Long-term planning is part and parcel with leading a financially healthy life. It's important to consider taxes when you plan.
Long-term planning is part and parcel with leading a financially healthy life. I have found the Roth IRA to be useful as a post-tax investment vehicle.
There are benefits to making Roth contributions or using the Back Door if your earned income exceeds eligibility. These benefits are worth taking into account for not only yourself but your potential heirs if you ever decide to pass on your wealth.
The 2015 eligibility for those filling single was income less than $116,000 and will be $117,000 for 2016. If you are married and filing jointly the phase-out begins at $183,000 and $184,000 respectively.
If your income does not qualify, there is always the option of using the "Back Door Roth" as a vehicle to accomplish making Roth contributions. This method can be thought of as a “contribute and convert” two-step process that allows you to continue building Roth accounts even if your earned income exceeds the eligibility criteria for a given year. In this fashion, you would contribute as planned to your traditional account with the intent of converting soon after.
However, like most things, there are better reasons than others to make conversions and one must weigh the long-term needs and how they fit into you and your family’s plan.
Roth accounts provide you the ability to invest funds that will be tax-free at the point of withdrawal during retirement. It is possible to convert your funds from a traditional IRA to a Roth, as federal and state tax codes permit for this as long as personal income taxes are paid on the converted funds.
The following are the top reasons why it may be of benefit to convert your funds from an IRA to a Roth:
1. Increasing Retirement Disposable Income
As mentioned, Roth account contributions are done post tax, and thus can be used without incurring taxes in the future. Increasing disposable retirement income is a valid reason for conversion. The goal of building an adequate nest egg is to be able to enjoy a financially secure life as we age and continue to add value to the world throughout our lives.
As the seasons of your life change, so may the disposable income needs you plan on using. If you have not calculated how much retirement income you will need, there are many easy to use calculators on the web that allow you to do so. Here is a calculator from Kiplinger for reference.
2. Pre-positioning Savings in the Retiree’s Estate to Reduce the Heirs’ Personal Income Tax Liability
If you intend to give the money to your heirs, converting to a Roth brings the additional benefit of being used tax-free by your heirs. However, it is worth optimizing for total tax cost incurred by both the giving as well as the receiving party. If heirs are in a lower tax bracket, the total tax cost may end up lower if they received a traditional IRA than if you paid at a high tax rate when converting and then passed it on to your heirs. It is advisable to work with an estate attorney in these matters, and consider the total cost involved.
Giving is a satisfying thing to do and when done correctly can save you and your family additional cost.
3. Preserving Tax-advantaged Savings for Heirs by Circumventing the IRA’s Required Minimum Distribution
Whether it’s an inherited IRA or Roth, the IRS will still require you take the required minimum distributions.
The Vanguard Group has a useful calculator for estimating RMDs. It may be to your heirs’ benefit to convert in order to retain the tax-advantaged savings during redistribution.
4. Insuring Against Personal Income Tax Rate Increases During Retirement
Although during the tenure of your working years traditional IRAs allow for deductions, they will be fully taxable when you withdraw. The conversions of these funds would ensure that these withdrawals will be tax-free and insure against possible personal income tax rate increases. If your tax rate has the potential to be higher during retirement for a myriad of reasons (one of which is hopefully you have amassed more than you thought possible in your traditional IRA and 401(k) accounts), it may be possible that your income as well as your taxes may increase with required redistributions.