Pay tax now, or, defer and potentially pay more later? That is the main consideration that taxpayers grapple with when considering whether to make a traditional IRA or a Roth IRA retirement contribution. With the Tax Cuts and Jobs Act (TCJA) lowering federal income tax rates through 2025 (when a sunset provision will revert rates back to 2017 levels) the relative appeal of a Roth over a traditional IRA has gone up for many households. Given this as well as other benefits, more retirement savers should consider utilizing a Roth as part of a balanced approach to retirement planning.
Why Consider a Roth?
As opposed to traditional IRAs and 401ks where pre-tax contributions grow tax deferred, Roth contributions are made with post-tax dollars and future earnings are tax-free. Despite the allure of tax-free growth, many taxpayers still prefer to defer taxes as long as possible and opt for the traditional pre-tax option. However, a Roth does offer a few key benefits over pre-tax retirement accounts that make it a compelling retirement savings vehicle, particularly with the new lower income tax regime.
- Hedge Against Higher Future Tax Rates – If you knew with certainty that your tax rate in retirement was going to be materially lower than it is now, then funding a pre-tax IRA is a slam dunk. You would get tax-deferred growth, and ultimately pay tax at a lower rate than you would today. However, tax rates, especially those far off in the future, represent a significant uncertainly. We do know, however, that current rates are relatively low by historical standards as illustrated by the chart below.
In addition, ballooning federal budget deficits will likely lead to a renewed era of higher taxes rates somewhere down the road.
In the meantime, the new, lower tax brackets (ranging from a high of 37% down to 10%) will make Roth contributions a more attractive option for a broader set of households.
- Not Subject to RMD – Unlike pre-tax IRAs that are subject to Required Minimum Distributions (RMDs) at age 70 ½, there are no mandatory withdrawals for Roth IRAs. So, funds can grow tax free until withdrawn. In addition, IRA RMDs count as ordinary income in the year in which they are taken and can, in effect, drive up a taxpayer’s tax bracket depending on how significant the distribution.
- Flexibility and Optionality – Having a Roth in addition to a traditional IRA and after-tax accounts will give you more flexibility in retirement to manage your taxable income; thereby potentially lowering your tax bill over time. If all your funds are in pre-tax IRA accounts, there is no other option but to draw from one source at that time. If prevailing tax rates are low, that’s not a problem. However, if they are high it could be financially damaging to a retirement plan.
Contributions and Phaseouts
Most companies now offer a Roth 401k option in addition to their regular 401k. Contribution limits in 2018 are $18,500 (or $24,500 if over 50). Furthermore, contributions are not all or nothing. For example, an employee could contribute half of their 401k with pre-tax dollars and the other half with Roth post-tax dollars.
If you are not offered a Roth option through your employer’s 401k plan, you can still make a $5,500 Roth contribution ($6,500 if over 50), subject to total phase-outs at $135,000 for single filers and $199,000 if married filing jointly.
Conversion and Recharacterizations
In addition, lower tax rates may make the prospect of fully or partially converting traditional IRA funds to a Roth even more appealing, especially for those households whose income has been temporarily lowered, and subject to much lower tax rates. There is one new catch associated with doing a conversion. Prior to the passage of the new tax law, those making a Roth conversion had an opportunity to do a so-called re-characterization of their Roth as long as it was done by October 15th of the following year. Essentially, a re-characterization allows the taxpayer to undo the Roth contribution. A taxpayer might do this if they had to recognize too much income or if their Roth investments lost a lot in the market. While the TCJA of 2017 eliminates Roth characterizations going forward, it does allow those that made a Roth conversion in 2017, one last chance to change their mind until October 15, 2018
As a result, in the future those converting their IRAs will want to be highly confident of the amount. Given this change, it would be more prudent to wait until later in the year when you have a clearer view of your income before deciding to convert to a Roth.
SMS can not only help you evaluate the impact of the new tax rates on your household income, but also identify and evaluate various retirement income strategies.