Many people often bypass the use of Roth IRAs in their retirement planning because of the absence of an upfront tax deduction. Therefore, many individuals choose to only fund their retirement with pre-tax contributions to a Traditional IRA and/or their company qualified retirement plan. After all, we were taught in economics 101 that a dollar saved today is more precious than a dollar saved tomorrow; plus deferring taxable income is often a prudent course of action. These tenets are important and rightfully given appropriate consideration, but should not serve as the only fundamental rules in your retirement plan. The following discussion points are intended to shed some light on Roth retirement vehicles and how/why to incorporate Roth’s into your retirement blueprint.
The Basics
A Roth IRA is an individual retirement savings account funded with after-tax dollars. Meaning contributions are not tax deductible, but subsequent qualified retirement age distributions are completely tax-free. For the 2013 tax year, you can contribute $5,500 ($6,500 if age 50 or older by December 31) to a Roth IRA. Contributions cannot exceed taxable compensation and are subject to phase-outs based on your modified adjusted gross income (MAGI). For 2013, the MAGI phase-out ranges from $178,000 – $188,000 for a joint return and $112,000 – $127,000 for single/head of household filers (special rules apply for married couples filing separately). Additionally, a spouse (filing jointly) may be able to contribute to a Roth IRA even if he/she had no taxable compensation.
Identical to traditional IRAs, contributions can be made for a tax year up until the original due date of your federal tax return (generally April 15th). Unlike traditional IRAs, contributions can be made beyond reaching 70 ½ years old and required minimum distributions are never imposed on a Roth. This can sometimes prove to be a significant advantage in terms of your estate planning.
In addition to Roth IRAs many qualified retirement plans such as 401(k) and 403(b) plans offer a designated Roth elective deferral option as well. Allowing the plan participant to contribute funds on a post-tax basis without the roadblock of income limitations associated with Roth IRAs.
Contribution Strategy for High Income Individuals
If you are not able to utilize a Roth 401(k) to circumvent the income limitations there is still another avenue to make Roth contributions. An individual can simply make a non-deductible Traditional IRA contribution and exercise a subsequent conversion (Roth Conversions discussed below) to a Roth IRA. Non-deductible contributions are allowable to a traditional IRA (if you have taxable compensation) up until the year you reach 70 ½ years old.
Roth Conversions
When converting assets held in a traditional IRA to a Roth you are essentially changing the tax treatment in which your retirement savings are held. The downfall is that you have to pay the tax bill on the conversion amount to convert the funds into post-tax dollars. As a result, the qualified distributions during retirement are completely tax-free (including the capital appreciation). One strategy that savvy individuals may employ from year-to-year is segregating their Roth conversions into several different accounts and evaluating the performance of each conversion individually to determine if recharacterizing or “undoing” the accounts back to traditional IRAs is desirable. Recharacterizng should be a consideration if the value of the assets converted has deceased since the original conversion date. Roth IRA conversions are great strategies, but should be carried out under the advisement of a CPA and/or financial adviser.
Tax Diversification
By only contributing to tax deferred retirement accounts you are not achieving the essential goal of tax diversification. Tax diversification is the strategy of investing in accounts with different tax treatments such as taxable, tax-deferred (i.e. traditional IRA) and tax-free (Roth IRA). By having your retirement savings spread out among these different accounts, it provides necessary flexibility needed for tax planning in your golden years.
-John Scaglione, RTRP