Decoding the Roth IRA
The Roth IRA is a wonderful retirement investment vehicle when used effectively and in the right situations. Individuals often neglect to make a Roth IRA contribution in years when they are able to do so simply because they will not be able to claim a tax deduction on that contribution. We like the here and now. However, this is short sighted thinking. You might find that you have been missing out on a tool that could add a world of ease to your future. And who wouldn’t like a little more of that?
The Roth IRA is a sibling to the more popular traditional IRA. Although we are not here to discuss the traditional IRA, it is important to know the fundamental differences between the two. Very simply stated, contributions that are made towards a traditional IRA receive a tax deduction for the tax year in which they are made. Assets then grow tax-deferred until retirement (or 59 ½), when distributions are taxed at ordinary income rates. In a Roth IRA, contributions do not receive this tax deduction; however, you won’t be paying income tax on withdrawals made after 59 ½ in retirement either. So the question often boils down to this: Would you rather pay taxes now or later? But not all are blessed with the ability to contribute to a Roth IRA at first glance. Income limitations are set at $132,000 for individuals (per 2016 tax regulations) and $194,000 for married couples filing jointly (again, for 2016 regulations).
Traditional thinking would state that individuals are better suited to contribute to a Roth IRA when they are fairly certain their effective tax rate will be higher in future years and even possibly in retirement. According to this model, only the younger working class would benefit, as their income producing and higher tax paying years are likely well ahead of them. However, no one knows for certain where tax rates will be in the future. With the current deficit balances and a convoluted tax code, it would be unwise to assume changes are not on the horizon. If you can afford the taxes now, it’s worth having the Roth IRA discussion.
Hidden Tax Advantages
Since all distributions from a Roth IRA after age 59 ½ are not taxable, they are not factored into your Modified Adjusted Gross Income (MAGI). This will place you in a lower tax bracket than would be the case if you were to take distributions from a traditional IRA, whose distributions are considered ordinary income and taxed accordingly. The possible advantages of this are varied and far reaching. For a range of retirees this could potentially mean: lower capital gains tax rates from taxable accounts, lowered taxes on social security benefits, eligibility for health insurance credits while under 65, lower Medicare premiums, and lowered required minimum distributions (RMDs) at age 70 1/2. These added benefits aren’t often discussed and could save you many a dollar in retirement.
Another major advantage of the Roth IRA lies in its flexibility. Unlike a traditional IRA, all contributions (not earnings on those contributions) made to a Roth can be withdrawn at any point in time without taxes or penalties. Don’t get me wrong, the Roth IRA is a retirement vehicle at heart and should be fundamentally used as such. However, it should not be overlooked as a potential emergency fund as well. For those individuals struggling to balance saving towards an emergency fund or retirement, one should consider the Roth IRA as a very nice intermediary. Successful planning should never dismiss creativity.
Options for High Earners
For those individuals that find themselves over the income limitations listed previously, there are other ways to still jump aboard the Roth IRA train. As of 2010, there is no income limit on Roth IRA conversions. This means that you can rollover an existing traditional IRA (and often a 401k) to a Roth IRA if you are willing to pay the taxes on that conversion. This is a great strategy to implement in years when taxable income may be light, such as those years when you might be in a career change or going back to school.
High earners can also contribute annually to a Roth IRA through another strategy, often referred to as a backdoor Roth conversion. Here, an individual would contribute to a nondeductible Traditional IRA and then immediately convert those funds to a Roth IRA. Since the contribution to the Traditional IRA is non-deductible, there would be no taxes on an immediate Roth conversion unless other IRAs are held by the individual converting. If other non-Roth IRA’s are in existence the process becomes less efficient, as you would then have to divide the conversion amount by the total of all IRA's outstanding to calculate the percentage of the conversion that will be considered taxable. This can get expensive, so the backdoor strategy works best when no other tax advantaged accounts are held outside of qualified work retirement plans such as a 401(k), 403(b), etc.
If you do make a conversion to a Roth IRA, do know that you have until October 15 (your extended tax filing deadline) of the year after to undo your conversion. That in mind, one might consider converting a large sum into two Roth IRA accounts: one that houses your equity portfolio and the other your bond holdings, then watch how the two perform through October of the following year. If one account has dropped in value, you could revoke the Roth conversation on that particular account so you’re not paying taxes on the higher initial conversion amount.
Also, when considering the backdoor Roth conversion while holding other IRA assets, check and see if your work retirement plan will accept a rollover of IRA assets to the plan. If so, you could roll your traditional rollover IRA assets into the work retirement plan, and then proceed with your nondeductible IRA contribution. The IRS does not consider qualified work retirement plans in the conversion pro-rata calculation mentioned earlier; therefore you could then make the backdoor Roth conversion hassle (and tax) free.
The Roth IRA is a great tool that can save you much in the form of stress and taxes down the road which warrants exploration of some creative planning strategies. However, these can become a bit more complex in nature, so I would recommend consulting your accountant and/or financial advisor before tackling on your own.