In an earlier post I described the basics of a Roth IRA and one of the main loopholes in retirement savings – that you can make non-deductible contributions to an IRA account and convert to a Roth IRA. However, there are some times in life that may make more sense to save and to convert. In the financial planning process, Independent Financial Planning seeks creative ways to save the best way to achieve each investor’s unique goals. You may want to consider one or more of these for you.
When You Are Young
The classic example of saving in a Roth IRA is when an investor is in a low tax bracket. If you make such an amount that your taxes are lower than what you expect it to be in retirement, i.e. 15% bracket now, likely 28% in retirement; then it makes sense to pay the tax bill when it’s lower. Therefore any investor who thinks that he or she will be earning more and saving later in their working lives may want to save in the Roth. At Independent Financial Planning, however, an investor can expect to second-level thinking. For example, if a late twenty-something wants to save and knows that he would like to buy a home in the next few years, Roth IRAs are especially helpful. Not only can you take out Roth IRA contributions at any point without penalty or tax, you can take out the gains as well without penalty (you will have to pay tax on the gains) so long as you are a first-time home buyer. The flexibility in regard to the contributions makes the Roth IRA especially helpful if and when an investor does not have much non-retirement savings.
Assumptions: 25% tax bracket, contribute $5k per year Jan 1 starting at 25 for 30 years. Compounded growth at 7% for tax-advantaged accounts and 15% less at 5.95% for taxable accounts. Tax savings from traditional is invested and earns a 5.95% return. Percentage calculated is net of taxes paid on the deferred investment.
When You Are On Sabbatical or Between Jobs
Another example of second-level thinking is considering conversions in years that your tax bracket will be lower. I’ll give the example of a government employee that took a one-year sabbatical. After working for 20 years and saving $150,000 in deductible IRA savings an investor decided to go on Sabbatical and live on savings for a year to spend with his family. The sabbatical started in June so the investor had income for the first half of the first year and resumed work half way through the second year. The income earned each year would have put the investor in the 15% tax bracket both years rather than the 28% tax bracket he had been in previously. He took this opportunity to convert $100,000 of the $150,000 IRA, thereby boosting his adjusted income by $50,000 both years. This effectively had him paying 15% and 25% (once the converted amount exceeded the 15% bracket) rather than the 28% he would have paid if he converted in other years. Now headed into retirement he has $100,000 that will be able to grow tax-free for ten years or more until he retires. That will substantially help him in his retirement, mostly by keeping the taxes down and increasing the amount he can spend without realizing a tax burden.
A similar situation exists for investors who are recently retired. It is possible that an investor who has saved well will have a significant amount in retirement accounts and relatively little outside of retirement accounts. Instead of waiting until 70 and a half for required minimum distributions (which are not required in a Roth IRA!) it may make sense to start converting small amounts of an IRA account each year, realizing the taxes slowly, especially if the bracket it low, and building up a savings source that will not cause a large tax impact upon a large distribution.
When You Want to Leave Money to Others
Roth IRAs are also effective in estate planning. Should an investor want to leave assets on to children or grandchildren, the Roth IRA is a tax-free gift, which the beneficiary can stretch out over his or her lifetime and have a lifetime of tax-free income. When you take into account the effect of compounding and the long lifespan a grandchild may have the results are quite substantial.
In sum, there are many good opportunities to save or convert into a Roth IRA. According to my research, it is almost always beneficial to save in a Roth IRA rather than a traditional IRA. I would strongly encourage any investor to take advantage of this investment vehicle while it lasts. Contact Independent Financial Planning for more information.
