With apologies to Shakespeare, to change a line from one of his greatest plays, "to Roth or not to Roth, that is the question/Whether 'tis better to suffer the tax now, and reduce my forture, or hold it tight..."
More than a few of us feel like Hamlet come tax time when we struggle with this question and think long and hard on it. As we get ready for Tax Day in April, it's good to review some of the advantages of suffering "the slings and arrows" of paying taxes now in order to secure future benefits.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
First, there's that tax bite. Ouch. It's hard to let go of those funds when you could simply enter a traditional IRA contribution on Line 32 on the front of your 1040 for an immediate reward of less taxes. But you need to look ahead before doing that. You need to ask yourself when you have retired, do you expect your taxable income to be higher or lower than it is today?
As you are doing your taxes and comparing this year's tax bill and income to last year's, where do you stand? The goal is to pay the tax on the Roth contribution when you expect your tax bracket to be the lowest. If you are having a higher-income year, it may not be the best time to make a Roth contribution. If your bracket is lower in retirement, you may want to wait and work on a Roth conversion strategy at that stage of life. If this is the year your income is lower than you expect it will be in retirement, then by all means contribute to the Roth.
On the other hand, if your current tax bracket will be the same in retirement, it’s a wash and the old adage of putting off paying taxes as long as possible could be the right way to go. Looking ahead here could lead to another wrinkle. If you are married, the day will eventually come when one of you will pass on, leaving a single spouse. Tax brackets change dramatically when your status changes from married filing jointly to filing as a single taxpayer. You may slip into the next higher bracket even if you have lost some Social Security income due to your spouse’s passing.
The next question then becomes: Is it appropriate to convert some of the IRA funds into a Roth while you are in the lower married tax bracket, thus reducing taxable RMD income, in order to potentially reduce the impact of the higher tax bracket when the time comes that the survivor will file without the married benefit?
Also keep timing in mind. There is a five-year rule in play. While you can withdraw your contributions to a Roth without penalty or taxes at any time, the same is not true of the earnings. Think of it like a clock that says that you must have owned the Roth for five years and be older than 59 1/2 before the earnings may be withdrawn tax-free (there are some special exceptions that apply).
The actual wording of the rule states five “tax years,” which start Jan. 1 of the year for which you open and contribute to the Roth. If you open and contribute to the Roth by April 15, 2017, you can claim the contribution for 2016, causing your five years to start on Jan. 1, 2016. You have 16 months of actual time from the five-year wait. Subsequent new contributions and other Roths do not have their own five years (this is not addressing Roth conversions, which have a second five-year rule). It all starts when you open and fund that first Roth account.
Simply put, you could meet the five-year rule in as little as three years and eight months. Once you have opened and funded a Roth and met the time requirement, you have met it forever. Keep in mind this is a hard-and-fast rule. Should you pass away, the account still must meet the five -year rule before earnings, not principal, can be withdrawn tax-free for your beneficiaries.
Remember, due to your growth being tax-free, you should try to put your highest-earning and least tax-efficient investments in this account. Even with Tax Day looming, you might as well give yourself the most Roth reward possible. No point in playing Hamlet on this one.
See Also:Why You Need a Roth IRA
Nancy Fleming, CFP®, is the president of Fleming Financial Services, based in Gilbert, Arizona. She is an Investment Adviser Representative and licensed insurance professional.
-
What Is a Qualified Charitable Distribution (QCD)?Tax Breaks A QCD can lower your tax bill while meeting your charitable giving goals in retirement. Here’s how.
-
Embracing Generative AI for Financial SuccessGenerative AI has the potential to reshape how we approach learning about and managing our personal finances.
-
10 Ways Your 1031 Exchange Can Go Horribly WrongDon't let your tax-saving strategy become a financial nightmare — discover the hidden pitfalls that could turn your 1031 exchange into a costly disaster.
-
From Entrepreneur to Retiree: Boosting Your Business' ValueWhen business owners contemplate retirement, their first step should be maximizing the value of their biggest asset. Here are a few steps that could help.
-
You've Got a Trust: Now Who Should Be the Successor Trustee?You've set up a trust to protect your assets and your beneficiaries, but you still must choose the right person to execute your wishes. Here's how to do that.
-
Three Ways Fiduciary Financial Planners Put You FirstFiduciary financial advisers are required by law to work in your best interest. Here's how they are key to intentional and efficient financial management.
-
How Long-Term Care Insurance Has Become More FlexibleToday's long-term care insurance offers retirees more appealing options, which can preserve assets and protect the financial stability of a healthier partner.
-
Your Loved One Fell for a Romance Scam: What Not to DoConfronting them probably won't work, but asking them some key questions and urging them to take certain actions could.
-
Three Ways to Help Create Financial Stability for a WidowLoss of a spouse often leads to financial insecurity in retirement. These strategies can help ensure financial stability for the surviving spouse.
-
How to Embrace Personal Growth After a Gray DivorceDivorce at any age is a traumatic event, and resetting psychologically, especially after a late-in-life divorce, is more important than ever.
