By Jon Lawton, CFP®
There are two types of IRAs: Traditional IRAs and Roth IRAs. They each have their advantages and disadvantages that become particularly meaningful at certain points during your life. One of the most pivotal times to consider which type of IRA you should own is during the 5-to10-year window before and after retirement.
What’s the difference between a Roth and a regular IRA? In a nutshell: taxes. If you’ve been saving for retirement, then you should be worried about taxes. Here’s why and what you can do about it.
Meet the Traditional IRA
A traditional IRA is one that you contribute to while you are working. It grows your savings tax-deferred while also reducing your income during your wage-earning years, which lowers your tax bill come April. Instead, you are taxed when you withdraw the funds.
The idea is that in retirement your taxes will be lower than what they were during your working years. Distributing the IRA when you are older, in a lower tax bracket, will help you reduce the taxes owed over your lifetime.
However, many retirees discover that this idea of lower taxes in retirement turns out to be a myth. According to a 2020 study conducted by the Center for Retirement Research at Boston College, 40% of “wealthy” households—defined as having a combined income from Social Security and savings of at least $3,000 a month—are at risk of not being able to maintain their lifestyle due to taxation in retirement.[1]
Enter the Roth
In 1997, a new kind of IRA emerged: the Roth IRA. This type of IRA does not give you an immediate tax benefit lowering your income, the same way a traditional IRA does. The money inside the Roth grows tax-deferred just like the traditional IRA, but when you spend the money, the money comes out tax-free. This includes any dividends or gains that you earn—they are never taxed.
Like a traditional IRA, these accounts have contribution limits, but because the tax deal is so good, they also have income limits.
These structures apply equally to 401(k)s. There are traditional 401(k)s and, lately, we have been seeing more Roth 401(k) options.
Will Your Taxes Be Lower in Retirement?
You might expect your income to be lower in retirement. But more and more people who sit across the desk from me, who have been working hard and saving diligently, are becoming 401(k) millionaires. It’s great that they are saving but these are tax-deferred accounts, which means that unless they want to drastically change their lifestyle, they’re not going to see a reduction of taxes come retirement.
The strategy of delaying taxes during your working years builds both wealth and a tax mountain that may very well put you in an even higher tax bracket come retirement. Couple that with the Tax Cuts and Jobs Act of 2017 set to expire in 2025, increasing the tax rates for five out of the seven income tax brackets, and we have a known increase in tax rates that’s just around the corner.
What this means for the diligent saver is that right now, we have a limited opportunity to capture today’s tax rate by completing a Roth Conversion.
Are You a Good Candidate for a Conversion?
If you want to avoid running out of money in retirement, then you’ll want a portfolio that’s as tax-efficient as possible. Studies find that a tax-efficient withdrawal strategy can add more than six years to the life of a portfolio as compared to a tax-inefficient strategy.”[2] Adding a Roth can help you achieve that efficiency.
I hear many people say: “I make too much money to contribute to a Roth.” Or they worry about the contribution limits: “I can only contribute $6,000 to a Roth.” And that’s all true. But here is what you don’t know.
There are no income qualifications or limits on the amount you can convert.
To contribute to a Roth IRA in 2021, single tax filers must have a modified adjusted gross income (MAGI) of $140,000 or less. If married and filing jointly, your joint MAGI must be under $208,000 in 2021.
Roth Conversion Q&A
How does it work? In practice, your or your advisor fill out a form with the custodian or bank where your IRA is located. The form will ask which assets you would like to convert and if you would like to have taxes taken out of your conversion.
How do I pay the taxes? You have two options for paying the taxes: 1) You can pay the taxes with the money from the IRA itself. This is the least effective method for most people. Or, 2) You can use funds from outside the IRA to pay the taxes owed. To gain the most benefit, most people find that option two makes the most mathematical sense.
How much do I convert? This is where a competent financial planner will help you convert an amount that provides the most benefit to your exact tax situation as part of a full financial plan. Depending on your tax rate you could convert the entire traditional IRA balance at once. This would be an extreme example, and I don’t advocate for it often. Most likely the best strategy is to convert a portion of the money each year while keeping below certain tax thresholds so you can pay the lowest rates possible.
What else do I need to know?
Current Tax Bracket: Will you stay within your existing tax bracket or move up into a higher bracket? Converting too much may reduce some of the benefits if you move into a significantly higher tax bracket.
Medicare Premiums: The amount of your Medicare premium is dependent on certain income thresholds, so if you’re over age 65, you want to be aware of them. It can still make sense to do a conversion, but for best results, work with an advisor who will alert you to potential cost increases to your Medicare premium if you convert too much.
5-year Rule: You cannot use the converted funds for five years.
Deadline: Conversions must be completed by Dec 31st in the year you will be filing taxes. There is no April deadline.
What are the benefits of converting?
Legacy: The money goes to your heirs tax-free.
No Social Security Tax: Roth distributions do not count as income, so they do not increase the amount of tax you pay on your Social Security income. Many people find they can even reduce or eliminate their Social Security taxation via a conversion.
RMDs: Required minimum distributions (RMDs) are not required from a Roth IRA like they are from a traditional IRA. RMDs start low, less than 4% per year of the IRA’s balance, but that percentage increases every year. At age 85, that percentage is over 6.7%. At age 93, it's over 10%.
How do I maximize my conversion?
Pay the taxes owed from money outside of your IRA, such as from a savings account.
Convert the most aggressive assets in your IRA first to turbo-charge your tax-free returns.
If there is a dip in the market, convert while stock prices are low and expected to go up.
Work with a qualified advisor who can guide you through the process so that you’ll pay the least amount of taxes possible.
[1] Chen, Anqi, and Munnell, Alicia H., How Much Taxes Will Retirees Owe on Their Retirement Income? Center for Retirement Research at Boston College, November 2020. https://crr.bc.edu/wp-content/uploads/2020/11/wp_2020-16..pdf. Accessed 7/08/2021. [2] Cook, Kristen A.; Meyer, William; Reichenstein, William. “Tax-Efficient Withdrawal Strategies, Financial Analysts Journal.” December 2018. https://www.tandfonline.com/doi/abs/10.2469/faj.v71.n2.2. Accessed 6/4/2021.
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