Here's What To Think About When Considering A Roth IRA
I remember picking my oldest son up from school, when out of the blue he asked, “Mom, what’s the difference between a Roth and an IRA?” Pretty astute for a High School Freshman. One article I read described the difference as “paying taxes on the acorn or the oak tree”.
The Taxpayer Relief Act of 1997 had a provision that created the Roth IRA. A Roth IRA is an IRA that is subject to the same rules that apply to a traditional IRA, with the following differences:
- You cannot deduct contributions to a Roth IRA – contributions are made with after-tax dollars. No current tax break.
- If you satisfy the requirements, qualified distributions are tax-free. You pay tax on the contribution, but the earnings are distributed tax free.
- You can continue to make contributions to your Roth IRA after you reach age 70½.
- There are no Required Minimum Distributions (RMD).
- Non-Qualified distributions are deemed to be from nontaxable contributions first and then from taxable earnings.
As a long-term investor, I like the fact that the earnings on my money will not be taxed when withdrawn. Contrast this feature with an IRA or 401K where you put money in now without paying taxes. Sometime in the future when you take your money out, you will pay taxes. You pay taxes on what you contribute, as well as what it has earned over the years.
The Roth is an excellent retirement savings strategy for young professionals with significant future earning potential. In theory as they progress through their career, their incomes will rise, along with the tax rate. In peak earning years Roth accounts are not as beneficial. As we age, we also reduce the time available for tax-free compounding to work for us.
As there are no RMD’s after age 70 and no taxes on distributions, Roth accounts offer more flexibility in controlling taxable income in retirement. One planning strategy to reduce future taxable RMD’s is to do a “Roth conversion”. This involves converting a portion of your regular IRA or 401k to a Roth and paying the taxes on your next tax return. While paying taxes on an acorn is likely to be more appealing than paying taxes on the whole tree, there are many assumptions that become part of the decision.
Deciding to convert funds to a Roth requires correctly predicting the value of several variables many years, or even decades, into the future. To complicate things even further, some of the variables are likely to change over time as Congress is almost certain to change the law. This could easily render a good decision today a bad decision at a later date and really requires a good crystal ball to be certain.
The two biggest factors are tax rates and inheritance goals. Assumptions need to be made about future tax rates, not only when taxes are due on the conversion but also what they would be if you did not convert. How likely is it for tax rates to increase in the future? How much and when? Will you be in a higher tax bracket in the future? When you start taking RMD’s, what impact will that have on taxes?
It is also important to have money available to pay the current taxes. If that must come from the dollars converted, then there’s little to be gained. If you have other sources of funds to pay the taxes now and will be in a higher tax bracket or taxed at a higher rate in the future, conversion may make sense.
So, the answer is simple. Before signing the paperwork to convert funds to a Roth, whip out your crystal ball, make some educated guesses about future events and wait to see if your assumptions stand the test of time.