Until 2010, folks with high income were stuck admiring Roth Individual Retirement Accounts (IRAs) from a distance. Not only was there an income cut-off for being able to contribute to a Roth, but even more frustrating was the requirement that you could only convert any existing retirement accounts—401(k) rollovers, traditional IRAs–if your modified adjusted gross income was below $100,000. That $100,000 applied to individuals as well as married couples filing a joint tax return.
Now that’s all changed. Ever since 2010 anyone, regardless of income, can convert existing retirement assets into a Roth IRA. That’s an alluring option because money in a Roth account that you withdraw in retirement will be 100 percent tax-free. Not tax-deferred, but 100 percent tax free.
Roths: An Heir’s Best Friend
Rather than view this as some sort of either/or challenge, consider the advantages of maybe incorporating both Traditional and Roth retirement vehicles into your long-term planning.
The IRS is happy to ignore your Roth account. That is, there is no IRS-imposed requirement that you must make withdrawals from a Roth when you hit retirement. So if you don’t need to tap into your Roth to cover your living expenses in retirement, you are free to just let it grow until you pass it along to your heirs. That’s quite different from money you have invested in a Traditional IRA, or 401(k): the IRS insists that in the year after you turn 70 ½ you start pulling out some of the money in those accounts. And all withdrawals from non-Roth retirement accounts are reported as taxable income (you don’t even get the preferential long-term capital gains treatment.) That’s important tax revenue for the feds.
To Roth or Not? … Is the Wrong Question
When Roths were opened up to all comers in 2010 there was plenty of chatter that high income folks should be eager to make the switch into Roth IRAs. After all, the prospect for tax-free income is too good to pass up. But it turns out it isn’t exactly an easy slam-dunk. There are upfront costs to making the conversion; you get a tax bill in the year you convert in exchange for the IRS promising you no tax bill when you withdraw your converted Roth assets in retirement. And the money you convert in any year counts as taxable income, so it could be enough to push you into a higher tax bracket today.
Those tradeoffs make it vexingly hard to figure whether you should stick with Traditional IRAs and 401(k)s or bite the bullet and make the switch to Roths. A potential solution: own both.
Rather than view this as some sort of either/or challenge, consider the advantages of maybe incorporating both Traditional and Roth retirement vehicles into your long-term planning. In financial advisor circles this is another form of diversification. Just as diversifying your investments is a smart way to wrestle with the risk/reward challenge, diversifying the type of investment accounts you have, is a way to manage your tax risk.
Risk management is simply acknowledging that some stuff is unknowable. We hedge our bets so we don’t get caught going all-in on a bet that is wrong. With tax diversification you’re acknowledging it’s hard to predict with absolute certainty what your income (and tax rates) may be in retirement. If you are in fact in a high tax bracket in retirement, having tax free income (the Roth option) is going to be a godsend. But if you shift into Roths and it ends up that you’re not in a top tax bracket, perhaps you would have been better off leaving the money in a Traditional account, and paying the lower tax on withdrawals in retirement.
The other tax risk is the Washington wildcard. Tax policy is front and center in the debate about how to address the groaning federal deficit. No one can say with any certainty how things will pan out. We may indeed get tax reform that could change the math of how best to tuck away money for retirement. And let’s face it, for anyone in their 40s or 50s, it wouldn’t be out of the question to see another round of tax changes sometime before retirement. The reality is, tax law changes.
The potential big win from the 2010 law that allows high income earners to convert money into Roths is that you—at least for now-have the ability to diversify your money in terms of its future tax treatment.