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Does a Roth IRA Make Sense for Me?

| October 01, 2019
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The Basics

With a traditional IRA you get to reduce your taxes in the year that you contribute to it, and take the tax hit in retirement when you start taking withdrawals.  Roth IRAs are the opposite, you put the cash in after its already been taxed and then your retirement distributions are tax free.  Importantly, a roth account will pass tax free to your heirs and effectively can’t be taxed in any way.  

Many people fail to realize that they can still contribute to Roth IRAs while participating in an employer sponsored retirement plan.  Married couples making less than $193,000 in 2019 can make a full $6,000 contribution ($7,000 if over 50).  Single people can make the full contribution if their income is less than $122,000.  The contribution is somewhat reduced for married incomes from $193k - $203k, and $122k -137k for single taxpayers.  If you are eligible and have the funds to spare it makes a ton of sense to go ahead and make some sort of contribution.

For Young Savers

I consider this to be the best account available for young people.  The most important factor when considering a Roth is how your current tax rate is likely to be different from your tax rate at retirement.  For most new entrants to the workforce it is a safe bet that your tax rate will be higher later in life.  Once the Roth account has been opened for five years, you are permitted to make penalty free withdrawals of your original principal, though earnings would be taxed.  There are many expenses incurred when starting out as a young person in life, this added flexibility is often a deciding factor for individuals debating whether or not they can afford to start investing.

For Retirees

For many people in or approaching retirement there may be no Roth account yet.  While Roth IRAs were codified in 1997 the Roth 401(K) option only became available in 2006, and many employers still don’t offer such an option in their plans.  For others their income was always too high to make any Roth Contributions.

Conversions

Anyone can convert a traditional IRA to a Roth IRA regardless of their income.  The amount converted will be fully taxed at your marginal tax rate so ideally you look for a low income year in which to make one.  Many people in their first few years of retirement may have such an opportunity. 

Why you may have a low tax rate and decide to convert in early retirement years:

  • No more employment income
  • May have decided to defer social security to increase the benefit
  • Drawing your living expenses from a taxable account or trust rather than 401K/IRA
  • Not yet 70.5 years old and required to take minimum distributions from IRA

Why would the government allow and promote tax free accounts?  It means revenue today vs. revenue many years from now and that likely score well with congress.

Who shouldn’t use a Roth IRA?

  • Very wealthy people who will are unlikely to have a low income tax year
  • Real Estate investors with large portfolios that can effectively avoid taxes indefinitely using depreciation and 1031 exchanges on their properties

Why this matters?

It’s very common for retirees to have the bulk of their assets in their 401(K)/IRA.  When you turn 70.5 you are required to begin taking required minimum distributions weather you want to or not, and it’s fully taxable.  This doesn’t give you much room to maneuver.  Anytime money comes out of the IRA more has to come out to pay taxes leading to a bit of a vicious cycle.  It’s far better if you have trust/taxable account, a Roth account, and an IRA so you can have more control over how much income you take and how much you pay in taxes.

 

 

The Roth IRA offers tax deferral on any earnings in the account.  Withdrawals from the account may be tax free, as long as they are considered qualified.  Limitations and restrictions may apply.  Withdrawals prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax.  Future tax laws can change at any time and may impact the benefits of Roth IRAs.  Their tax treatment may change.

Traditional IRA account owners should consider the tax ramifications, age and income restrictions in regards to executing a conversion from a Traditional IRA to a Roth IRA.  The converted amount is generally subject income taxation.

 

 

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