Each and every year, I run across countless individuals who foolishly pass up the opportunity to shift money from a taxable account to a tax-free account—all without increasing their tax bill. This is generally a big mistake. It may not make or break your retirement, but most long-term financial success comes not as the result of one or two really good big decisions, but rather, by taking small, but consistently positive steps.
Roth individual retirement accounts can be powerful tools. They allow you to put money aside today that can grow tax-free for the remainder of your lifetime, and there are no required minimum distributions, as there are for traditional IRAs. Of course, nothing worth having in life comes without a cost, and the Roth IRA is no exception. In order to get money into the future tax- and RMD-free haven that is the Roth IRA, you have to pay tax on the funds that go into the Roth IRA before they go into the Roth IRA.
Broadly speaking, there are two ways to get money into your Roth IRA: through contributions and conversions. One important distinction between the two is that conversions generally increase your taxable income and therefore your tax bill. Contributions, on the other hand, do not increase your income. Huh?
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Let me explain: When you make a Roth IRA conversion, you're generally taking money that was put into an account on a pre-tax basis—meaning funds for which a tax break was already received when you made the contribution—and turning it into after-tax Roth IRA money. In order to do that, you essentially have to reverse your old tax break by adding to your income the pre-tax funds you contributed to your IRA, 401(k) or similar account and paying tax on those funds.
For example, let's say that from 2011 to 2015, you made annual deductible contributions to a traditional IRA of $5,000, for a total of $25,000 of contributions. Over time, the account has grown to $40,000. Now, if you want to convert those funds to Roth IRA savings in 2016, you'll have to add that $40,000 to your income. Thus, if you convert today and your income would otherwise be $100,000, the conversion will result in you owing tax on $140,000 for 2016.
It's often misunderstood, but the same is not true of Roth IRA contributions. When you make a Roth IRA contribution your income is not increased and you do not owe any more tax for a year than if you had not made a Roth IRA contribution. So why the confusion?
In my experience, the confusion typically arises because people are mentally comparing a tax bill after making a deductible traditional IRA contribution with a tax bill after making a Roth IRA contribution. In comparing the two, the latter will leave you with a higher tax bill, but that's an unfair comparison. It's only higher relative to a tax bill that's been reduced because of a deduction, not because something's been done to increase the tax bill, like a Roth IRA conversion does. Saying a Roth IRA contribution increases your tax bill is the equivalent of saying that not giving to charity increases your tax bill. Sure, your tax bill could be lower if you made charitable contributions, but not making them doesn't increase your tax bill. It just doesn't lower it. The Roth IRA contribution works the same way.
Consider the following three scenarios to further illustrate the point:
Scenario 1: You make $100,000 and make a $5,000 deductible contribution to a traditional IRA. You pay tax on $95,000.
Scenario 2: You make $100,000 and make a $5,000 contribution to a Roth IRA. You pay tax on $100,000.
Scenario 3: You make $100,000 and do not contribute to either a traditional IRA or a Roth IRA. You pay tax on $100,000.
All else being equal, scenario 1 will yield the lowest tax bill. Scenarios 2 and 3 will produce identical tax bills.
What's not in the illustration: Scenario 2 offers you a good opportunity to save on future tax bills because contributions to a Roth IRA grow tax-free. Consider this: If you make a $5,000 Roth IRA contribution with funds that were previously in a taxable investment account and that contribution earns 10%, you've essentially shifted $500 ($5,000 x 10% = $500) from a taxable pocket to a tax-free pocket. Do that year over year, and you're talking some serious tax savings!
And if you have $25,000 just sitting in a savings account, it's probably earning almost next to nothing considering today's rates. That may be frustrating, but a further slap in the face is that every dollar of your barely-there interest is taxable. If, on the other hand, you shifted $5,000 of your savings account money into a Roth IRA, it may not earn a higher rate of interest, but at least that interest will generally be tax-free.
So how do you know if contributing to a Roth is the right move for you? Simple. Just ask yourself these two questions:
1. Am I eligible to make a Roth IRA contribution?
To be eligible, you or your spouse must have compensation (generally earned income), and your income must be below certain thresholds. Furthermore, the maximum Roth IRA contribution amount of $5,500 ($6,500 for those 50 or older by the end of the year) for 2015 and 2016 is reduced by any contributions made to a traditional IRA.
2. Do I have money sitting in a taxable account that I can use to make a Roth IRA contribution?
If you have cash sitting in a savings or other bank account or cash or other investments in a taxable brokerage account, you're likely better off putting it to work in a Roth.
If the answer to both of the above questions is yes, then chances are that you're missing out on a great opportunity. When both answers are yes, there is almost no viable reason why you should not be making a Roth IRA contribution. Even if you need the money at some point, it's no problem. Roth IRA contributions can be distributed at any time, and for any reason, tax and penalty free. (Any earnings you withdraw, however, would be subject to taxes and penalties unless you are over age 59½ and your account has been open for at least five years.)
There aren't many opportunities to reduce future tax bills that come without an upfront cost, but Roth IRA contributions can be the exception to the rule. So before you file your 2015 tax return, and as you continue to plan for your 2016 return, make sure you're not passing up an opportunity to pad your Roth IRA savings without padding your tax bill.