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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.

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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…‭”‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬

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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. ‬‬‬‬‬‬‬‬‬‬‬‬

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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?

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‭ ‬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.‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬

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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.‭ ‬

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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?‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬

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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)‬.‭ ‬

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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.‭ ‬

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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.‭

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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. ‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬‬

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‬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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