Your primary goal in saving for retirement is to have enough money to cover your expenses during your senior years. (You should always consult with a Certified Financial Planner before attempting any change in your retirement strategy.)
When you were starting out, the most attractive retirement investment may have been a pre-tax traditional IRA, introduced in 1974, which is funded with pretax dollars, meaning your investment can grow before taxes are imposed on their value. As you strategize your distributions in retirement, that money is treated similarly to the income you've earned throughout your working life.
On the other hand, the Roth IRA, introduced in 1997, uses dollars that have already been taxed. The IRS treats this after-tax money as if it were yours the entire time. That means that whether your Roth IRA grows by a single dollar or by $1 million over the course of its lifetime, the entire sum of money has grown tax-free and remains completely out of the hands of Uncle Sam (so long as you follow a few key distribution regulations like holding the funds in your account for 5 years before withdrawals). More pressingly, for older Americans who might have spent a lot of their working life in the pre-Roth era, there remains an opportunity to convert your traditional IRA into a Roth IRA.
The closer you are to retirement, the less advantageous these traditional IRA accounts are in terms of taxes and wealth preservation for heirs. Traditional pre-tax IRA accounts were designed to be used up before you die. While you can begin to make penalty-free withdrawals from your Traditional IRA, or conversions to a Roth IRA when you are age 59 ½, minimum withdrawals are required beginning the year you turn the age of 73. These yearly Required Minimum Distributions are based on your IRA account balance on December 31st, and the IRS life expectancy table. Traditional IRAs are calculated to be depleted sometime in your 90s. Depending on how much your account has increased in value, your RMDs can be quite sizable. The RMDs add to your yearly income for Income Tax purposes. Failing to take an RMD results in a huge penalty — losing 25% of the sum you fail to remove. (The penalty was 50% previously.) Currently your heir will need to take RMDs on an inherited Traditional IRA calculated to drain the account within 10 years.
Before you are required to make these RMD withdrawals, it would be wise to consult a tax advisor to get an optimal plan for how to handle or avoid the taxes on your RMDs and pass wealth down to your heirs.
One solution might be to convert some of your Traditional IRA money to a Roth IRA. There's no up-front tax break on contributions, but Roth IRAs offer numerous benefits. Not only do they allow for tax-free investment gains and tax-free withdrawals in retirement, but they're also the only tax-advantaged long-term savings plan that does not impose RMDs. Even Roth 401(k)s, which also offer tax-free gains and withdrawals, have RMDs. Roth IRAs are inheritable and have no required distribution for your heirs, making them an ideal vehicle for passing wealth to another generation.
One tricky thing about Roth IRAs is that higher earners are barred from funding one directly. However, if your income is over the yearly limit for contributing to a Roth IRA, you have the option to put money into a traditional IRA and convert it to a Roth afterward. You'll pay taxes on that conversion the year you make it, but then you'll enjoy the tax benefits Roth IRAs offer down the line and leave your money in your retirement savings plan according to your wishes. It's helpful to think of the tax payment on a Roth IRA conversion as an investment. You're making it now so that you don't have to make it later.
What is the cost of paying the tax now? It's likely you'll be paying with cash from outside the retirement account, so you need to consider what amount you might earn by investing that tax payment money in some other way. What if you pay a big tax bill now, then the market increases by more than average over the next few years?
You should also think about tax brackets. What tax bracket are you in now, and where do you expect to be during retirement? If you're making a high salary now and expect to have a lower income in retirement, converting now might mean paying a much higher rate of tax on the funds than you would if you held off.
For more information: attend our presentation by William Price, on April 30th at 2 pm – Assets Appreciating While You are Depreciating? What do you do now? IRAs, Gifting and Estate Planning. Mr. Price is a retired Certified Financial Planner who worked in Barnesville for over forty years. Semi-retired, he still maintains his CPA license and securities license dealing with family and a few legacy clients.