Many people rely on their employer’s retirement plan, such as a 401(k), but more than one-third of workers don’t have access to these kinds of plans, according to Pew Charitable Trusts. Individual Retirement Accounts, or IRAs, are a great way for these individuals to start saving for retirement, as well as a way for those with 401(k)s to supplement their savings. These accounts enjoy unique tax advantages that depend on the type of IRA account.
Traditional vs. Roth IRAs
The two most common types of IRAs are Traditional IRAs and Roth IRAs. These accounts have annual contribution limits of $5,500 in 2018 and $6,500 for those over 50 years old. While both accounts offer unique tax advantages, there are some important differences that you should consider before opening an account or making contributions for the year.
Some of the most important differences to consider include:
- Income Limits – Anyone with earned income who is younger than 70½ can contribute to a traditional IRA, but there are income restrictions on Roth IRAs. If you’re a single filer, you must have a modified adjusted gross income of less than $133,000 in 2017 and $135,000 in 2018 to quality. If you’re married and filing jointly, you must have adjusted gross income of less than $196,000 in 2017 and $199,000 in 2018. Contributions also start to phase out at $186,000 in 2017 and $189,000 in 2018.
- Tax Deductions – Traditional IRA contributions are tax deductible on both state and federal levels in the year that you made the contribution, but withdrawals are taxed at ordinary income tax rates when they’re made. By comparison, Roth IRA contributions are not tax deductible when they’re made, but withdrawals are generally tax-free – including any gains realized on the investments over time.
- Withdrawal Rules – Traditional IRAs require that you start taking required minimum distributions, or RMDs, at age 70½. These are taxed at ordinary tax rates, whereas Roth IRAs don’t have any requirements to withdraw during an owner’s lifetime. Both types of IRAs can take qualified penalty-free distributions at age 59½.
Converting a Roth IRA
A Roth conversion involves taking all or part of a traditional IRA and moving it into a Roth IRA. You choose to pay taxes on the funds now rather than in the future. Once the funds are in the Roth, you receive continued tax-deferred growth and avoid some of the distribution rules of a traditional IRA.
There are a few reasons to consider these conversions:
- Backdoor Roth IRAs – Roth conversions are most common among high earners that don’t qualify to contribute to Roth IRAs, since they can contribute to a traditional IRA and convert it into a Roth IRA each year in a process known as a backdoor Roth IRA.
- Change in Circumstances – If you expect to generate higher taxable income in the future, expect strong capital gains, or if you expect tax rates to rise, you may want to consider a Roth conversion to minimize your tax exposure during retirement.
- Larger Legacy – Without the Required Minimum Distributions rules of a traditional IRA, Roths can continue to grow tax-deferred well beyond age 70. This can be a big advantage to your heirs if you plan on all or part of your retirement funds to be left to future generations.
The process of converting an IRA is usually as simple as opening a new Roth IRA – or choosing an existing Roth IRA – and talking to your broker about converting an existing traditional IRA. They will provide you with the paperwork needed to complete the conversion and you will be responsible for paying any taxes on the conversion in the current tax year. You can complete one Roth conversion per year (12-month period).
When Does It Make Sense?
The decision between a traditional or Roth IRA depends on how you think your income level and tax brackets will compare in the future to your current situation. While most people anticipate lower taxable income during retirement, it’s common to overlook Social Security income, freelance work, and the loss of tax credits that tend to be a lot more common during working years – such as deductions for children, childcare credits, or mortgage deductions.
You must also consider the impact of the conversion on your current tax brackets. For example, converting $50,000 to a Roth IRA involves generating extra taxable income of $50,000 in the current tax year. You should take a look at your current tax bracket and see if the extra amount will push you into a higher tax bracket. If so, you may want to consider spreading out the conversion over several years to avoid overpaying taxes.
If you have a single low-tax year due to a job loss or other reasons, you may want to consider a Roth conversion to benefit from a lower tax bracket. If you want to convert the full amount and can’t spread out the income, you may want to consider making charitable contributions to lower your taxable income to your desired level. You can even spread the giving out over many years – despite making a single year contribution – through donor-advised funds.
In general, Roth IRAs are preferable if you anticipate an increase in income tax rates or your own tax bracket during retirement. Many people believe that an increase in tax rates is likely, given the record low tax rates that may not be sustainable at current levels, but there could be significant changes to the economy in the future that alter these dynamics. Traditional IRAs are preferable if you’re earning more now and don’t anticipate higher taxes during retirement.
The new GOP tax bill introduces some important changes to the way that traditional and Roth IRAs are handled. Most importantly, the new bill eliminates the ability to reverse a Roth conversion, which means that so-called recharacterizations are no longer possible.
These changes are a big deal because you could previously change your mind if the market dropped toward the end of the year. For example, suppose that you started a Roth conversion for a traditional IRA in March or April and the market moved sharply lower in November. The Roth conversion would have involved paying taxes on capital gains that may no longer exist, so undoing the conversion would help save you money.
Recharacterizations were also helpful in cases where you didn’t know your taxable income by the December 31 Roth conversion deadline. For example, suppose that you have multiple income sources and weren’t entirely sure how much taxable income you had, and the Roth conversion ended up moving you to a higher tax bracket. In the past, you could have undone the conversion to avoid overpaying taxes, but that’s no longer possible in 2018.
The Bottom Line
There are many reasons that you should consider converting a traditional IRA into a Roth IRA, such as if you’re a high earner or if your expectations change. Roth conversions are a relatively straightforward process, but new rules in 2018 make it impossible to undo a conversion. This means that you should carefully consider the market’s dynamics and your expectations for the future before undergoing a conversion.