A widely held financial principle is that the longer an investor can defer paying taxes, the better. Choosing to utilize a Roth IRA to accumulate retirement savings seems to defy this theory because it purposely accelerates the payment of taxes.
The tax issues surrounding traditional tax-deferred accounts vs. Roth accounts and the impact on an individual’s ability to build wealth is one of the most debated areas of retirement planning. Countless articles have addressed the advantages and disadvantages of contributing to Roth vs. traditional IRAs and of converting from a traditional to a Roth account. This topic has attracted even greater attention over the last few years since Congress lifted the income restrictions on Roth IRA conversions, allowing anyone with a traditional IRA to convert to a Roth regardless of their level of income or wealth.
There’s no question that the decision regarding which type of IRA to contribute to or whether to convert an existing IRA to a Roth is an important one that will have long-term financial implications. It is also a particularly difficult one because it is highly dependent upon an investor’s individual circumstances and assumptions about the future, including tax-brackets and accumulated wealth, that simply cannot be known in advance. Taxpayers have no guarantee that the choice they make today will be the right one. But those who take the time to understand the tradeoffs between traditional and Roth accounts and the implications for their finances can improve the odds dramatically. It’s important to first understand the main features of these IRAs.
Both traditional and Roth IRAs receive favorable tax treatment, making them powerful wealth-building tools. Those who are eligible (based upon income limitations) to contribute should do so. It is important though to understand their differences so you can select the type that’s best for you. Traditional and Roth IRAs have the same annual contribution limits, provide tax-advantaged growth and allow the individual to begin withdrawals at age 59 ½ without penalty.
On the other hand, there are some big differences. Subject to income limitations, traditional IRA contributions are tax-deductible and all earnings on those contributions are “tax-deferred.” This means that taxes are delayed until distributions from these accounts are taken (presumably in retirement), at which time they are taxed at ordinary income. Because the IRS eventually wants to collect its share of taxes, traditional IRA rules mandate that people stop making deposits and begin taking distributions at age 70 ½.
In contrast, with a Roth IRA, the account owner makes contributions (again subject to income limitations) with after-tax money. In other words, taxes must be paid on contributions before they are made. The good news is that as long as certain basic requirements are met, the account growth and all distributions from the account are tax-free. The other key differences worth noting are that there is no requirement to take distributions from a Roth account, and as long as the individual remains in the workforce, they can continue contributing to a Roth. This enables a retiree to allow the account to grow tax-free for as long as they want and, if they wish, pass on the balance to their heirs in a highly tax-efficient manner.
In coming weeks we will identify the key criteria investors can use to determine if a Roth is right for them.
John Spoto is the founder of Sentry Financial Planning, LLC in Andover and Danvers. For more information, call 978-475-2533 or visit www.sentryfinancialplanning.com.
This article is for general information purposes only and is not intended to provide specific advice on individual financial, tax, or legal matters. Please consult the appropriate professional concerning your specific situation before making any decisions.