Have you noticed the increased attention to Roth IRAs and 401(k)s recently? It seems that, every day, I see a new article promoting the advantages of using a Roth for your retirement planning. Sure, a Roth is a great way to fill up the tax-free bucket of funds available for you at retirement. But as of this year, the Roth option of retirement savings has been around for 20 years. Why the fuss lately?
Before I get into the reasons for the attention that the Roth is getting, it’s important to make sure we understand how the Roth is different from a traditional IRA or 401(k). Contributions that you make into your traditional IRA or 401(k) are made with “pre-tax” dollars. That means that you get to reduce your current taxable income by the amount of your contributions. Lower income means a lower tax bill. When you retire and take money out of the IRA or 401(k), the distributions are taxable.
On the other hand, contributions you make into a Roth IRA or 401(k) are made with “after-tax” dollars, so you do not get the benefit of a reduction on your current tax bill. However, when you take money out of your account at retirement, the funds are tax-free.
Two things have occurred within the last several months that helped boost savers’ awareness of the Roth. The new tax law that was passed at the end of last year and went into effect this year was the first trigger. Suddenly, most of us found ourselves in a lower tax bracket. That meant that the deductibility of a contribution into a traditional IRA or 401(k) wasn’t worth as much.
Shortly after the new tax law went into effect, Congress passed a $1.3 trillion spending bill, averting a government shutdown. The new spending will mean an increase in our national debt, which is already an outrageously big number. It is widely assumed that in order to pay down that massive debt in the future, taxes will have to eventually go higher. This spending bill is the second trigger for the new popularity of a Roth account.
The reason you use a Roth as part of your overall retirement and tax strategy is to take advantage of tax arbitrage, which means that you pay tax at a lower rate at the time of the contribution than you would when you take the funds out of the account. With relatively low income tax rates and the expectation that they will be higher in the future, the Roth becomes a more attractive option.
Another way of getting funds into your tax-free retirement bucket is to do a Roth conversion. This means that you convert the pre-tax deductions in a traditional IRA or 401(k) to a Roth account. To accomplish this, you must pay current tax on the amount you are converting. Once again, with low current tax rates and higher rates anticipated in the future, the Roth becomes more popular than ever. A Roth conversion can also be a good way to get funds into a Roth account if your income is too high to make a Roth contribution.
It’s important to keep in mind that this article is very general and that the ideas may not be applicable to your personal situation. However, it is also important to have a tax and cash flow strategy in place that does match your situation. Are you contributing to a 401(k) through your employer? You should at least investigate whether it would make sense for you to redirect some or all of those contributions to the Roth option in the plan, if one is offered. Do you have an IRA that you might be able to convert some or all of it to your tax-free bucket? It doesn’t cost anything to run the numbers, and it may save you some tax dollars in the future.