Roth IRA accounts are well known for providing tax-free growth and retirement income within specific parameters. The catch is that contributions must be made with earned income that has been taxed already. In other words, Roth accounts aren’t exactly tax-free, they are merely taxed differently.
On the other hand, Traditional IRA retirement accounts are funded with pretax dollars, thereby reducing taxable income in the year of contribution. Then, distributions from Traditional IRA retirement accounts are taxed as income.
The Roth IRA is not tax-free, it is merely taxed differently
However, the tax benefit remains the most prominent factor in the Roth vs. Traditional IRA decision. To make the decision that helps you pay fewer lifetime taxes requires an analysis of current vs. future taxes. That will usually require you to enlist professional help. After all, you would not want to choose to contribute to a Roth to pay fewer taxes and end up paying more taxes instead!
As everyone’s circumstances will be different, it would be beneficial to check with a Certified Financial Planner® or a tax professional to plan a strategy that will minimize lifetime taxes, taking into account future income and projected taxes.
Check out our other posts on Retirement Accounts issues:
In general, when IRA aggregation is permissible for distribution purposes, all the Traditional IRAs, SEP IRAs, and SIMPLE IRAs of an individual are treated as one traditional IRA. Similarly, all of an individual’s Roth IRAs are treated as a single Roth IRA.
IRA Aggregation does not apply to the return of excess IRA contributions
The IRA contribution limit for individuals is based on earned income. Individuals under 50 years of age can contribute up to $5,500 a year of earned income. Those older than 50 years of age are allowed an additional catch up contribution of $1,000. The contribution limit is a joint limit that applies to the combination of Traditional and Roth IRAs.
When the IRA contribution happens to be in excess of the $5,500 or the $6,500 limit (for people over 50), the excess contributions, including net attributable income (NIA), ie the growth generated by the excess contribution, must be returned before the IRA owner’s tax filing due date, or extended tax filing due date. Those who file their returns before the due date receive an automatic six-month extension to correct the excess contributions.
Mandatory aggregation applies to the application of bases for Traditional IRAs
Contributions to Traditional IRAs are usually pre-tax. Thus, distributions from IRAs are taxable as income. In addition, distributions prior to 59.5 years of age are also subject to a 10% penalty.
After-tax contributions to an IRA, but not the earnings thereof, may be distributed prior to 59 ½ years of age without the customary 10% penalty. Distributions from an IRA that contains after-tax contributions are usually prorated to include a proportionate amount of after-tax basis (amount contributed) and pre-tax balance (pro rata rule).
Suppose that Janice has contributed $700 to a non-deductible Traditional IRA, and it has grown to $1,400. If Janice takes a distribution of $500, one half of the distribution is returnable on a non-taxable basis, and the other half is taxable and subject to the 10% penalty if Janice happens to be under 59½ years of age. You can see why Janice would want to keep accurate records of her transaction in order to document the taxable and non-taxable portions of her IRA.
Limited aggregation applies for inherited Traditional IRAs
In practice, it means that if Johnny inherited two IRAs from his Mom and another from his Dad, Johnny must take the Required Minimum Distributions for his Mom’s two IRAs separately from his Dad’s, and also separately from his own IRAs.
Furthermore, IRAs inherited from different people must also be kept separate from one another. They can only be aggregated if they are inherited from the same person. In addition, inheriting an IRA with basis must be reported to the IRS for each person.
Mandatory aggregation applies to qualified Roth IRA distributions
Qualified distributions from Roth IRAs are tax-free. In addition, the 10% early distribution penalty does not apply to qualified distributions from Roth IRAs.
Roth IRA distributions are qualified if:
– they are taken at least five years after the individual’s first Roth IRA is funded;
– no more than $10,000 is taken for a qualified first time home purchase;
– the IRA owner is disabled at the time of distribution;
– the distribution is made from an inherited Roth IRA; or
– the IRA owner is 59½ or older at the time of the distribution.
If Dawn has two Roth IRAs, she must consider both of them when she takes a distribution. For instance, if Dawn takes a distribution for a first time home purchase, she can only take a total $10,000 from her two Roth IRAs
Optional aggregation applies to required minimum distributions
The RMD for each IRA must be calculated separately; however, the owner can choose whether to take the aggregate distribution from one or more of his Traditional, SEP or SIMPLE IRAs.
So, if Mike has a Traditional, a SIMPLE and a SEP IRA, he would calculate the RMD for each of the accounts separately. He could then take the RMD from one, two or three accounts in the proportions that make sense for him.
As a reminder, Roth IRA owners are not subject to RMDs.
Limited aggregation applies to Inherited IRAs
Beneficiaries must take RMDs from the Traditional and Roth IRAs that they inherit with the exception of spouse beneficiaries that elect to treat an inherited IRA as their own.
With this latter exception, RMD rules apply as if the spouse was the original owner of the IRA.
When a beneficiary inherits multiple Traditional IRAs from one person, he or she can choose to aggregate the RMD for those inherited IRAs and take it from one or more of the inherited Traditional IRAs. The same aggregation rule applies to Roth IRAs that are inherited from the same person.
Suppose again that Johnny has inherited two IRAs from his Mom and one from his Dad. Johnny can calculate the RMDs for the two IRAs inherited from his Mom, and take it from just one. Johnny must calculate the RMD from the IRA inherited from his Dad separately, and take it from that IRA.
If in addition, Johnny has inherited an IRA from his wife, he may aggregate that IRA with his own.
If an IRA distribution is rolled over to the same type of IRA from which the distribution was made within 60 days, that distribution is excluded from income.
Such a rollover can be done only once during a 12-month period.
In this kind of situation, all IRAs regardless of types (Roth and non-Roth) must be aggregated. For instance, if an individual rolls over a Traditional IRA to another Traditional IRA, no other IRA to IRA (Roth or non-Roth) rollover is permitted for the next 12 months.
Conclusion: What you should keep in mind
These are some of the more common IRA aggregation rules. There are others including rules for substantially equal periodic payments programs (an exception to the 10% early distribution penalty), and those that apply to Roth IRAs when the owner is not eligible for a qualified distribution.
Lastly, many of the potential problems that people may face with IRA aggregation can be avoided with proper documentation. Recordkeeping is essential. Individuals can do it themselves or they can rely on their Wealth Managers. In the case where you have to change financial professionals, make sure that you have documented the history of your IRAs.
When working year taxes are lower than projected tax rates in retirement, it usually makes sense to contribute to a Roth account . In this situation, paying taxes upfront results in lower projected lifetime taxes. For instance, assuming that Vanessa is in the 24% tax bracket, she will need to earn $7,236 to make a $5,500 contribution to a Roth IRA. That is because, she will owe federal taxes of $1,736 on her earnings (not counting state taxes where applicable), leaving her with $5,500 to contribute. However, Vanessa’s distributions in retirement would be tax free. If her marginal tax rate in retirement is greater than 24%, she would have saved on her distributions.
When working year tax rates are higher than projected tax rates in retirement, it usually makes sense to contribute to a Traditional IRA or Traditional 401(k) . Contributing to a Traditional account in that situation generally results in a reduction in taxes in the year of contribution; taxes will be due when the assets are withdrawn from the account, hopefully in retirement. For instance, If Vanessa contributes $5,500 to a Traditional IRA can result in a reduction in taxable income of $5,500. If she is in the 24% federal income tax bracket, Vanessa would save $1,320 in federal income taxes (not counting potential applicable state income taxes). If Vanessa is in the 12% marginal federal tax bracket in retirement, when she takes $5,500 in distribution, she would then owe federal income taxes of $660.
The new Tax law, aka the Tax Cut and Jobs Act or TCJA, passed in December 2017, comes with a number of features, including a permanent reduction in corporate taxes. Most important for individuals and families, it significantly reduces individual tax brackets starting in 2018.
In practice this will result in a large tax hike in 2026 for many individuals and families. For instance if Susanna and Kevin make $150,000 and file “Married Filing Jointly”, they might be in the 22% marginal tax bracket in 2018. With the same income in 2026, Susanna and Kevin would be in the 25% marginal tax bracket. Of course, there are several other factors that will impact their final tax bill, but most people in that situation will stare at a higher tax bill.
Susanna and Kevin could also take advantage of the temporary nature of the TCJA tax cuts to convert some of their traditional tax deferred retirement accounts to Roth accounts. In so doing, they would take distributions from the Traditional account, transfer to the Roth, and pay income taxes on the conversion. This way Susanna and Kevin would create themselves a source of tax free income in retirement, that could help them stay in their tax bracket and partially insulate them from future tax increases.
Now is the time to take steps to manage your taxes
Because Roth conversions increase current taxable income, many people will find them a limited possibility as only so much funds can be converted without jumping into the next tax bracket. However, working people can also think in terms of changing their current contributions from Traditional 401(k)s to Roth 401(k)s. That would have the similar impact of increasing current taxable income and income tax due for the benefit of creating a reserve of future tax free assets.
Consider changing from a Traditional 401(k) to a Roth 401(k)
Of course, it is not always clear where Susanna’s and Kevin’s taxable income would come from in retirement. That is because their sources of income will likely change significantly. While they would no longer earn income, they may then have social security income, pension income, and retirement plan income which are all taxed as ordinary income. They may also take income from other assets with different tax characteristics, such as savings or investments. That might make the projection of their taxable income more difficult.
It is possible that Susanna and Kevin’s income needs will influence the tax characteristics of their income when they retire in 2026 or later; that may place them in a different tax bracket altogether. For instance Wealth Managers routinely advise clients to postpone Social Security income as late as they can, preferably until 70 in order to maximize lifetime social security income. When that happens it is possible that income between retirement and 70 could come from other sources, such as investments. When that happens taxable income could be significantly lower as investments are usually taxed at a lower capital gains rate.
This may sound self serving, but I’ll write it anyway: the best way to know what Susanna and Kevin’s income would look like in retirement, and how it might be taxed, is for them to check in with a skilled Certified Financial Planner. Otherwise they would just be guessing.
Considering a Roth Conversion in Retirement
So what about people who are already retired? The situation is similar. Take David and Emily, a retired couple with social security income, state pension income, and retirement plan income. From 2018 to 2025, their $100,000 taxable income places them in the marginal 22% federal tax bracket. With the same income in 2026, they would end up in the 25% tax bracket. Through no fault of their own David and Emily will see their income tax increase in 2026.
One of the ways that David and Emily can fight that is to convert some of their Traditional retirement accounts to Roth between 2018 and 2025, pay the income taxes on the additional income, and then use distributions from the Roth when their taxes go up in 2026 to stay within their desired tax bracket. In this way, David and Emily could potentially reduce their overall taxes over the long term.
The key challenge for retirement contributors would be to calibrate the right amount of Roth conversion or Roth contributions so as to minimize current and overall taxes owed.
Because each situation will be different, it will pay to check with a Certified Financial Planner to estimate future income and tax rates, and to plan a strategy that will maximize your financial well being.
Check out our other posts on Retirement Accounts issues:
Note 1: this post makes assumptions regarding potential individual tax situations. It simplifies the many factors that enter into tax calculations. It omits many of the rules that are applicable to Roth accounts and Roth conversions. It also assumes that the TCJA will be unchanged. None of these assumptions may be correct. Please check with the relevant professionals for your individual situation.
Note 2: Insight Financial Strategists LLC does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Insight Financial Strategists LLC cannot guarantee that the information herein is accurate, complete, or timely, and makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.
Is 2018 the Year of the Roth 401(k) or the Roth IRA?
Much of the emphasis of the Tax Cuts and Jobs Act(TCJA) passed in December 2017 affected individual income taxes. However, there are also impacts on investment strategies.
From an individual standpoint, the primary feature of the TCJA is a reduction in income tax rates. Except for the lowest rate of 10% all other tax brackets go down starting with the top rate which drops from 39.6% to 37%.
Table 1: 2018 Tax Rates for Married Filing Jointly and Surviving Spouses
However, in general, it is safe to say that most people will see a reduction in their federal income taxes in 2018. Of course, this may prompt a review of many of the decisions investors make with taxes in mind.
Most people are pretty excited to see their taxes go down this year! However, the long-term consequences of the tax decrease should be considered. While the TCJA was passed with the theory that it would stimulate growth such that tax revenues would grow enough to make up for the increased deficit created in the short term by tax cuts, few serious people believe that. The most likely result is that we will experience a small boost in growth in the short term and that federal deficits and the National Debt will seriously increase thereafter.
In the opinion of the non-partisan Committee for a Responsible Federal Budget, not even the expectation of additional short-term growth is enough to temper the seemingly irresistible growth in the federal debt.
Increased deficits will make it more difficult to fund our national priorities, whether it is defense, social security, healthcare, or investment in our national infrastructure. Therefore, I expect that we will initiate another tax discussion in a few years, most likely resulting in tax increases, in addition to the automatic tax increases that are embedded in the TCJA.
With federal income tax rates down in 2018 and our expectation that individual taxes will start increasing after 2018, now may be the time to consider a Roth instead of a Traditional account. The consideration of current and future tax rates remains the same. It just so happens that with lower tax rates in the current year, it becomes marginally more attractive to consider the Roth instead.
Consider the case of Lisa, a married pharma executive, making $225,000. This places her in the 24% federal tax bracket. In 2018, her $10,000 Traditional 401(k) contribution reduces her income taxes by $2,400. In 2017, Lisa would have been in the 28% tax bracket. Her $10,000 Traditional 401(k) contribution would have resulted in a $2,800 reduction in income taxes. Hence, Lisa’s tax savings in 2018 from contributing to his 401(k) goes down by $400 compared to 2017.
Table 2: Tax savings on a 401(k) contribution with $180,000 taxable income
From a tax standpoint, contributing to a Traditional 401(k) is still attractive, just a little less so. To optimize her lifetime tax liabilities, Lisa may consider adding to a Roth 401(k) instead, trading her current tax savings for future tax savings. If Lisa were to direct the entire $10,000 to the Roth 401(k), her 2018 income taxes would increase by $2,400 compared with 2017. Why would Lisa do that? If she expects future income tax rates to go back up, she could save overall lifetime taxes. It may be an attractive diversification of her lifetime tax exposure.
For instance, suppose now that the national debt does grow out of hand and that a future Congress decides to increase tax rates to attempt to deal with the problem. Suppose that Lisa’s retirement income places her in a hypothetical future marginal federal tax rate of 30%. In that case, she will be glad to have invested in a Roth IRA in 2018 when she would have been taxed at a marginal rate of 24%: she would have saved on her lifetime income taxes.
Of course, if Lisa’s retirement marginal tax rate ends up being 20%, she would have been better off saving in her Traditional 401(k), saving with a 28% tax benefit in her working years and paying retirement income tax at 20%.
Note also that Lisa would not have to put the entire $10,000 in the 401(k). She could divide her annual retirement contribution between her Roth and her Traditional accounts, thus capturing some of the tax advantages of the Traditional account, reducing the tax bite in the current year, and preserving a bet on a future increase in income tax rates.
Another possible course of action to optimize one’s lifetime tax bill is to consider a Roth conversion. With a Roth conversion, you take money from a Traditional account, transfer it to a Roth account, and pay income taxes on the distribution in the current year. As we know, future distributions from the Roth account can be tax-free, provided certain conditions are met . A distribution from a Roth IRA is tax-free and penalty free provided that the five-year aging requirement has been satisfied and at least one of the following conditions is met: you have reached age 59½, become disabled, you make a qualified first-time home purchase, or you die. (Note: The 5-year aging requirement also applies to assets in a Roth 401(k), although the 401(k) plan’s distribution rules differ slightly; check your plan document for details.) Because tax rates are lower in 2018 for most individuals and households, it makes it marginally more attractive to do the conversion on at least part of your retirement funds.
Consider David, a single pharma marketing communications analyst. With $70,000 in taxable income, he is now in the 12% marginal federal income tax bracket, down from the 25% federal income tax bracket in 2017. He is working on his part-time MBA in 2019 and expects his income to jump substantially as a result. Additionally, David, a keen student of political economy expects his taxable retirement income to be higher than his current income and overall tax rates to go back up before he reaches retirement. David now has a sizeable Traditional IRA.
For David, the opportunity is to convert some of his Traditional IRA into a Roth IRA. To do that, David would transfer some of his Traditional IRA into a Roth IRA. He would pay income taxes on the conversion amount at his federal marginal rate of 22%. David would only convert as much as he could before creeping into the next federal tax bracket of 24%. If he feels bold, David could contribute up to the 32% federal tax bracket. Effectively this means that David would stop converting when his taxable income reaches $82,500 if he wanted to stay in the 22% tax bracket, and $157,500 if he wanted to stay in the 24% tax bracket.
In this example, if David were to convert $10,000 from his Traditional IRA to his Roth IRA, he would incur $2,200 in additional federal income taxes. If David expects to be in a higher tax bracket in retirement, he would end up saving on his lifetime income taxes.
David could combine this strategy with continuing to contribute to his Traditional 401(k), thus reducing his overall taxable income, and increasing the amount that he can convert from his IRA before he hits the next tax bracket. If he were to contribute $10,000 to his Traditional 401(k) and convert $10,000 from his Traditional IRA to a Roth IRA, you could view this as a tax neutral transaction.
Table 3: Balancing a Traditional 401(k) and a Roth Conversion
This strategy may work best for people who expect to have a reduced income in 2018. Maybe it is people who are back in graduate school, or people taking a sabbatical, or individuals who are no longer working full time while they wait to reach the age of 70 and start collecting social security at the maximum rate.
It is worth remembering that Roth accounts are not tax-free; they are merely taxed differently . That is because contributions to a Roth account are post-tax, not pre-tax as in the case of Traditional accounts. You should note that the examples in this article are simplified. They do not take into account the myriad of other financial, fiscal and other circumstances that you should consider in a tax analysis, including your State tax situation. The examples suppose future changes in taxes that may or may not happen.
According to a 2017researchpaper at Harvard Business School, employees who have the option to contribute to a Roth 401(k) instead of a traditional 401(k) tend to contribute the same amount to either account. Given that a Roth 401k tends to result in more money taken out of your paycheck every week or month than a traditional 401k, that’s unexpected!
Take the case of Priya, a 49-year-old single mom. She makes $135,000 a year and lives alone with her son. Not counting her employer’s match, Priya saves $350 per pay period in her traditional 401k, totaling $9,100 a year. Absent other considerations, her $9,100 contribution reduces her annual taxable income from $135,000 to $125,900. As a result, since her taxable income is less, she will pay less income taxes.
Roth 401ks and Roth IRAs are not tax-free: they are merely taxed differently
What if she would reduce her Roth contribution to keep her current cash flow constant? In that case, it is not clear that Priya’s after-tax income in retirement would be higher or lower with a Roth 401k than with a traditional 401k. Answers would require further analysis of her situation.
According to John Beshears, the lead author of theHarvard study, one possible explanation for his finding is that people are confused about the tax properties of the Roth . Another possibility could be that people have greater budget flexibility than they give themselves credit for. Either way, employees should seek additional support before making this very important decision.
A prior version of this article appeared in Kiplinger and Nasdaq.com
As a Financial Planner, I often get asked if people should save money in a Traditional IRA or a Roth IRA. In a Traditional IRA, we contribute money on a pre-tax basis (i.e. we do not pay taxes on our IRA contributions), we let it grow tax-deferred, and we pay taxes when we withdraw the money in retirement. In a Roth IRA, we contribute after-tax money, we let it grow tax-free and we pay no taxes when we withdraw the money in retirement.
That last point (“we pay no taxes when we withdraw the money in retirement”) is, of course, the one that gets our attention. We don’t like paying taxes, and the thought that we could have tax-free income in retirement is really motivating, so much so, that, sometimes, it can be the only thing we focus on.
However, the Traditional IRA vs Roth IRA story is not quite that straightforward.
The reality is that we WILL pay taxes whether it is for a Roth IRA or a Traditional IRA. With the Traditional IRA tax deduction, we reduce taxes at contribution, and we pay taxes when we withdraw the money. With a Roth IRA, we pay taxes before we contribute the money. At the risk of disappointing many readers, allow me to repeat: the Roth IRA is NOT tax-free, it is taxed differently.
When you do the math you will find that if you 1) invest in the same way in a Roth IRA vs IRA, and 2) are taxed at the same rate on your Roth IRA contribution today, as on your Traditional IRA withdrawals at retirement, you will end up with the exact same amount of money to spend in retirement. Call us: we will show you the math.
So which one is best? The answer is that it depends.
In general, it makes sense to invest through a Roth IRA when we think that our tax rate in retirement will be equal to or higher than our current tax rate. If we think that our tax rate in retirement will be equal or lower than our current tax rate it makes better sense to invest through a Regular IRA.
How then should you decide?
It depends on your situation.
For instance, if you are at the peak of your earnings, and you can calculate that your income in retirement will be significantly less than it is today, a Traditional IRA calculator will tell you that you will save tax money immediately. Since you expect to be in a lower tax bracket at retirement, you will end up paying less taxes.
If you are currently a low earner, and expect to have higher income in retirement than you have now, a Roth IRA calculator will thell you that your cost in taxes will be relatively low, and you will not pay any more when you retire.
Because there are many phases in our working life, there are times when it makes better sense to invest through a Roth IRA or Roth 401(k), and other times when it makes better sense to invest through a Traditional IRA or a Traditional 401(k). Conversely, there will be times in our retired life when it will make better sense to withdraw from a Roth IRA, and others when it will make better sense to withdraw from a Traditional IRA.
There are some other constraints. For instance, the traditional IRA max contribution is significantly lower than the 401(k). In addition, if your income is above the Traditional IRA income limits or the Roth IRA limit you may not be able to contribute.
It is about balance and careful financial planning. In the right circumstances, the proper balance between Roth and Traditional IRAs could save you a significant tax bill. In my opinion, it justifies a consultation with a professional financial planner.
The Great Recession has many older Americans considering the prospects of going back to work after retirement or staying in the workforce past their normal retirement age. But working after retirement age is not a new necessity. According to the Social Security Administration, more than 30% of individuals between the ages of 70 and 74 reported income from earnings in 2010, the latest year data are available. Among a younger age group, those between 65 and 69, nearly 49% had income from a job.
Some remain employed for personal reasons, such as a desire for stimulation and social contact; others still want a regular paycheck. Whatever the reason, the decision to continue working into your senior years could potentially have a positive impact on your financial future.
Working later in life may permit you to continue adding to your retirement savings and delay making withdrawals. For example, if you earn enough to forgo Social Security benefits until after your full retirement age, your eventual benefit will increase by between 5.5% and 8% per year for each year that you wait, depending on the year of your birth. Although you can continue working after age 70, you cannot delay social security benefits past age 70. You can determine your full retirement age at the Social Security Web site (www.ssa.gov) or by calling the Social Security Administration at 1-800-772-1213.
Adding to Your Nest Egg
Depending on the circumstances of your career, working could also enable you to continue adding to your retirement nest egg. If you have access to an employer-sponsored retirement plan, you may be able to make contributions and continue building retirement assets. If not, consider whether you can fund an IRA. Just remember that after age 70 1/2, you will be required to make withdrawals, known as required minimum distributions (RMDs), from traditional 401(k)s and traditional IRAs. RMDs are not required from Roth IRAs and Roth 401(k)s.
Even if you do not have access to a retirement account, continuing to earn income may help you to delay tapping your personal assets for living expenses, which could help your portfolio last longer in the years to come. Whatever your decision, be sure to apply for Medicare at age 65. In certain circumstances, medical insurance might cost more if you delay your application.
Work doesn’t have to be a chore. You may find opportunities to work part time, on a seasonal basis, or capitalize on a personal interest that you didn’t have time to pursue earlier in life.