To Roth or not to Roth? That is the question
My conversations with CPAs can be spirited as we work through the complexities of our client’s financial lives. Your CPA’s job is to save you money on your taxes today. Your CFP’s job is to look at your financial picture today and tomorrow from many different angles. One area that provides a dynamic discussion is the Roth IRA.
Are you considering a Roth IRA, converting a traditional IRA over to a Roth IRA, or using a “back door Roth” if your earnings exceed Roth limits? There is a lot of appeal to the tax-free growth and potential tax-free distribution from these accounts, but there are considerations to make before signing on the dotted line. Four factors determine whether a Roth will or will not be more beneficial than the traditional pre-tax IRA.
The first and most important factor is current versus future tax rates. Where are you sitting now? Your current tax rate means the marginal rate that will be paid today by using a pre-tax retirement account versus contributing to or converting to the Roth. Next, get out your crystal ball and gaze intently into the future. Know that wealth is built by paying taxes when the rates are lowest, we can look at principles and trends and prognosticate. Historically, we are in a low tax rate environment. Where are we headed? What do you want your cash flow to be in the future? Where will it be coming from? How will it be taxed? How do you want to manage cash flows from different sources? If you think tax rates will rise in the future, how will that affect you? Do you want to have a variety of buckets to choose from? Traditional IRA monies are taxed as ordinary income when distributed. Roth monies come to you tax-free, once you meet requirements.
Another defining factor is the impact of Required Minimum Distributions. You must begin receiving traditional IRA distributions by April 1 of the year following the year in which you reach age 70½. This RMD component creates an ongoing tax-drag on the account as it self-liquidates as you get older. A Roth (not Roth 401(k) accounts) is not subject to RMDs during the lifetime of the account owner. This provides a benefit of dollars staying inside their tax-favored wrapper. The benefit applies only while the IRA owner is alive, and if they live past 70 ½. Once an account owner dies, RMD will apply to inherited IRA or Roth IRA accounts, but tax treatments will be different and can be “stretched” if set up properly.
The third aspect to consider is the contribution limits and the embedded tax liability. Consider a person in the 28% tax bracket. If they have $100,000 in an IRA, the reality is that they actually have $72,000 available for themselves and $28,000 “on hold” for the IRS in the form of future taxes. As the account grows, so does the IRS’s share. Not a problem if the hope is that you will retire in a lower tax bracket as mentioned above. The problem is that you can’t make a “full” $5,000 contribution. In reality, you are contributing $3,600 for yourself and $1,400 on behalf of Uncle Sam. If on the other hand, you contribute to the Roth, the entire $5,000 is made on your behalf because it is in after tax dollars.
Finally, the Roth is a good bucket to have when it comes to estate taxes. It’s bad news to pay state estate taxes on a retirement account when part of it is earmarked for Uncle Sam in the first place.
This starts getting too complicated for a short column but talk to your tax, financial, and legal advisors to determine how to best lay out your plan.
The bottom line, while a Roth may be favorable in many situations, it’s hardly automatic in all of them. It is important to evaluate your situation from many different angles based on what you are trying to accomplish both now and down the road. We don’t know what the future holds and I am of the mindset that flexibility is key. How are you building options and opportunity into your financial life? It’s not only with the hard assets, but with your mindset around contentment and change.
Danielle Howard is a Certified Financial Planner practitioner. Her office, Wealth By Design LLC, is in Basalt. Visit her at http://www.wealthbydesign4u.com or call 927-3909. Advisory Services offered through Cambridge Investment Research Advisors Inc., a Registered Investment Advisor. Securities offered through Cambridge Investment Research Inc., a broker/dealer, member FINRA/SIPC. Cambridge and WBD are not affiliated.
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