To help encourage people to save for retirement, the federal government established retirement accounts that offer tax benefits to the participant. Two of the most popular Individual Retirement Accounts (IRA) are Traditional and Roth. With a “Traditional” IRA, participants can deduct their contributions, thus reducing their tax bill in the year they contribute. Participants are then taxed when the funds are distributed. With “Roth” retirement accounts, participants fund their accounts with after-tax contributions and then pay no tax when funds are distributed.
When preparing for retirement, investors should review objectives and marginal income tax brackets to evaluate whether to contribute to a Traditional retirement account, a Roth retirement account, or a combination of both.
The following chart breaks down four common retirement accounts:
If you are uncertain of your future income tax rates, you should consider using a combination of both Traditional and Roth retirement accounts as a “tax hedge.”
Additional Roth Considerations
Backdoor Roth Contributions
If a taxpayer’s income is higher than the noted thresholds for contributing to a Roth IRA, a taxpayer may fund a Traditional IRA with a “non-deductible” contribution. This contribution may, in turn, be converted tax-free to a Roth IRA, provided the taxpayer does not have any other holdings in a Traditional IRA. If a taxpayer has an outstanding Traditional, SEP or SIMPLE IRA balance, a portion of the conversion will be treated as taxable income.
Roth Conversions
Unlike income limits for Roth IRA contributions, there are no such income limitations for completing a Roth conversion. Taxpayers should recognize that converting a Traditional IRA to a Roth IRA typically produces taxable income. You should evaluate your income tax picture to compare how your current tax bracket might compare to a future tax bracket.
You might consider a partial conversion, where income is recognized up to a certain tax bracket.
For ultra-high net worth individuals that will otherwise have a taxable estate, a Roth conversion may make sense as it reduces the size of the taxable estate by the amount of taxes paid on conversion while eventually leaving a more beneficial asset to heirs (i.e. inheriting a Roth IRA is preferable to inheriting a Traditional IRA).
Do you have questions about which retirement account (or accounts) is right for you? Contact an advisor at Fi3 today to learn how we can help you reach your retirement goals.
The information contained within this document offers only a summary of tax and legal provisions. This information may not be relied upon for legal or tax action and may not be considered legal or tax advice for any taxpayer. Please consult your legal and tax professionals for assistance and guidance.