment returns is a major wealth-building opportunity .

The Math : Regular IRA Vs . Roths

A Roth IRA is best understood by comparison to its older relative , the regular individual retirement account . The regular IRA was authorized in the early 1980s , and U . S . taxpayers were originally allowed to contribute $ 2,000 per year ( which is tax-deductible ) into the account ( the contribution limit in 2023 is now up to $ 6,500 for younger taxpayers and $ 7,500 for taxpayers over 50 ). The IRA then allows the investment to compound tax-free , and it makes taxable distributions to the investors after they reach age 59½ . Distributions be-

SEPTEMBER 2023 | FINANCIAL ADVISOR MAGAZINE | 23