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Roth IRAs – A Good Deal!

J Terwilliger 2014
James P. Terwilliger, PhD, CFP®
Senior Vice President, Senior Planning Advisor
[email protected]
(585) 419-0670 x50630

It’s no secret that I like Roth IRAs …a lot.

The Roth IRA was established by the Taxpayer Relief Act of 1997 and named for its chief legislative sponsor, Senator William Roth of Delaware. It is one of the most-beneficial gifts ever bestowed by Congress upon the American taxpayer.

Yet, many folks are not familiar with its features and, as a result, do not take advantage of its benefits.

Roth IRAs generally are funded during one’s working years by making annual contributions. The 2014 maximum IRA contribution is unchanged from last year – $5,500 plus $1,000 “catch-up” for taxpayers age 50 or older. Contributions can only be made in a given year by workers who have W-2 or net self-employment earned income equal to or greater than the contribution. Spouses of workers may also contribute.

The maximum annual contribution can be allocated in any ratio between traditional IRAs and Roth IRAs.

The primary difference between the two is that Roth IRAs are funded with after-tax dollars. Further, Roth IRAs are tax-free accounts. No income tax will ever be paid on the money in the account, provided that certain conditions are met.

Traditional IRAs generally are funded with pre-tax money. Such contributions are tax-deductible in the year of the contribution. When withdrawn in retirement, distributions are then taxed.

More recently, Congress allowed employers to offer Roth 401(k)s in addition to traditional 401(k)s. As with IRAs, the former is funded with after-tax money and the latter with pre-tax money. The 2014 maximum contribution into a Roth 401(k) is $17,500 with $5,500 “catch-up”.

The conventional wisdom is that people who expect to face the same or higher tax rates during their retirement years should direct as much money as possible into Roth IRAs and Roth 401(k)s, if employer plans allow the latter.

But, none of us has a crystal ball to know what Congress and NYS are going to do with tax rates. Also, this guidance may discourage those who believe their tax rates may be lower in retirement from building a strong Roth position.

My recommendation usually goes beyond the tax-rate criterion. It is my judgment that folks saving for retirement should focus on the first two of the following types of assets:

  • After-tax – savings, CDs, investment accounts 
  • Tax-free – Roth IRAs and Roth 401(k)s 
  • Pre-tax – traditional IRAs and 401(k)s

Why emphasize the building of after-tax and tax-free assets vs. pre-tax? At retirement, the retiree will have significantly more spending power with, say, $500,000 in a combination of after-tax and tax-free accounts vs. $500,000 in pre-tax accounts.

Accordingly, my recommended order of preference for working folks saving for retirement is: First, max out traditional 401(k) contributions annually to the level of any employer match; second, max out Roth IRA contributions; third, consider contributing to a Roth 401(k), if available; and fourth, direct any remaining savings primarily to after-tax accounts.

The only advantage, in my view, for building pre-tax assets is the tax deduction at the time of contribution. But, if one is saving for retirement, why not maximize the spending power of the money at retirement vs. benefitting from a tax deduction now for the same number of dollars set aside during one’s working years?

There is an issue for high earners. While they can contribute annually to employer Roth 401(k) plans if available, regardless of income, high earners cannot make Roth IRA contributions this year if their 2014 modified adjusted gross income exceeds $129,000 for unmarried taxpayers or $191,000 for married taxpayers.

But there is a workaround if high income prevents you from making Roth IRA contributions.

First, make a non-deductible (after-tax) contribution to a traditional IRA. There is no income restriction.

Next, immediately convert the non-deductible traditional IRA balance into Roth status. Since the non-deductible contribution is after-tax money, there will be no income tax owed on the conversion, and your money is now in a Roth IRA.

There are three watch-outs:

  1. you must have earned income;
  2. you must be under age 70-1/2; and
  3. if you have one or more existing traditional IRAs containing pre-tax money, converting the new non-deductible traditional IRA into Roth status will not be tax-free.

This article does not address the wisdom of converting pre-tax IRAs and traditional 401(s) into Roth IRAs. That is another topic for another day.

As always, be sure to consult with a trusted financial planner and tax advisor to map out a Roth strategy that works best for your circumstances.

This material is provided for general information purposes only. Investments and insurance products are not FDIC insured, not bank deposits, not obligations of, or guaranteed by Canandaigua National Bank & Trust or any of its affiliates. Investments are subject to investment risks, including possible loss of principal amount invested. Past performance is not indicative of future investment results. Before making any investment decision, please consult your legal, tax or financial advisor. Investments and services may be offered through affiliate companies.