“Today’s federal income tax rates might be the lowest you’ll see for the rest of your life.”
Roth IRAs are still a wise retirement savings alternative for many people. MarketWatch explains in the recent article, “How the new tax law creates a ‘perfect storm’ for Roth IRA conversions,” that Roth IRAs have two big tax advantages: tax-free withdrawals and being exempt from required minimum distribution (RMD) rules.
Tax-Free Withdrawals. Unlike traditional IRA withdrawals, qualified Roth IRA withdrawals are federal-income-tax-free and most often state-income-tax-free. A qualified withdrawal is one taken after you, as the Roth account owner, have met both of the following requirements: (i) you’ve had at least one Roth IRA open for more than five years; and (ii) you’ve reached age 59½ or become disabled or dead. To satisfy the five-year requirement, the clock starts on the first day of the tax year for which you make your initial contribution to your first Roth account. That initial contribution can be a regular annual contribution or a conversion contribution.
RMD Exemption. Unlike a traditional IRA, you don’t have to start taking annual required minimum distributions (RMDs) from Roth accounts after reaching age 70½. Instead, you can leave your Roth account(s) untouched for as long as you live if you want. This makes your Roth IRA a great asset to leave to your family, if you don’t need the Roth money to help finance your retirement.
Annual Roth contributions make the most sense for those who think they’ll pay the same or higher tax rates during retirement. Higher future taxes can be avoided on Roth account earnings, because qualified Roth withdrawals are federal-income-tax-free (and typically not taxed at the state level). However, the downside is you don’t get a deduction for making Roth contributions.
Therefore, if you anticipate paying lower taxes in retirement, you might want to make deductible traditional IRA contributions (if your income allows). That’s because the current deductions may be worth more to you, than tax-free withdrawals down the road.
What is the other best-case scenario for annual Roth contributions? It is when you’ve maxed out on deductible retirement plan contributions. Annual contributions are limited, and earned income is required. The maximum you can contribute to a Roth for any tax year is the lesser of: (1) your earned income for the year; or (2) the annual contribution limit for the year. Earned income is wage and salary income (including bonuses), self-employment income, and alimony received that is included in your gross income (believe it or not). If you’re married, you can add your spouse’s earned income to the total. Remember, after reaching age 70½, you can still make annual Roth IRA contributions, provided there are no problems with the earned income limitation or the income-based phase-out rule. However, you can’t make any more contributions to traditional IRAs after you reach age 70½.
Roth conversions. The fastest way to get a significant sum into a Roth IRA is by converting a traditional IRA to a Roth. The conversion is treated as a taxable distribution from your traditional IRA, since you’re deemed to receive a payout from the traditional account. The money then is deposited into the new Roth. A conversion before year-end, will trigger a bigger income tax bill. However, today’s federal income tax rates might be the lowest you’ll ever see. Therefore, if you convert now, you’ll pay today’s low tax rates on the extra income from the conversion and avoid the potential for higher future rates on all the post-conversion income that’ll be earned in your Roth account. Roth withdrawals taken after age 59½ are federal income tax-free, provided you’ve had at least one Roth account open for over five years.
Reference: MarketWatch (March 27, 2018) “How the new tax law creates a ‘perfect storm’ for Roth IRA conversions”