Are You Harnessing the Most Powerful Tool for Retirement?

Thu, Nov 29, 2018 - 11:25am

By now I’m sure you understand the benefits of a Roth account. You put money in after taxes and it grows tax free over time. It’s universally known that a Roth account is great for those in lower tax brackets or for anyone who’s younger. It can also be attractive for those close to or even in retirement.

Potential Ways to Harness Roth

Roth IRAs are not ideal for most people because they have relatively low contribution limits and income limitations. A more attractive option could be using a Roth 401(k) if it’s available through your employer. A study last year showed that 52 percent of 401(k)s have a Roth option available. In a Roth 401(k) there are no income limitations and much higher contribution limits making it an ideal option for many.

Back-Door Roth

Those who are still working but are over the income limits for the Roth IRA and who don’t have a Roth 401(k) option, can potentially look at doing a back-door Roth IRA. This is a complex two-step transaction where non-deductible contributions are made into an IRA and then converted to a Roth IRA.

Thanks to recent tax changes, this process is less of a gray area than in years past, but you should consult a tax or financial professional to help with this transaction to avoid potential unintended tax consequences. For example, this option isn’t ideal for those over 70 ½ and when the conversion is done the pro-rata rules still apply.

Roth Conversions

The final option to consider is a Roth conversion. Typically these are done for recent retirees before they reach 70 ½ (where RMDs kick in) or if you have a low-income earning year, perhaps you took some time off work or were laid off. With the changes in the tax code, you’ll want to consult a tax professional as there is no longer a do over. In the past, you could get a mulligan from a recharacterization, but this will be eliminated in 2019.

Roth conversions, as discussed yesterday (see Should You Consider a Roth Conversion), are tricky as they can’t be reversed and also require careful planning. Ideally, you’ll want to complete them at the end of the year, so you have a better idea of your tax situation. Below are some points to consider when looking at a conversion.

Reasons to Consider Using a Roth Account

1. Tax Free Growth

Assuming a 20-year-old puts in $5,000 a year over 40 years they would have nearly $800,000 assuming a 6 percent return. This would result in almost $600,000 in tax free growth ($800k total – $200k in contributions) compared to an IRA where that $600k would be taxable.

2. Pay Taxes Now or Later

You will eventually pay taxes on your contributions whether using a traditional account or a Roth. The difference is, do you want the growth to be taxable or tax free?

3. Many Expect Tax Rates to Rise in the Future

I do expect tax rates to increase in the future. With government deficits predicted to reach $1 Trillion dollars next year, tax increases are anticipated to help cover the shortfall. Ideally, you want to do conversions if you are expected to be in a higher tax bracket in the future.

4. Lean Into It If You're Stuck With an AMT

Alternative minimum tax (AMT) is a purgatory that is difficult to leave. With AMT you pay the greater of your normal tax or the AMT. If you must pay the AMT instead, you are losing the benefits of a traditional IRA so making Roth contributions or completing a Roth conversion may be beneficial for taking advantage of the higher tax rate you are forced to pay.

Disadvantages of Roth

1. No Instant Tax Benefits

With tax deferred accounts, you are able to lower taxes by delaying taxes due on contributions to tax deferred accounts. This can be very beneficial if you’re close to retirement or if you’re in the highest tax brackets.

2. Potential Legislation Changes in the Future

Roth accounts are not subject to RMDs and the growth is completely tax free. It is feasible that changes could be made down the road making them less desirable.

Currently, a Roth account is the most powerful tool at your disposal to help rev up your retirement. The assets will grow faster as there is no tax drag and it’s ideal to provide tax diversification in retirement. For most, contributing to a Roth is a no brainer but please speak with an advisor to discuss what your ideal strategy, even if you are near retirement or a high-income earner.

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Advisory services offered through Financial Sense® Advisors, Inc., a registered investment adviser. Securities offered through Financial Sense® Securities, Inc., Member FINRA/SIPC. DBA Financial Sense® Wealth Management.

About the Author

Paul Horn CFP