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When investors are deciding where to stash their cash for retirement, there are several options.
Americans rely more and more on saving in their employer-sponsored 401(k) plans — which are heavily funded by tax-deferred salary deferrals from the employee and tax-deferred employer matching contributions.
Once employment ends, these 401(k) plan accounts are often rolled over into an individual retirement account for purposes of managing the portfolio and continuing the tax advantages previously enjoyed in the 401(k).
However, a big opportunity often missed in this area is Roth savings. The current landscape and rules around retirement savings provide a number of strong incentives for you to consider setting up a Roth IRA this year.
With Roth tax treatment of your savings, money goes in after tax. But the investment gains are tax-deferred, and if you meet certain requirements, you can withdraw all of the investment gains tax-free. In order to receive the investment gains tax-free from a Roth IRA, the account will need to have been open for five years and you must qualify for a trigger event, such as the following:
- When distributions are made on or after the IRA owner reaches age 59½.
- After the death of the IRA owner.
- After a disability in which the IRA owner can’t do any substantial work.
- If a withdrawal, of up to $10,000, is being used for first-time home-buying expenses.
The five-year rule makes it wise to set up a Roth IRA as soon as possible. As soon as money goes into any Roth IRA, the five-year period begins. The rule allows for aggregation back to the first Roth IRA contributed to in order to satisfy the five-year rule. This means you need one Roth IRA to satisfy the five-year rule for any other Roth IRAs opened in the future.
The rule also looks at tax years. In 2019 you can still contribute to a Roth IRA for 2018 until April 15. This would technically start the five-year clock as of 2018. It’s also important to note that if you are saving in your Roth 401(k) account and roll it over to a Roth IRA, the years it was open in the 401(k) don’t carry over to the Roth IRA. If you have a Roth 401(k), consider opening a Roth IRA and contribute to start the five-year clock, as you will likely do a rollover to a Roth IRA at some point.
You can contribute a small amount to the Roth IRA — say, $50 or $100 — to get the clock running. Be aware of any account minimums, fees or other charges that your provider might charge. Certain companies, such as Fidelity, now offer Roth IRAs with no account fee or minimums.
If you make too much money, you will not be able to directly contribute to a Roth IRA. For single filers in 2018, that income threshold starts at $120,000 and ends at $135,000. For married people filing jointly — and qualifying widowers — that income threshold starts at $189,000 and ends at $199,000.
Another option to get money into a Roth IRA is to do a Roth conversion from a traditional IRA, as there are no income limits or phase-out ranges for doing conversions. If you make too much money to contribute to a Roth IRA or don’t have any money in an IRA and want to get money into one this year, you can use the backdoor Roth IRA strategy. The backdoor allows you to contribute to an IRA as non-deductible and then convert it to a Roth IRA. To learn more about the backdoor Roth IRA strategy, click here.
Another reason to save in a Roth IRA today is tax diversification. You might have heard the phrase “Father Time is still undefeated.” I often say, “Diversification is still undefeated against Father Time.”
Diversification is crucial to smart long-term financial planning. It doesn’t matter if it’s within asset classes, among asset classes or across different tax treatments, diversification helps. We don’t know for certain what the future holds, but by diversifying we reduce the risk of relying solely on the outcome of one event.
Most workers who are saving for retirement have tax-deferred retirement savings in their 401(k) plan. They also might have after-tax savings in their bank account. However, far fewer people have Roth savings. Roth savings are most beneficial when compared to tax-deferred savings when tax rates are lower today and higher in the future. This allows us to save after-tax today at a lower rate than if we had waited to pay taxes in the future.
Generally speaking, when you are younger and earlier in your career, Roth IRA makes more sense as you will likely increase your earnings over time and therefore move to a higher tax bracket. But it isn’t a given. Since we don’t know where tax rates will be in the future there is a benefit to having some tax diversification in your savings.
While I just said we don’t know where tax rates will be in the future, there are strong indications tax rates are lower today than they will be soon. You can see clear needs for revenue increases at both the state and federal levels with state budgets feeling a lot of pressure, underfunded state pensions needing additional funding, Social Security needing more funding and the federal deficit increasing.
Furthermore, the Tax Cut and Jobs Act of 2017 temporarily reduced tax rates and income taxes for many Americans. The tax cuts are temporary according to the bill itself, as the individual tax cuts expire after 2025 and will revert back to the previous rates. If you paid lower taxes for 2018, consider using a Roth IRA to save for retirement. And remember, you still have time to contribute for 2018 until April 15.
One of the best features of a Roth IRA is its ability to serve double duty as an emergency fund and a retirement savings vehicle. Since many Americans have less than $1,000 saved at any time, it’s not always feasible to have separate funds for retirement, college savings, emergency funds and other goals. Instead, we’re required to be flexible. To this point, Roth IRAs offer flexibility that IRAs and 401(k) plans don’t when it comes to accessing your savings.
With a Roth IRA, you can withdraw your contributions at any time without having to pay additional income taxes — because it was after-tax already — and you avoid the 10 percent early withdrawal penalty on the withdrawals. Withdrawals from IRAs and 401(k) plans prior to age 59½ are generally subject to the 10 percent penalty. If you are trying to invest and save for retirement, but might need access to your savings, a Roth IRA could be the right vehicle for you.
Make 2019 the year that counts. Review your finances, look at your savings opportunities and consider adding a Roth IRA to the mix. There are a lot of benefits to adding a Roth IRA sooner rather than later.
— By Jamie Hopkins, director of retirement research at Carson Group