IRAs and 401Ks are excellent tools for investing and growing your wealth. I often get asked the question: “when should I be using a Roth IRA or Roth 401K?”. There’s no short answer for this, but hopefully by the end of this article, you’ll have a clearer picture of whether a Roth is best for you right now or not.
Let’s start talking about IRAs and 401Ks first. Once upon a time, the government gave us a gift. This was the gift of “tax deferral”. The IRS law basically says1: if you put money into a retirement account like an IRA, 401K, or other retirement vehicles, we will allow you to DEFER paying taxes on that money. Forever? No, unfortunately. But at least until you take your money back out of the account (which you have to wait until you’re 59.5 years or older or pay a penalty).
Why is this a gift? If you made $100,000 in income in a year but you put $15,000 into your 401K retirement account (remember, 401Ks are retirement accounts just like IRAs), you only get taxed on $85,000 in that year. You’ll pay the taxes on the $15,000 in the year that you take the money out. This lets the money grow without being reduced by taxes every year.
In comes the Roth IRA. With the Roth, any amount that you put into a Roth is NOT a deduction from your taxable income. You pay taxes now on the money you earned and THEN it goes into the Roth IRA/401K. Well then why would I want to have a Roth IRA then? A few great reasons:
Your Future Income may be greater than your current income
You might expect your level of income in the future or in retirement to be higher than it is now. The more money you make in a given year, the more likely you will be in a higher tax bracket. Most young people have not reached their earning potential yet, so there’s a good chance you’re in a much lower tax bracket now than when you’re older. Would you rather pay 25% in taxes or 40% in taxes? If you’re going to be a high earner, it may merit the discussions and analysis to see if a Roth IRA makes sense.
You like tax free income.
That’s right, tax free. Since you already paid the taxes, the IRS says that you don’t owe taxes on that money anymore. PLUS, since it’s in an IRA, it GROWS tax-free as well1. That means you have money growing without having to pay taxes, and it comes out completely tax free. This is quite literally, the best-case scenario.
Roth conversions can save you hundreds of thousands of dollars in taxes. A Roth conversion is when you take money in a regular retirement account and convert it into a Roth. Yes, you’ll owe the taxes on this money now, but if you time these conversions right, you can potentially save yourself hundreds of thousands in taxes as your Roth account grows. When’s the right time? I’m glad you asked. Maybe it’s in a year where you didn’t work the full year because you went back to school. Maybe it’s a year where you switched jobs and didn’t have income for 3 months. Maybe you have a lot of tax write-offs and deductions in a particular year. Maybe it’s because tax rates are historically low right now and future administration changes might ramp up tax rates again. The point is, Roth conversions are a great planning tool. One or two well-timed Roth conversions can help you break into the next level with your wealth. Another thing to note is that if your income level is right in between a tax bracket, it might merit a Roth conversion. This is because you might still have another $10,000 or so available to you in your tax bracket, before you get taken up to a higher bracket. Here's an image that helps explain this:
Earning too much money to contribute to a Roth IRA
Roth IRAs are only eligible for people that fall within a certain level of income for the year. This effectively makes it so that it's possible that you earn too much in order to contribute to Roth IRAs and reap the benefits of tax-free growth. There is a work-around, however. In 20101, the income limits on Roth conversions was removed. With the new rules, it became possible for high income individuals that made too much to contribute to a Roth IRA to instead, make a contribution into a non-deductible traditional (regular) IRA, and then do a Roth conversion to move those dollars into a Roth IRA and start earning that tax-free growth status. This is called using a "Back-Door Roth" technique.
Be weary, though, there are many details to consider when doing a Back-Door Roth contribution. This technique is like walking on thin ice -- you have to be really careful not to break the ground you walk on. It's not an official IRS rule, thus the "back-door" name. You must carefully consider the IRA attribution rules in Code Section 408(d). This is a critical piece that many commit an error in and have problems with the IRS. I'll also note that, while there is no official "schedule" for how long you need to wait between doing the non-deductible contribution and moving it into the Roth, many tax professionals agree that there are certain conditions that need to be met or else the IRS may audit you and reject your "back-door" Roth contribution. Definitely be in touch with us if you're considering a back-door Roth contribution.
Future Estate Planning and Avoiding Required Minimum Distributions (RMD)
IRAs and 401Ks have the gift of tax-deferral but the gift eventually comes to an end, when you turn 70.5 years old (except for a 401K of an employer you're still affiliated with). The IRS says you MUST start taking Required Minimum Distributions (RMD), because in doing so, that withdraw will count as income for you and you'll need to pay taxes on it. This can be a major problem for those that are high earners or have a lot of retirement assets. Being forced to take distributions means you'll likely be paying taxes in your highest tax bracket. Additionally, this forces the account to self-liquidate and be sent into a taxable account where their future growth will be slowed down by an ongoing tax drag. Roth IRAs can be a great tool to help offset this, even though, notably, the account will still need to take RMDs if the owner passes, but again, the taxes are already paid.
Roth IRAs/401Ks are a great tool but can’t mindlessly be used. Using them needs to be intentional and carefully thought about. If you're curious about how you might be able to benefit from utilizing a Roth IRA, let us know. We'd be happy to discuss your options with you and see how you can benefit from this great tool.
1 - www.irs.gov