In these uncertain times, itâ€™s reassuring to know that strategies are available to help shelter your savings from taxes. Moreover, these savings will continue to grow, as well as allow you to make tax-free withdrawals during retirement.
Tax Rates are Low
The 2017 Tax Cuts and Jobs Act (TCJA) lowered marginal tax rates and broadened the income tax brackets. With the lower rates, this new tax environment makes Roth-type accounts especially attractive since they receive after-tax contributions. By paying the taxes now, when tax rates are lower, you are protecting yourself from potential increases in tax rates after retirement.
No Required Minimum Distributions (RMDs)
In addition, since Roth IRAs donâ€™t have required minimum distributions (RMDs) every year, your money can remain in the account and keep growing tax-free. And if you choose to leave a tax-free inheritance to your heirs, the people who receive it will have to take RMDs, but they wonâ€™t have to pay any federal income tax on their withdrawals as long as the account has been open for at least five years.
Higher Contribution Savings Rate
More employers are offering employees a Roth 401(k) option, but Roth-type accounts are not as popular as they could be â€“ especially among high-income earners. Since traditional 401(k)s have the same contribution limits as Roth 401(k)s, a taxpayer can achieve a higher effective savings rate. Thereâ€™s no â€œtax dragâ€ â€“ the reduction of potential income due to taxes that eventually must be paid.
In 2020, you can deposit up to $6,000 in earned income into a Roth IRA, assuming your Modified Adjust Gross Income is below $196,000 for married couples. If you are age 50 or more, the maximum increases to $7,000. The limits apply to all traditional and Roth IRAs combined.
Partial Roth Conversions
Higher-income individuals have another incentive when considering the Roth option. Since 2010, when the income limits were removed, taxpayers with a pre-tax retirement account â€“ IRA, 401(k) or any other employer retirement plan â€“ have been permitted to convert to a Roth IRA. The taxpayer decides how much to convert, and whatever dollar amounts are distributed to a pre-tax IRA and rolled into a Roth will be treated as taxable. Partial Roth conversions secure lower tax rates on some pretax retirement savings.
Partial Roth conversions are especially attractive while weâ€™re in the TCJA tax brackets as they are set to return the previous tax brackets in 7 years. It can also be argued that with all the new government debt created in the COVID-19 pandemic, there will be higher tax rates going forward. So, by doing partial Roth conversions over the next few years, you can take advantage of the lower TCJA tax brackets and spread your tax liability over those years.
That said, itâ€™s possible to safely do an indirect, â€œbackdoorâ€ Roth contribution by simply contributing to a non-deductible IRA â€“ allowed even at high income levels â€“ and converting it to a Roth. However, this strategy may be affected by the so-called â€œIRA aggregation ruleâ€: when a person has multiple IRAs, they all are treated as one account when determining the tax consequences of any distributions â€“ including when planning a distribution for a Roth conversion.
How REDW Wealth Can Help
The right retirement planning can help you to maximize income and reduce taxes. REDW Wealth financial planning advisors are experienced at helping our clients achieve these goals. Please contact Paul Madrid, Principal and REDW Wealth Practice Leader.