It’s One of the Smartest Tax Moves You Can Make.
The Roth IRA may be the best retirement savings vehicle available to the American investor today. Whether you are young or old, a white-collar worker or a business owner, this type of account is a fantastic investment choice. Special features like tax-free withdrawals and the lack of compulsory distributions mean the Roth IRA has a huge leg up on traditional IRAs and other types of retirement savings accounts.
Now, let’s walk through the details and explain when a Roth may be in your best interests. We will cover:
- How the different types of IRAs work
- Contribution limits and their impact on high income earners
- How to tell what type of IRA can save you the most on taxes
- The estate benefits of a Roth IRA
- What to know before you convert
IRA Basics
There are two main types of IRAs: Traditional and Roth. They each have the same annual contribution limits (for tax year 2021, the combined limit is $6,000; $7,000 for those over 50). Both traditional and Roth IRAs assess a 10% penalty when you make withdrawals before age 59½.
While these similarities are helpful to know, it’s their differences that are significant for investors.
Income Threshold Limitations
Traditional IRAs are less tax-friendly to investors over certain income thresholds when they (or their spouse) are covered by an employer-sponsored retirement plan. For instance, in tax-year 2021, if you contribute to a 401(k) plan and make $66,000 or more as a single tax filer (or $105,000 or more combined for married couples filing jointly) your tax deduction for contributions to an IRA begins to be limited—if you make $76,000 or more ($125,000 or more for married couples), your contribution becomes nondeductible. (Note that all income thresholds quoted are based on the IRS’ “adjusted gross income” or AGI, which includes adjustments for education expenses, retirement contributions and alimony payments, among others.)
That doesn’t mean you can’t contribute to a traditional IRA. In fact, many people still do. You just can’t deduct your contributions when you make them.
The Roth IRA is a different animal. All regular contributions are made after-tax, and those contributions can be withdrawn tax-free at any point. If you add $3,000 to a Roth IRA in one year and find you need to spend that $3,000 the next year, you can withdraw it without taxes or penalties.
The rub, however, has always been the Roth’s income limits. Investors who make $125,000 or more a year as a single tax filer ($198,000 or more for married couples filing jointly) are limited in how much they can contribute to a Roth IRA. If you make $140,000 or more a year as a single tax filer ($208,000 or more for married couples filing jointly), you can’t contribute to a Roth IRA at all. (These income limits are for tax year 2021 and increase from year to year, based on inflation.)
Diversification comes in different flavors. You can diversify the types of assets you hold—stocks, bonds, cash, real estate, commodities, alternatives, etc. You can also diversify by owning multiple stocks. And in this report, we are talking about diversifying by investing in stocks of companies based in multiple countries.
Required Minimum Distributions
One catch with a traditional IRA is required minimum distributions (RMDs). Once you hit age 72, you are obligated to withdraw a certain amount of your IRA’s assets each year or face penalties. RMDs are mandated by the IRS, which provides several tables—the most common being the “Uniform Lifetime Table”—to help taxpayers calculate what they need to withdraw each tax year. For tax year 2021, for example, an 80-year-old retiree with a $100,000 IRA balance as of December 31 of the previous year would have a “distribution period” of 18.7 years to fully draw down her IRA. To calculate her distribution, she would divide her account by 18.7 to come up with her RMD of $5,348.
There are no RMDs for Roth IRAs; you can continue to grow your account for as long as you want. For this reason, Roth IRAs are a good way to save money tax-free to leave to your heirs. But, like a traditional IRA, you are subject to that 10% penalty on withdrawals of any gains or income before age 59½ and on withdrawals of earnings made within the first five years (known as the five-year seasoning rule). After that, all distributions are tax-free.
Rollovers and conversions can be withdrawn tax- and penalty-free after the five-year period regardless of your age, and there are a number of special circumstances (such as severe disability, high medical expenses or a first-time home purchase) in which distributions can be taken penalty-free.
Traditional IRA vs. Roth IRA: Pros and Cons
The basic advantages and disadvantages of these two types of investments are pretty clear-cut:
Traditional IRAs
- Give you an immediate tax deferral when you contribute
- Allow tax-free compounding—until it’s time to begin taking withdrawals
- Require you to pay income tax when you make withdrawals
- Penalize you for any withdrawals made before age 59½
- Eventually require you to begin taking money out through RMDs, whether you want to or not
Roth IRAs
- Offer no initial tax benefit because contributions are made after-tax
- Allow you to withdraw funds tax-free (as long as you don’t violate the five-year seasoning rule)
- Don’t require you to take withdrawals unless you want to
- Provide penalty-free access to your savings
All together, these factors make Roth IRAs a particularly potent way to save money for retirement—often far superior to a traditional IRA for many investors.
Now, let’s look at a tax comparison example.
Traders have typically been willing to pay higher prices for U.S. stocks because the economy was likely to grow at a faster clip than foreign economies. But today, the gap in valuations between U.S. and developed and emerging markets stocks has widened even as economic growth outside of the U.S. has picked up. This means that foreign stocks appear to be selling at enough of a discount to be highly attractive.
IRA Earnings and Taxes
The table below shows the results of taking the same $5,000 per year and investing it in the S&P 500 index for a 30-year period, from 1991 through 2020 via both types of IRAs. We’ve calculated the taxes an investor would pay in the 24% bracket (the highest bracket still eligible to invest in a Roth IRA) using the effective tax rate of 19.3% that a single taxpayer making $125,000 a year would be subject to.
Since contributions to a Roth IRA are made after-tax, you would have to earn $6,193 pretax to get that $5,000 after-tax investment. Thus, you would pay $1,193 in taxes. Over 30 years, that adds up to a total of $35,790 in taxes paid on contributions.* In contrast, a traditional IRA investor would have saved $28,895 in taxes on their pretax contributions to their account (a little over $963 a year).
When it comes time to withdraw, however, the traditional IRA investor owes over $172,000 in taxes. Even including the entire $28,895 saved on taxes when contributing, that would leave the traditional IRA investor $752,921 to spend in retirement. The Roth investor would get the entire $896,777 tax-free, and would have paid about $108,000 less in taxes while saving it.
Note: Table assumes $5,000 a year investment using total returns of the S&P 500 index from 1991 through 2020, taxed in the 24% bracket (effective rate of 19.3%) and no penalties on withdrawals. *Some amounts are rounded.
As long as you are making steady contributions and will be in the same or a higher tax bracket in retirement, a Roth IRA will net you more savings and fewer tax headaches than a traditional IRA.
The Tax Impact of Roth Conversions
When converting from a traditional IRA to a Roth IRA, the first thing you need to think about is taxes.
With traditional IRAs, taxes are generally paid when money comes out. With Roth IRAs, taxes are paid before money goes in. Conversion, in effect, takes all the money out of the traditional IRA and puts it into a Roth—resulting in a hefty tax bill in many cases.
As with most tax issues, however, it’s not quite that simple. For many investors, their annual salary and participation in an employer-sponsored retirement plan disqualifies them from deducting some or all of their traditional IRA contribution. For example:
- If your traditional IRA contributions are nondeductible, you will only have to pay taxes on any gains earned over and above your after-tax contributions.
- If your traditional IRA contributions are tax-deductible, then you must pay the taxes due on the full sum of those contributions in the year when you convert—plus the taxes on any gains you make while the funds are invested.
- If you have a traditional IRA to which you make both deductible and nondeductible contributions, you’ll be taxed on any gains plus the deductible contributions.
If you have more than one traditional IRA account to convert, calculations become more complex. (For example, if you established different IRA accounts while working for different employers.)
If you’re converting all your IRA accounts at once, each is taxed based on its own liability. But if you’re wincing at the thought of paying such a hefty fee to Uncle Sam in a single year, you can choose to convert only some of your accounts from traditional to Roth. In that case, however, the amount of tax you’ll owe is based on the percentage of all of the taxable funds in all of your IRA accounts that you will be converting. We recommend consulting with a tax professional if you are in this position—call us and we’ll be happy to help.
When Should I Convert My IRA to a Roth IRA?
The decision to convert traditional IRAs into Roth IRAs must be made on a case-by-case basis. Consult a tax professional or call your portfolio team—we’ll be happy to help point you in the right direction. But in general, if you’ll be in the same or a higher tax bracket when you anticipate taking withdrawals, it might be better to pay taxes on your IRA assets in the conversion process and then not have to worry about any future taxes. It could also be a wise move if you have a traditional IRA that you don’t expect to ever tap into. Converting would mean you don’t have to deal with RMDs; instead, you could allow your account to grow tax-free indefinitely and perhaps leave it to your heirs.
If you think you’ll be in a lower tax bracket when it’s time to take withdrawals, or if you’ll need to take distributions within five years of making the conversion, then it may not make sense to convert. You should speak to a tax or retirement planning professional and carefully consider the tax implications before making your decision.
This material is distributed for informational purposes only and is not financial or investment advice. Speak to your financial adviser before taking specific action. The investment ideas and opinions contained herein should not be viewed as recommendations or personal investment advice or considered an offer to buy or sell specific securities. Data and statistics contained in this report are obtained from what we believe to be reliable sources; however, their accuracy, completeness or reliability cannot be guaranteed
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