Roth IRAs Still a Tax-Smart Retirement Savings Strategy


Choosing between a Roth IRA and a traditional IRA often feels like making a bet about your income in a few decades. Will you be making more than you are now? Will you be making less? Will you still be working full-time at 65? At 70?

The actual mechanics of the difference are a bit more detailed than that, and recent tax laws have provided Roth IRAs with distinct advantages beyond making a plan for your income at 59½ or 65.

First, and the most commonly known advantage of Roth IRAs: tax-free withdrawals. So long as your withdrawal is a “qualified withdrawal,” you can take money from your Roth IRA without paying further federal income tax or (in most states) state income tax. A “qualified withdrawal” is a withdrawal made by the Roth IRA account owner when you’ve had at least one Roth IRA account open for more than five years and you’ve either reached age 59½, become disabled, or died. That five-year period starts on the first day of the tax year in which you make your first contribution to your first Roth account.

Second, a Roth IRA does not have annual required minimum distributions (RMDs). In a traditional IRA, you have to start taking a required minimum amount out after reaching age 70½. A Roth IRA has no such requirement, and if you have money to live on from other sources, a Roth IRA can continue to accrue until your passing, at which point it makes a valuable asset to pass to family.

The most well-known advantage of a Roth IRA is as discussed: avoiding a higher tax rate in the future. As such, it makes the most sense to make a regular yearly contribution to your Roth IRA when you are making a lower yearly salary than you expect to make later in your career.

Some contributions to a traditional IRA are tax-deductible, while Roth IRA contributions are not tax-deductible. However, there is a limit to the amount of deduction you can take from traditional IRA contributions. If your tax planning strategy includes significant contributions to a traditional IRA, you can put any contributions beyond the deductible threshold into a Roth IRA, subject to its maximum contribution limit.

That contribution limit is set, by tax year, as the lesser of your annual contribution limit for the year or your earned income for that tax year. Earned income includes your job earnings (even for the self-employed) and money received as alimony (as part of gross income).

Even if you have made significant contributions to a traditional IRA already, you can convert the traditional IRA into a Roth IRA as a whole. However, the conversion is itself considered a distribution from the traditional IRA and therefore taxable. The use case for a Roth conversion is based on a prediction that federal income tax rates will increase (possibly to a significant degree) over your lifetime, and therefore that today’s income tax rates will be the lowest you see. The idea is that although you are taxed on the conversion since that tax rate is so much lower than your prediction of future tax rates that you will end up with more money when you ultimately distribute funds for retirement.

These are all factors to consider when forming a tax strategy and plan for your money in the future. Consider speaking to a financial advisor or estate planner to discuss your unique situation. An expert can help you spot strategies and pitfalls that you would either not find, or discover too late to take advantage of.

Reference: MarketWatch (March 27, 2018) “How the new tax law creates a ‘perfect storm’ for Roth IRA conversions”