As tax season approaches, it’s a good time to review the tax planning moves you may make to better your financial position. Due to its unique tax features, contributing or converting to a Roth IRA might be considered during your review. There are certain limitations on how much and who can contribute to a Roth IRA, but oftentimes, individuals miss the opportunity to take advantage of Roth benefits simply because they aren’t familiar with the rules. Let’s take a look at some of the benefits of a Roth IRA, as well as the various ways to fund it. With proper planning, a Roth can be a powerful part of your financial picture and can complement your other “tax buckets.”
The Power of Roth IRAs
A Roth IRA is a type of individual retirement account which, unlike traditional IRAs or traditional 401(k)s, is funded with after-tax dollars. The funds within the Roth grow, and can be distributed tax-free, if certain rules are followed. Although your contributions to a Roth are not deductible the year you make them (since they are made with after-tax dollars), the tax-free growth is the power of a Roth IRA.
The key to understanding whether a Roth IRA makes sense for you is to answer the following question: Will my tax bracket be higher or lower in the future? If the answer is higher, then the Roth option could make sense. The problem is, we can’t be certain of our future tax rate. In retirement, we could potentially see increased income from investments, real estate holdings, pensions, tax law changes, and a host of other scenarios that could put you in a higher tax bracket. This is why diversifying your investments in a variety of tax types, also known as “tax buckets,” is beneficial.
We call this type of planning “tax bracket management.” If you are currently in a low tax bracket, it may benefit you to choose the Roth route instead of opting for a tax deduction via the traditional IRA or 401(k). Once your income reaches the higher tax brackets, then you may want to consider a tax-deductible plan instead. Plans that provide for a tax-deduction can be useful tools to defer taxes, but keep in mind that some point in the future either you or your beneficiaries will have to pay a tax when those funds are distributed.
The power of Roth IRAs also extends into the area of estate planning. There are distinct advantages for the beneficiaries when inheriting a Roth IRA. First, they too can take distributions income tax free. Also, the recently passed tax law called “The SECURE Act” made Roth IRAs even more appealing as an asset to leave to beneficiaries. For instance, if certain requirements are met, children can inherit a Roth IRA from a parent and continue to allow it to grow tax-free for another 10 years after the parent’s death.
Ways to Fund a Roth IRA
- Annual Roth IRA Contribution Limit - The most common way to fund a Roth IRA is to contribute up to the annual limit, which is $6,000 ($7,000 if you’re age 50 or older). You are not eligible for this method if your income is above a certain amount.
- Roth 401(k) - Most 401(k) plans are now providing a Roth option. With a Roth 401(k) there are no income limitations and you can contribute up to $20,500 ($27,000 if you’re age 50 or older).
- Roth Conversion - A Roth Conversion simply means taking funds that are in a traditional IRA and “converting” them to a Roth IRA. You typically have to pay the taxes on the converted funds, but it may make sense if you’re in a lower tax bracket. There is also no income limit and there is no maximum amount that you can convert in any one year.
- Back-Door Roth Conversion - A unique funding method that may be going away as tax laws change. This is a combination of the 1st and 3rd method, and allows you to fund a Roth IRA even if you are above the income threshold.
- Roth As a Gift – If you’re planning on gifting to family members (above 18 years old and must have an earned income), encourage them to contribute a portion of your gift to a Roth IRA. Roth IRAs for young individuals, when compounded over time tax free, can be very beneficial.
For some individuals the planning can be straightforward but for others the planning is complex and may affect other areas of your finances. For this reason, it's important to consult with a comprehensive financial planner who will examine all areas of your financial plan. With proper planning, Roth IRAs can be a powerful tool in your financial plan.