Recently we have received several questions about the Roth IRA. While many studies show only about 1 in 4 would benefit from a Roth, there are times when a Roth is the best choice. There are distinct differences in Roth’s versus other pre-tax plans which make appropiate tax planning very important when implementing a Roth contribution.
Roth Versus 401k or other Pre-tax Plans
The most important factor in determining to contribute to a Roth or not is understanding one key component:
A Roth is a bet your tax rate will be higher at retirement or in the future rather than currently!
Due to the tax benefits, all other items being equal, a Roth is most beneficial when one expects to be in a higher tax rate later or at retirement. Under normal circustances most families are in a LOWER tax bracket at retirement than during their working years, making a pre-tax plan more appropriate.
As a refresher, a Roth is an after tax contribution that grows tax deferred until used. No tax deduction up front makes for less immediate tax benefits but greater benefits during retirement or later in life when draws are taken on a tax free basis, under current tax laws.
Roth plans have less stringent RMD (Required Minimum Distribution) requirements than many other IRA/401k type plans. Pre-tax plans have mandatory distribution requirements due to their “never taxed” status. Since the contributions to funds and growth in pre-tax plans are without taxes, the IRS wants to get their taxes. 70.5 is the latest age one can defer the distributions of a pre-tax plan in most cases. Contrasting that to a Roth; Since taxes were originally paid on the contributions, distributions are not mandatory in most cases as the IRS receives no benefit under current law and thereby deems no mandatory distributions unless a Roth has been received as a beneficiary in which is it subject to similar mandatory distributions of pre-tax plans.
When a Roth is correct?
Since a Roth is a bet taxes will be higher in retirement or later in an earning career, lower income periods of employment/careers tend to be the most beneficial for making contributions. Think early in a career or on off years of regular work for most tax beneficial Roth contribution times.
In a year of negative or low income the conversion of IRA to Roth may be an optimal strategy. Under certain situations a regular IRA may be converted to a Roth showing the income from the IRA. This would essentially pull forward the taxes from the IRA to the current year, which may be beneficial during very low or even better during a negative earning year. There are very few limitations on converting a IRA to a Roth as the IRS is benefiting early from the pull forward to taxes. These conversions, done correctly are without the normal early IRA 10% penalty.
Since a Roth is after tax and growth is tax deferred, the earlier the better for maximizing a Roth’s full potential. Tax deferred growth over longer periods of time will have greater benefits than short periods of time. In fact, VERY short periods of tax deferred growth in a Roth make it MUCH less appealing, if even appropriate at all!
Roth contribution limits
Single filers cannot make a Roth contribution once their income is greater than $133k in 2017 and married filing joint cannot make a contributions with incomes greater than $196k.
Roth contribution limits in total are $5500 regular plus $1000 catch up for those greater than age 50. Some employers offer Roth 401k plans which allow higher contribution amounts similar to the $18k and $6k catch up of regular 401k plans, however mandatory RMD distributions do come with these types of plans.
Conversion from IRA as mentioned above has no limits on income or earnings to qualify. Since the IRS is receiving tax dollar early, all other things considered, the rules are much more flexible for converting an IRA and creating a tax liability earlier than may otherwise have occurred (as mentioned above, carefully timed conversions may lead to very little tax liability if other outside factors have lowered the tax exposure.)
In closing, we agree with the studies that most do not need a Roth and many may never have the option for a Roth at all. This being the case, there are always certain circumstances that may make a Roth or a Roth conversion an ideal tax planning tool to offset unique income years as mentioned above.
Have a Great Day!
John A. Kvale CFA, CFP
Founder of J.K. Financial, Inc.
A Dallas Texas based fee only
Financial Planning Total Wealth