Mike Burt, MBA, CPA (Jul, 2016)

Many Americans worry about whether or not they have built up a large enough nest-egg over their working years and will have enough income during their retirement years.  It is often estimated that individuals will need approximately 70% to 80% of their pre-retirement income to live comfortably during retirement.  This article will focus on whether or not a Roth IRA may make sense for you as a tool in reaching your retirement goals.

Almost everyone has heard that the silver lining regarding Roth IRA’s is the ability to generate tax-free distributions in the future.  This is true as long as the distributions are qualified distributions.  To be qualified, the distributions need to be made after a five-year period beginning with the first tax year the individual contributed to the Roth IRA.  Also, these distributions have to be made either:  on or after the taxpayer reaches age 59 ½, after an individual becomes disabled, up to $10,000 for a first-time home buyer, or to a beneficiary or individual’s estate after death.   For 2015 and 2016, the annual total contributions to an individual’s Roth IRA accounts cannot exceed either:  $5,500 ($6,500 if you’re age 50 or older), or your taxable compensation for the year (if your compensation was less than these amounts).

Roth IRA’s make the most sense for individuals who believe their qualified distributions during their retirement years will be withdrawn tax-free in a period of higher tax, versus lower rates than when contributed.  This is because the contributions to the Roth IRA account have already been taxed, as they are funded by after tax dollars at a lower tax rate.  However, funding with after-tax dollars can create cash flow issues for certain individuals who need a certain amount of take home pay to live on.

Another benefit of Roth IRA accounts are that these accounts are not subject to RMDs (required minimum distributions) in the year upon attaining age 70 1/2) so they can potentially grow tax-free indefinitely.  An individual who has a Roth 401(k) must be careful because these are not the same as Roth IRA’s.  Roth 401(k) accounts are subject to RMDs.  To circumvent the RMD requirements, individuals can roll over their Roth 401(k) accounts into a Roth IRA account.

Traditional IRA’s on the other hand may make more sense for individuals anticipating lower taxes in retirement, versus when the contributions are made.  Very often taxpayers pay less tax in retirement, due to the simple fact that they are earning less income than when they were working.  With traditional IRA’s the taxpayer may get an above-the-line deduction providing a current year tax benefit, but the distributions taken later in retirement are taxable income to them.  A tax professional can help individuals by letting them know what tax savings are realized if they are able to get an above-the-line deduction.  If an individual’s cash flow situation permits, then this tax savings amount can be invested or the taxpayer may be able to enjoy a refund.

Roth IRA conversions may be an option in certain situations.  The goal is to have the conversion result in little or no additional tax liability.  Scenarios where Roth conversions work well and provide the most substantial tax benefit is when an individual anticipates a tax year with much lower income than normal, or even losses.  This may be a good strategy for new business owners who may not have large income until a few years down the road or someone who receives a K-1 with a loss that can be picked up on page 1 of their Form 1040, minimizing their income.    Separate Roth IRA accounts can be set-up for different investment categories and market sectors.  Depending on investment results affecting the account's values, the contributions for the separate accounts can be selectively re-characterized.

Amounts in a traditional IRA may be converted into a Roth IRA by rollover contributions (within 60 days of a distribution), by a trustee-to-trustee transfer, or having a transfer done to a Roth account maintained by the same trustee.  Any distributions or transfers not treated as returns of after-tax contributions to traditional IRA’s are added to the individual’s taxable gross income in the year of the conversion, but are not subject to the 10% additional tax under Internal Revenue Code Sec. 72(t).  One consideration for individuals converting to a Roth is how will any additional taxes due be paid.  Conversions should not be done too close to retirement.  Roth IRA’s are intended as a retirement tool, and as such, should be given time to grow by allowing the contributions and interest time to compound.  Individuals are allowed to reconvert contributions back to a Roth IRA after they have been re-characterized from a Roth to a traditional IRA.  However, there is a waiting period.  Individuals must wait until the later of 30 days after the re-characterization, or wait until the beginning of the tax year following the first Roth conversion.

The future is an unknown for everyone.  There is no telling if the tax rates when a person retires will be higher or lower, making investment choices often a gamble and diversification a wise choice.  However, if there is reason to believe that tax rates will be higher in an individual’s retirement years, rather than when distributions are taken, then a Roth IRA may prove to be a prudent investment option versus a traditional IRA in helping build a retirement nest-egg.  Just remember to consider the expected sources and types of retirement income.  

Please feel free to contact your Dermody, Burke & Brown tax advisor to further discuss any questions you may have.


The information reflected in this article was current at the time of publication.  This information will not be modified or updated for any subsequent tax law changes, if any.

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