Roth IRAs Demystified

A question we hear from folks far and wide is, “when does a Roth IRA make sense”? Well, you’re in luck! Today we address that very topic.

A “Roth” retirement account means it is funded with after tax dollars. Instead of contributing to our retirement account with pre-tax dollars like in a traditional retirement account, we use post-tax dollars.

There are unique features when it comes to a Roth IRA. Some of the common advantages include tax deferred growth, no required minimum distributions, and the ability to withdraw the contributions you make without paying taxes or a penalty. Though, any earnings you withdraw would be subject to taxation and penalties if you aren’t at least 59 ½ and your account is not at least 5 years old.

There are also drawbacks when using a Roth IRA, such as income phaseout limits and nondeductible contributions.

Some features could be an advantage or a disadvantage depending on your financial situation. For example, when you contribute to a Roth IRA account, it “locks in” your current tax rate. This would be an advantage if you plan on being in a higher tax bracket in retirement years. It would be a disadvantage if you plan on being in a lower tax bracket during your retirement. It also assumes you don’t make an unqualified withdrawal which would result in taxes and penalties on the earnings portion of your withdrawal.

While we don’t have a crystal ball and can’t know what tax rates will be when we retire, we can take our current situation into account and make an educated guess. If you are currently a high earner and will not have as much income in retirement, chances are you’ll pay less in taxes when you are retired, and a Roth IRA may not be for you. Alternatively, you may be getting started in your career and chances are you’ll have higher income and pay more in taxes later in life, which could make a Roth IRA a great option.

In addition, many changes from the Tax Cuts and Jobs Act (TCJA) in 2017 are set to sunset in 2025. Meaning if legislation doesn’t extend features from the TCJA, taxes could revert to higher rates.

Circling back to the fact that Roth IRAs do not have required minimum distributions (RMDs), it allows you to have more flexibility as a retiree on if and when you want to take distributions from your retirement account. If you have other income sources, perhaps you don’t need to tap into your Roth until later into retirement and your money is able to continue accumulating.

All facts considered there are generally three times in life when Roth IRAs are most appropriate. First is when you’re at the beginning of your career, earning less than expected over your lifetime. Second is when your income dips, perhaps you take some prolonged time off work or make a career change. Third is before income tax rates increase, which is harder to plan for, but if you can make some proactive moves to take advantage of lower tax rates, it could be a good time to invest in a Roth IRA.

Another popular topic is Roth IRA conversions. Also known as the “back door Roth IRA”. A Roth IRA conversion is characterized by taking money saved in a traditional IRA and putting it into a Roth IRA. You pay taxes on the earnings of the amount transferred into the Roth IRA, and pre-tax dollars become post-tax dollars.  Attractive features of a Roth IRA conversion include no income phase out limits, no need to have earned income, and no limits on how much you can convert each year.

If you are earning less than normal or income taxes are lower than normal, a conversion could be a useful tool. Perhaps you have some money in a traditional IRA and are taking a prolonged break from work. A Roth IRA conversion may be a perfect opportunity to make use of low tax rates while you take care of family, look for a new job, or take a much-needed sabbatical.

If you get laid off from your job, the last thing you’ll probably be thinking about is retirement, though it may be wise to do so. While looking for new job opportunities, it may make sense to convert your old 401k into a Roth IRA. It is a chance to make lemonade when life gives you lemons.

Roth IRA conversions can be enticing but be cautious about the tax bracket it will push you into. You want to be mindful of how much you convert and when. Ultimately, the decision to convert or to not convert comes down to your own individual situation and goals.

Lastly, Roth IRAs and Roth 401k’s are similar in almost as many ways as they are different. Generally, Roth 401k’s are appropriate for the same periods of life you would use a Roth IRA. Though, be cautious of the differences and let us know if you have any questions.

As always it is a pleasure to be of service.

Sirra Anderson Crum CFP®
Financial Planner

The information contained in this correspondence is intended for general educational purposes only and as a means for facilitating a conversation.  Please consider our door always open to discuss your particular situation and how this information might benefit you and fit your specific needs.