A client with substantial IRA and 401(k) account balances recently asked if there was any way they could contribute to a Roth IRA. They had heard that Roth IRA's are great because earnings grow tax-free and there aren't any required minimum distributions starting at age 70 1/2. We agreed that they are great. But, maybe not for this client.
The Roth IRA/401(k) Basics:
- Contributions to a Roth IRA or 401(k) plan are not tax-deductible.
- Roth IRA contributions are limited to $5,500 per year if you are younger than age 50 and $6,500 per year if you are 50 or older.
- Roth 401(k) contribution limits are the same as Traditional 401(k) plans (younger than age 50 - $17,500. Age 50 or older - $23,000)
If your 2014 joint adjusted gross income is in excess of $190,999, you can't make Roth IRA contributions.
Who Should Consider Contributing to a Roth IRA?
If you are in a lower tax-bracket now and believe you will be in a higher tax-bracket in the future, consider making a Roth IRA contribution in the year you will be in a lower tax-bracket. For example, the Roth IRA is fantastic for children and young adults that currently have low-earned income. The Roth IRA will compound tax-free for the next 30, 40 or even 50 years and will become very valuable in the future.
Unlike Traditional IRA's, Roth IRA's don't require that distributions start at age 70 1/2 and they are great vehicles to pass on to the next generation. The Roth IRA is included in your taxable estate, but there is no income tax due on the account and your heirs will receive this asset without any income tax obligations. Your heirs must take required minimum distributions based on their life expectancy.
Who Shouldn't Contribute to a Roth IRA?
If your marginal tax bracket will likely be lower during retirement, consider making a tax-deferred contribution to a Traditional IRA or 401(k).
Always take advantage of your employer's matching 401(k) contribution. Only then, if appropriate, do the Roth IRA.
Converting a Traditional IRA to Roth IRA
It is possible to convert all or a part of your Traditional IRA to a Roth IRA. However, this strategy may trigger a large income tax liability. The tax-deferred amount you convert to a Roth IRA will be taxed in the year you make the conversion. For example, if your Traditional IRA is valued at $100,000 and is all tax-deferred, the $100,000 would be taxable income. Consider converting all or a portion of your Traditional IRA if your earned income is unusually low and will likely increase in the future.
Make a non-deductible Traditional IRA contribution, immediately convert it to a Roth IRA.
If you exceed the income limitations and participate in an employer-sponsored retirement plan, you may not be able to make a deductible IRA contribution. Consider making a contribution to a non-deductible Traditional IRA and then converting this IRA to a Roth IRA. There will be very little taxable income due upon conversion.
This strategy works well if you don't have tax-deferred Traditional IRA's. If you do, then you might have to recognize some or most of the tax-deferred income from the Traditional IRA.
What’s the take-away?
Roth IRA's are fantastic retirement accounts. They should be utilized If you can contribute to them now while you are in a low marginal tax bracket.
However, they may not be appropriate in every situation and may not be worth the effort. If you have to pay a lot of tax now in order take advantage of the Roth IRA, think twice. Predicting future income or tax rates is difficult at best and the Roth IRA may or may not work out to your advantage. We recommend a detailed analysis in order to help you decide what retirement account is most advantageous.
We did this analysis for our clients that asked about the Roth IRA. The results suggested the Roth IRA was marginally advantageous, but they decided against it at this time. They decided to make Roth IRA contributions to benefit a couple of grandchildren. If you have questions, please call the Raskin Planning Group at 617-728-7433.