The Roth IRA - A Tax Nerd's Dream

The Roth IRA has been around for about two decades now and if you are closing in on your retirement date then it may be time to rediscover its benefits.  I shared some thoughts on Roth IRA planning with reporter Rebecca Lake for an article in US News & World Report.  You can read the entire piece by clicking here.

One of the most amazing things I’m discovering about my clients is that retirement brings out their inner tax nerd.  What’s that all about?  Perhaps folks have more time on their hands.  Perhaps folks are watching every dollar they spend.  I can’t explain it but I will say this much – if you are nearing or in retirement and haven’t had the “Roth conversation” with your advisor, book an appointment now.

We are big fans of the Roth IRA because it offers tax diversification, which is a buffet for tax nerds.  Let’s recap some of the tax basics to illustrate.  Savings in taxable accounts, when sold, generate capital gains, which are taxed at capital gains rates.  Withdrawals from traditional IRAs and 401(k) plans are taxed at ordinary income tax rates.  Qualified withdrawals from Roth IRAs, however, can be made with no income tax consequences.  Having different pools of resources, each with different tax consequences, offers flexibility for tax planning.  A retiree might draw from tax-qualified accounts and taxable savings accounts, for example, up to a level which keeps the income below a certain threshold.  Then, to avoid further taxation at a higher marginal rate, the retiree might tap Roth IRA accounts for qualified withdrawals to stay within that same, lower tax bracket.

There are other advantages of the Roth IRA, too. First, withdrawals of the amounts you contributed to the Roth IRA can be taken without incurring taxes.  Second, if you are under 59 ½ and make qualified distributions from the Roth IRA to pay for unreimbursed medical expenses, you can avoid the 10% penalty on distributions which might otherwise have applied.

Converting a traditional IRA to a Roth IRA is another planning opportunity for retirees to consider, but beware it could be like buying a used Ferrari:  intriguing and seductive, but potentially very expensive.  The funds you convert are treated as ordinary income, thus, you will pay taxes on the converted amount.  If you do not have liquid funds with which to pay incremental taxes stemming from the conversion and instead are forced to sell taxable investments to raise the funds, then the Roth conversion becomes expensive.  You may incur capital gains taxes on top of the ordinary income taxes, a situation you will want to avoid.  Before you undertake a Roth IRA conversion, plan ahead and make sure you have ample resources available to cover any incremental taxes that result from the transaction.

Another danger is that the Roth IRA conversion amount may push you into a higher income tax bracket, thus subjecting the converted funds to a higher tax burden.  If you do not have additional deductions or offsets to lower your taxable income the Roth IRA conversion loses some of its luster.  Like I said, it could be like owning a used Ferrari.

While you are rediscovering the benefits of the Roth IRA (and getting in touch with your inner tax nerd) take a moment and consult with your advisor, CPA or tax preparer to make sure you haven’t overlooked anything.  Chances are you will find a way to use a Roth IRA to optimize your taxes and keep yourself on track for long-term financial security.

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