A Good Game Plan on Roth IRAs Can Take the Bite Out of Tax Day
Tax considerations for Roth IRAs vs. traditional IRAs: Here’s what investors need to know.
With apologies to Shakespeare, to change a line from one of his greatest plays, “to Roth or not to Roth, that is the question/Whether ’tis better to suffer the tax now, and reduce my fortune, or hold it tight…”
More than a few of us feel like Hamlet come tax time when we struggle with this question and think long and hard on it. As we get ready for Tax Day in April, it’s good to review some of the advantages of suffering “the slings and arrows” of paying taxes now in order to secure future benefits.
First, there’s that tax bite. Ouch. It’s hard to let go of those funds when you could simply enter a traditional IRA contribution on Line 32 on the front of your 1040 for an immediate reward of less taxes. But you need to look ahead before doing that. You need to ask yourself when you have retired, do you expect your taxable income to be higher or lower than it is today?
As you are doing your taxes and comparing this year’s tax bill and income to last year’s, where do you stand? The goal is to pay the tax on the Roth contribution when you expect your tax bracket to be the lowest. If you are having a higher-income year, it may not be the best time to make a Roth contribution. If your bracket is lower in retirement, you may want to wait and work on a Roth conversion strategy at that stage of life. If this is the year your income is lower than you expect it will be in retirement, then by all means contribute to the Roth.
On the other hand, if your current tax bracket will be the same in retirement, it’s a wash and the old adage of putting off paying taxes as long as possible could be the right way to go. Looking ahead here could lead to another wrinkle. If you are married, the day will eventually come when one of you will pass on, leaving a single spouse. Tax brackets change dramatically when your status changes from married filing jointly to filing as a single taxpayer. You may slip into the next higher bracket even if you have lost some Social Security income due to your spouse’s passing.
The next question then becomes: Is it appropriate to convert some of the IRA funds into a Roth while you are in the lower married tax bracket, thus reducing taxable RMD income, in order to potentially reduce the impact of the higher tax bracket when the time comes that the survivor will file without the married benefit?
Also keep timing in mind. There is a five-year rule in play. While you can withdraw your contributions to a Roth without penalty or taxes at any time, the same is not true of the earnings. Think of it like a clock that says that you must have owned the Roth for five years and be older than 59 1/2 before the earnings may be withdrawn tax-free (there are some special exceptions that apply).
The actual wording of the rule states five “tax years,” which start Jan. 1 of the year for which you open and contribute to the Roth. If you open and contribute to the Roth by April 15, 2017, you can claim the contribution for 2016, causing your five years to start on Jan. 1, 2016. You have 16 months of actual time from the five-year wait. Subsequent new contributions and other Roths do not have their own five years (this is not addressing Roth conversions, which have a second five-year rule). It all starts when you open and fund that first Roth account.
Simply put, you could meet the five-year rule in as little as three years and eight months. Once you have opened and funded a Roth and met the time requirement, you have met it forever. Keep in mind this is a hard-and-fast rule. Should you pass away, the account still must meet the five -year rule before earnings, not principal, can be withdrawn tax-free for your beneficiaries.
Remember, due to your growth being tax-free, you should try to put your highest-earning and least tax-efficient investments in this account. Even with Tax Day looming, you might as well give yourself the most Roth reward possible. No point in playing Hamlet on this one.
Nancy Fleming, CFP®, is the president of Fleming Financial Services, based in Gilbert, Arizona. She is an Investment Adviser Representative and licensed insurance professional.
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