To Roth or Not to Roth? That is the question!
Interpreting IRS rules for retirement saving can be as difficult as reading Shakespeare. The options and guidelines can feel overwhelming. But if you take the time to understand some basic concepts, you can determine the best solution for your situation.
Traditional retirement accounts allow you to save pre-tax money now and defer income taxes until you withdraw the funds in retirement. The IRS requires you to start withdrawing funds and paying income taxes on the distributions at age 73 (or age 75 if you were born after 1959). By deferring the taxes, the accounts really have a chance to grow!
How are Roth Accounts different?
A Roth IRA or Roth 401k is funded with after-tax money. The account’s appreciation and interest are not taxed, just like a traditional retirement account. The key difference is that the distributions from a Roth account can be income tax free. You will not pay taxes when you withdraw the contribution amounts, and five years after the account is initially funded, distributions that include earnings are not taxed. Unlike traditional accounts, there are no required minimum distributions for you in the future, and your beneficiaries may not pay income taxes on their future withdrawals either.
Should you contribute to a traditional or Roth retirement account?
When determining which account to contribute to now, try to estimate what your income tax rate will be in the future when you will be withdrawing the funds. If your tax rate is lower now, then use after-tax money for a Roth contribution. If your tax rate is higher now, then use pre-tax dollars for a traditional contribution. Generally, you want to pay the income taxes when the tax rate is the lowest.
Can anyone contribute to a Roth account?
Unfortunately, no. Not all employer retirement plans offer a Roth option. To be eligible to contribute to a Roth IRA, you must have earned income below a certain threshold, which is set annually by the IRS.
What about converting funds from a traditional account to a Roth account?
This is where things get even more complicated. You can convert funds from a traditional account into a Roth account, but since this is usually a taxable event, the IRS will be expecting their share. It can be a great idea when your income and tax rate are lower now than they will be in the future. However, you should ask your accountant or financial advisor if a conversion or back-door Roth contribution is the right solution for your situation. Generally, you want to pay the taxes owed on a Roth conversion from money outside of the IRA itself.
Knowledge is power! When you know more about the retirement savings options that are available to you, you can make better decisions about how you save for the future. Now that you know more about possible Roth account benefits, you can ask your financial advisor to dive deeper into the details and to help determine if a Roth account is the right fit for you.
Terri Velgara, CFP®
Terri is a Senior Financial Advisor and Director of Financial Planning at Rappaport Reiches Capital Management. She serves as a resource for our firm's advisors in designing plans that empower clients to achieve their personal and financial goals. Please connect with Terri below. She loves to talk about investing, financial planning, and family game nights!