Roth IRAs – When and How to Benefit Most

by Craig Pellet, CPA

Should you contribute to a Roth IRA? With a traditional IRA, you can get a deduction when you put money in. But you pay tax on distributions. And you are required to withdraw – and pay tax on – at least a minimum amount each year once you reach age 70½. With a Roth IRA, you do not get a deduction on funding the account. But you do not pay tax on withdrawals – no matter how much the account may have grown. And you are not required to take money out during your lifetime. Those are nice features, so many taxpayers think a Roth IRA is always beneficial. But that is not the case. Here are some of the situations when a Roth IRA could be just the ticket.

Higher tax bracket in retirement? Use a Roth account.

Most taxpayers will have a higher tax liability during their working years, and a lower one when they retire. That would make the deduction for contributions to a traditional IRA, or 401k more valuable. You’ll get a deduction that is bigger than the tax bill in retirement. However, if you expect that your tax liability will increase in retirement, a Roth account could be worthwhile. With a Roth IRA you’ll forego the deduction, but won’t owe tax on the distribution.

Don’t need the assets during your lifetime? Use a Roth account.

If you don’t expect to need to distributions from a retirement account during your lifetime, a Roth IRA could create a nice, tax-free legacy for your heirs. Roth IRAs have no required minimum distribution, so you can let those funds grow, free of tax, through your retirement. Just be sure that you have updated your beneficiaries. IRAs are not distributed according to your will, so be sure that you have properly identified beneficiaries with your IRA custodian. Your heirs will be required to take at least a minimum amount from an inherited Roth IRA each year. But they won’t have to pay tax on the distributions.

Can’t make a deductible IRA contribution? Use a Roth account.

Roth IRAs are beneficial when you are not able to deduct your contribution to a Traditional IRA. Deductions for contributions to traditional IRAs are limited at higher income levels when the taxpayer or their spouse is covered by a retirement plan at work. You may remember that Roth IRA contributions are limited at higher income levels as well. Here is what you can do: make a non-deductible traditional IRA contribution, then immediately convert that balance into a Roth IRA. The tax effect on the contribution is the same in either case, but when the funds sit in a Roth, they grow tax-free. When they sit in a traditional IRA, the growth is taxed upon withdrawal.

This works only if you do not have any other assets in traditional, SEP, or Simple IRAs. If you do, the conversion from traditional to Roth is at least partly taxable. In that case, you could consider rolling those other IRA funds into your 401k at work.

Variable income? Use a Roth account in low income years.

If your income varies from one year to the next, consider contributing to a Roth IRA in low income years. The deduction for a traditional IRA is not as powerful when your income drops. This idea goes hand-in-hand with using a Roth when you expect to be in a higher tax bracket in retirement.

If you are self-employed, you can set up a solo 401k plan with a Roth feature, and pick whether you make a deductible retirement contribution or a Roth contribution. You can make hefty annual contributions to a Roth-feature 401k – more than to a Roth IRA itself!

Young and starting your career? Use a Roth account.

Young professionals just starting to build their nest egg should strongly consider a Roth IRA. The deduction for making a traditional IRA contribution is not so beneficial when you are in the 10% or 12% tax bracket. As you advance in your career, and your salary increases, consider switching over to deductible retirement plan contributions.

One caveat to consider is that many employers offer matching or other retirement benefits that are only available to plan participants. Since those employer contributions are essentially free money, you’ll likely want to participate in your employer’s plan if possible. You should ask if your company’s retirement plan includes a Roth feature. Some employer’s plans will offer a Roth 401k alongside the traditional 401k.

Questions? Talk to us. Let’s discuss your retirement contributions, and how to maximize the tax benefits of saving for your future!