To Roth or Not to Roth?

Many earners are in the smart retirement savings habit of making pre-tax contributions to company or individual retirement plans, such as a 401(k), 403(b) or SEP IRA.  Strong incentives include a tax deduction for the contribution and often some form of employer match or contribution.   Accumulated contributions are then invested, usually in stocks and bonds, and grow tax “deferred” until money is distributed for income needs in retirement.  Distributions taken after age 59.5 are taxed as ordinary income.  (Although there are some exceptions to the rule, distributions prior to age 59.5 years are also penalized 10%).   However, a less common, and often equally powerful retirement savings vehicle to consider is the Roth account.

Company sponsored retirement plans often allow participants to make Roth contributions in addition to, or in lieu of, pre-tax contributions.  Unlike tax-deductible contributions, an earner receives no tax deduction for the Roth contribution.  However, the Roth IRA account grows “tax free” while contributions remain inside the account.  Also, there is no requirement to start distributing the account at 70.5 years old as is required with a pre-tax deferral account.

So, which is better, a tax-deductible IRA or Roth IRA contribution?  Well, it depends. The simple math suggests you should make a pre-tax contribution if the marginal tax savings on the contribution is greater than the marginal tax cost on the distribution in retirement.   Conventional wisdom suggests individuals are taxed at higher rates while working compared to in retirement where income is typically lower.   In reality, the analysis can be much more complex as future tax rates, income streams, and tax legislation are unknown.

Should you do both?  If you can afford it, the short answer is “yes”.  The contribution limit for a 401(k) or 403(b) company retirement plan for 2018 is $18,500, plus an additional $6,000 if you are age 50 or over.  Plus, you may be eligible to make an additional $5,500 Roth IRA contribution, plus an additional $1,000 if you are age 50 or over.   Here’s the catch: contributions to a Roth IRA are subject to income limits based on modified adjusted gross income (MAGI):  If MAGI is over $135,000 for single filers, or $199,000 for married filers, then Roth contributions are not allowed. However, there might be another way.

Once considered a gray area, the practice of completing a “backdoor” Roth contribution is now permitted by the IRS.  Here’s a how a “backdoor” Roth contribution works:

  1. Make an after-tax contribution (up to $5,500, plus an additional $1,000 for over 50 years old) to a Traditional IRA. This contribution is not subject to any MAGI limitations.
  2. Once the contribution is complete, the Traditional IRA owner is permitted to complete a taxable conversion to a Roth IRA account. However, this is not a taxable event because no deduction was claimed on the original contribution.  (Warning: If you have another pre-tax IRA account, this conversion could trigger a taxable event and adverse consequences.)
  3. Be sure to Fill out Form 8606 in your 1040 (Non-deductible IRA Contribution) for tax filing.

 

Once the process is complete, you have effectively contributed to a Roth IRA account and now have the benefits of compounding, tax-free growth.   As with any planning strategy, there is the potential for unintended consequences.  It is recommended that you work closely with your financial professional to help navigate the opportunities and potential pitfalls of your retirement savings strategy.