By now most people are familiar with the term “Roth IRA or “Roth 401(k)”, but we still get questions about what a Roth IRA is and what its benefits are. At its most broad level, a Roth IRA works in the opposite way a Traditional IRA or pre-tax 401(k) does. In a Traditional IRA or pre-tax 401(k), contributions are pre-tax, grow tax deferred, and then are taxable upon eventual distribution. In a Roth IRA or 401(k), contributions are after-tax (no current tax benefit), but then grow tax free and never have further tax paid on the earnings (as long as held past age 59 1/2 and leaves the money in the account for at least 5 years.)1. You might be a candidate for a Roth IRA if:
You are just getting started at a young age. Roth IRAs see their biggest benefits associated with compounding tax free if held a very long time. The benefits of compounding over a long period and then drawing tax free can very often be advantageous vs. the current year tax deduction.
You are worried about future tax rates. While you may want to receive the tax deduction today and while it’s possible your income will be lower in the future, you must weigh that against the unknown of what future tax rates will look like. Tax rates are relatively low today compared with the last 100 years of history. Ask yourself – based on the state of things today do you believe future tax rates will be lower, higher or the same as today? Having a base of funds that are tax free can help you hedge against the unknown of future tax rates.
You make too much money to contribute to a Roth IRA but you have no other IRAs. In this case you may be able to make “back door” contributions by contributing to a Traditional IRA after tax and immediately converting to a Roth IRA, annually.
You are saving for education. Roth IRAs can supplement things like 529 plans, because your contribution amounts are always available to you, and the Roth IRA provides flexibility in case your child does not attend college. In addition, having the funds in a Roth IRA vs. other vehicles may be advantageous for financial aid purposes.
You are a parent or grandparent, your kids or grandkids are employed, and you are looking for intergenerational planning. You could consider making Roth contributions to your working young adult’s Roth IRA up to the amount of their income or the contribution limit, whichever is lower. This could help them accumulate significant funds at a young age and help you in passing money on in a tax advantaged way. Imagine doing this for 5 years between the ages of 15-20, you could get $35K+ in tax free accounts by age 20 (or $70K+ by age 25) that would be compounding for the next 40+ years.
The market is down. Conversions can get extra leverage if done when markets are low as long as you assume that in time they will recover. After the conversion, the recovery amount would be growing in the tax-free account vs. the pre-tax account.
You are recently retired, under age 73, in a relatively low tax bracket and you have a pool of non-IRA funds that you can use to pay the tax on conversions. This may be the most impactful use of Roth Conversions. You have a window of time before after you retire and before age 73 (because of Required Minimum Distributions) where you can make annual conversions at relatively low tax rates to get funds out of a taxable position and into a tax-free position for yourself and for the next generation. We work closely with tax advisors to determine conversion amounts, while considering tax brackets as well as potential impact on Medicare premiums. Getting the funds in a tax-free position can often be worth the tax paid today, particularly if your kids are in higher tax brackets than your post-retiree self is.
If you see yourself in any of the above, get in touch. You can start with as little as $1,000 and $100/month.
Together, we can work to keep you on-track towards your financial goals.
Request a consultation with us to learn more.
Read more articles by Lance R Hoenig