While saving for retirement, many focus on the advantages of traditional Individual Retirement Accounts (IRA) and employer sponsored retirement plans. The advantages of these accounts include a regular savings method that reduces your current, overall taxable income – since your savings contribution comes “right off the top” of your paycheck; and the ability for your employer to make contributions, thereby growing your savings at no additional cost to you.
But what about Roth Accounts?
A Roth has benefits too – although some are different from its savings cousins the “traditional” IRA and 401(K). A key aspect of a Roth is that your contributions are never tax deductible. In addition, Roth IRAs offer tax-free withdrawals of contributions at any time. And under certain qualifying conditions, the earnings in Roths can also be withdrawn tax-free.
With a traditional IRA, you might qualify for a tax deduction up front for your contribution, but then you pay income taxes on withdrawals (which include initial contributions and potential earnings). With the Roth, you do not get a tax deduction when you contribute, but you also do not have to pay tax on the original contributions and/or Roth conversion amount when you withdraw the funds in retirement. The deferred earnings may also be tax free, provided you follow IRS rules.
Recent tax laws allow workers of any age to move pretax savings to a Roth 401(K) that may be now offered through his or her employer; this is called an “in-plan conversion.”
Are you a convert candidate?
The option to move existing pretax monies to an after-tax retirement account may be a great opportunity for some, but is it the right move for you?
Consider these factors:
- The amount of money you convert to a Roth is taxed as ordinary income, which means you may move into a higher tax bracket, and consequently incur a higher tax bill;
- Converting some of the money, or phasing conversion over time, may help you avoid such “spikes” in your ordinary income;
- Roths offer flexibility that traditional IRAs do not: specifically, you can withdraw amounts tax-free (earnings included) if you’ve had any Roth for at least five years and you are at least 59 ½ years old;
- Even if a withdrawal is made before a Roth is open for five years, the withdrawals are treated as coming first from contributions and are therefore still not taxable;
- Minimum distributions after age 70 ½, which are required for traditional pretax accounts, are not required for Roth IRAs; (non-spouse beneficiaries are still required to take Required Minimum Distributions (RMD)).
- An entire Roth account can pass tax-free to heirs (but are still subject to estate taxes if applicable);
- Since Roth distributions aren’t taxable, they are not included in “modified adjusted gross income” for purposes of determining social security benefits subject to income tax.
Generally, you may benefit from converting to a Roth if:
- You believe you will be in an equal or higher tax bracket in retirement, when you would be withdrawing from a traditional IRA.
- You would like to leave an income tax free inheritance(s).
- You can afford to pay the taxes on the conversion now.
- You have enough of a time horizon to recoup the amount paid in taxes for the conversion.
Remember there are limits.
There are limits to how much can be contributed to Roth IRAs, and it generally depends on whether contributions are made only to Roth IRAs or to both traditional IRAs and Roth IRAs. In 2013, your limit is the lesser of either $5,500 or your total taxable compensation for the year. If you are age 50 or older before 2014, and you have made only contributions to Roth IRAs, your contribution limit for 2013 will generally be the lesser of $6,500, or your total taxable compensation for the year.
However, if your modified adjusted gross income (AGI) is above a certain amount, your contribution limit may be phased-out or even eliminated. For more information, refer to the IRS’ website and the links included at the end of this article.
Whether to start a Roth or convert to one is an important decision. For many, retirement savings are one of their largest assets. Talking with a financial planner can help determine the next step given your particular situation, and save you time in the short term and money in the long term.
Heidi Clute, CFP® of Clute Wealth Management in South Burlington, VT and Plattsburgh, NY, an independent firm and registered investment advisor that provides strategic financial and investment planning for individuals and small businesses in the Champlain Valley region of New York and Vermont. Clute Wealth Management and LPL are separate entities. The opinions voiced in this material are for general information only and not intended to provide specific advice or recommendations.