Traditional or Roth IRA…Which is best for you?

PICIf given the option, would you rather defer taxes or pay them now? That seems like a fairly straightforward question with a no-brainer answer. In fact, most of us would probably take advantage of the chance to defer any type of payment. People work hard for their money and want to hold onto it for as long as possible. Unfortunately, the answer to that question isn’t as simple when determining which type of Individual Retirement Account (IRA), traditional or Roth, to use for retirement.

There are a handful of differences between traditional IRA’s and Roth IRA’s, but the core differences are in how the accounts are funded and how the contributions and earnings are taxed upon withdrawal. Traditional accounts are funded using pre-taxed dollars, which allows for a current year deferral of taxes by reducing your taxable income. Later, when the funds are withdrawn in retirement, the accumulated contributions and earnings are subject to income tax. On the other hand, Roth accounts are funded using after-tax dollars. Although no current tax break is received, the accumulated earnings and contributions are not subject to tax in retirement.  There is also an annual Required Minimum Distribution (RMD) that the traditional account owner must adhere to upon reaching age 70.5.  Roth accounts do not require any scheduled distributions and can be withdrawn at any time in retirement without a tax penalty.

Choosing a traditional or Roth account depends on many factors, most of which relate to an individual’s current and expected future income tax rates. A key question to consider is whether or not an individual’s income tax rates will be lower or higher in retirement. If income tax rates are higher now than in retirement, the individual is generally better off in a traditional account. Conversely, if income tax rates are lower now than in retirement, the individual is generally better off in a Roth account. Furthermore, if income tax rates are expected to be the same in retirement as they are now, both a traditional and a Roth account will result in the same purchasing power. In addition, another key factor is whether or not a legacy will be left for descendants, as Roth accounts can be “stretched” for decades for children and grandchildren without taxes being incurred.

So, for many, the decision may seem rather simple – just calculate future income. However, predicting future income is difficult, much less guessing whether or not Congress will increase tax rates within the next 10, 20 or 30 years. Instead of trying to predict the future, consider other factors that are more easily determined. Individuals are more likely to earn larger salaries and bonuses as they progress through their career. For a young professional or even a child, their tax rate is likely to be lower than when they would retire. Perhaps a Roth account would be more beneficial initially. It’s important to keep in mind income levels as a person progresses through their career as it may become advantageous to change to a traditional retirement account.

Another factor to consider is where does the individual plan to live upon retirement. States, like New York, have significantly high state tax rates, whereas states like South Carolina and Illinois offer deductions for retirees or even excluded retirement income from state taxes. Better yet, you can choose to retire in states like Florida or Texas, which do not have any state income taxes.

Just because a person is projecting a certain tax rate in retirement or plans to live in a state with minimal or no taxes, an individual can never make a completely wrong decision. Couples often times will look at other factors when choosing the right account for them. If an older couple would like to give a tax-free inheritance to their children, even if it means paying a higher tax rate for the contributions, a Roth account or back-door Roth may be the right fit for them. Or if a young couple is just starting a family and could use the extra tax savings now rather than later, a traditional account may be their best fit.

Whether a person or a couple chooses to defer current taxes using a traditional IRA or waits to receive a benefit upon retirement using a Roth IRA, they can’t go wrong. In either case, they are contributing to their future in an account designed to help them achieve long-term growth of retirement savings. In addition, funds can be converted from traditional to Roth in the future, especially in years of a lower tax bracket. Here at DWM, we strive to give our clients the information they need to make the best decisions for themselves and their family. If you are having trouble deciding which type of account to use or want to review your current strategy, we would be glad to assist.

Retirement Strategies You Shouldn’t Overlook: Back-Door Roths & QCDs

irarotheggsWithin the last several days, President Obama released his 2017 budget proposal to the public. Included in the proposal were many provisions that targeted retirement income. Between this proposal targeting retirement income and the Bipartisan Budget signed last year that eliminated Social Security claiming strategies, it sure seems retirement strategies are being picked on quite a bit lately. But let’s remember, the President’s proposal shouldn’t be seen as anything more than a “wish-list”. While the “wish-list” provides a good indication of where the administration may be heading, it could take years before any of the provisions gain traction. In the meantime, it’s important to take advantage of the retirement strategies available to us.

One strategy that the President’s proposal would eliminate but is still available this year is known as a “backdoor” Roth. A Roth IRA is funded with after-tax dollars which allows the funds to grow tax-free. In addition, Roth IRAs do not require a minimum distribution to be taken. The limitation with Roth IRAs is that higher earners are not allowed to contribute to these accounts. In the spirit of the law, this would only give these individuals access to a traditional IRA. Traditional IRAs are funded with pre-tax dollars which are then taxed upon withdrawal. These accounts also require a person to take a minimum distribution starting at age 70 ½. By using a “backdoor” approach, these higher earners can have the benefit of contributing money to a Roth IRA. The sequence of action would be for the person to contribute to a nondeductible IRA, then convert to a Roth immediately afterwards. If the taxpayer does not have any pre-tax funds in their IRA, the conversion can be made without tax.

Late in 2015, Congress made permanent a few tax provisions that were set to expire at year-end. One in particular allows individuals to make charitable donations directly from their traditional IRA without treating the distribution as taxable income. As mentioned above, distributions from a traditional IRA are generally taxable and are required when a person reaches age 70 1/2. This transaction, known as a Qualified Charitable Distribution (QCD), will count towards the required minimum distribution but will not be treated as taxable income. To be considered a QCD, the individual must be age 70 ½ or older, the distribution must be paid to a public charity, the full payment must qualify as a charitable contribution and the distributions must be a direct transfer from the IRA trustee to the charity.

Being that the QCD is excluded from taxable income, the charitable donation itself cannot be deducted on an individual’s tax return. At first glance, this may seem to provide no real tax benefit. Why not just include the distribution as income and take the deduction? For many people, this may be the right strategy. For those individuals that are subject to itemized deduction phaseouts and the 3.8% Medicare tax on investment income, a QCD can help minimize or avoid these consequences. In addition, excluding IRA distributions from income will lower adjusted gross income (AGI) and may make it easier to deduct medical expenses and miscellaneous expenses subject to 2% of AGI, reduce the taxability of social security benefits and minimize the Medicare Part B insurance premiums.

It’s typically best practice to make your Roth or Traditional IRA contributions early in the year, so they can grow tax-free or tax deferred all year. Most of you will be meeting with your CPA or financial advisor within the next several weeks. This will be a good time to discuss these two strategies and see if they will work for you. Here at DWM, we are always happy and available to have these discussions with our clients, during tax season or not. Please let us know how we can help.