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This is week five of our 7-week series. If you wish to read our previous articles, you can chose them from the list below:
When it comes to planning for retirement, choosing the right type of retirement account can have a significant impact on your financial future. Two of the most popular options are the traditional Individual Retirement Account (IRA) and the Roth IRA. Each has distinct advantages, particularly when it comes to how contributions are taxed—either pre-tax (traditional IRA) or post-tax (Roth IRA). Understanding these differences is crucial for optimizing your retirement savings strategy.
Traditional IRA: Pre-Tax Contributions
A traditional IRA allows you to contribute pre-tax dollars, meaning the money you put into the account is tax-deductible for the year you contribute. For example, if you earn $100,000 a year and contribute $6,000 to a traditional IRA, your taxable income for that year would be reduced to $94,000.
Key Features:
Tax-Deferred Growth: Investments within a traditional IRA grow tax-deferred, meaning you don’t pay taxes on the earnings until you withdraw the money in retirement.
Tax Deductibility: Contributions to a traditional IRA can reduce your taxable income in the year they are made, provided you meet certain income limits and other criteria.
Required Minimum Distributions (RMDs): Starting at age 73 (as of 2023), you must begin taking required minimum distributions, which are taxable, from your traditional IRA.
Who Benefits Most?
Individuals expecting to be in a lower tax bracket during retirement than they are currently.
Those seeking to reduce their current taxable income.
Roth IRA: Post-Tax Contributions
A Roth IRA, on the other hand, involves making contributions with post-tax dollars, meaning you contribute money that has already been taxed. While this doesn’t reduce your taxable income in the year of the contribution, the major benefit of a Roth IRA is that qualified withdrawals in retirement are tax-free.
Key Features:
Tax-Free Growth: Investments grow tax-free, and withdrawals during retirement are also tax-free.
No RMDs: Unlike traditional IRAs, Roth IRAs do not have required minimum distributions during the account holder’s lifetime, allowing your savings to grow tax-free for longer.
Income Limits: There are income limits for contributing to a Roth IRA. In 2024, for example, single filers with a modified adjusted gross income (MAGI) of $161,000 or more are ineligible to contribute (for married filing jointly, the MAGI limit begins at $228,000 and is completely phased out at $240,000).
Who Benefits Most?
Individuals expecting to be in a higher tax bracket in retirement.
Younger savers who anticipate decades of tax-free growth.
Conversions: Traditional IRA to Roth IRA
One strategy that many investors consider is converting a traditional IRA to a Roth IRA. This process, known as a Roth conversion, involves transferring assets from a traditional IRA to a Roth IRA and paying taxes on the converted amount at the time of conversion.
Why Consider a Conversion?
Future Tax-Free Income: If you expect to be in a higher tax bracket in the future, converting to a Roth IRA now could save you money in the long term, as future withdrawals will be tax-free.
No RMDs: By converting to a Roth IRA, you avoid RMDs, which allows your savings to continue growing tax-free.
Legacy Planning: Roth IRAs can be an attractive option for estate planning, as beneficiaries can inherit the account without immediate tax consequences.
When to Consider a Roth Conversion
There are a number of scenarios when Roth conversions can make sense:
If you are self-employed and your business has a bad year, the income drop may present a great opportunity to do a Roth conversion.
If you are a high wage earner, and you have a period of unemployment, the drop in income may present a good opportunity to do a Roth conversion.
If you are recently retired and not collecting Social Security, the drop in income may present a good opportunity to do a Roth conversion.
If you have a healthy pension income, and your retirement income is expected to be comparable to the income you earn while working, the Roth conversion may make sense before the Tax Cuts and Jobs Act tax rates expire in 2025, and we revert to the higher tax brackets.
If you have a substantial amount of income-producing assets, it may make sense to do a Roth conversion before the Tax Cuts and Jobs Act tax rates expire in 2025, and we revert to the higher tax brackets (for additional info check out: https://www.monotelo.com/tcja-retirement-planning).
Tax Implications:
When you convert, the amount transferred is added to your taxable income for that year. This could push you into a higher tax bracket, so timing and planning are essential.
Partial conversions can help manage tax liabilities by spreading out the tax impact over several years.
Choosing the Right Account
The decision between a traditional IRA and a Roth IRA—or whether to convert—depends on various factors, including your current and expected future tax rates, income level, and retirement goals. Here are some key considerations:
Current vs. Future Tax Bracket: If you believe you will be in a higher tax bracket in retirement, a Roth IRA may be more beneficial. Conversely, a traditional IRA might be better if you expect to be in a lower tax bracket.
Income Level: Higher earners who are ineligible for a Roth IRA can make a non-qualified contribution to a traditional IRA and “backdoor” that contribution through a Roth conversion.
Flexibility: Roth IRAs offer more flexibility with no RMDs, making them a good option for those who want to manage their taxable income in retirement.
Estate Planning: Roth IRAs can be advantageous for those who wish to leave a tax-free inheritance to their beneficiaries.
Both traditional and Roth IRAs offer valuable benefits for retirement savers. The choice between them, or the decision to convert from one to the other, hinges on your individual financial situation and retirement goals. By understanding the tax implications of each, you can make informed decisions that optimize your retirement savings and ensure a more secure financial future. For additional information on Tax-Efficient Retirement Planning, click here, or schedule a time to connect with one of our Tax-Efficient Retirement Planning Specialist below.
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