You may have heard that you make too much money to save into a Roth IRA.
You may have heard that Roth IRAs are only appropriate for young people early in their careers.
You may have heard that you should only invest in a Roth IRA if you think your tax bracket will be higher in retirement than it is in your working years.
I’d like to bust those myths for you, and show you how a Roth IRA can be potentially advantageous to savers in all stages of life in a variety of situations.
Myth #1: I make too much money to contribute to a Roth IRA.
If you haven’t heard of the “backdoor Roth” contribution solution, you need to know about it. This method of contributing to a Roth IRA allows high earners the opportunity to make Roth IRA contributions regardless of how much their income is. It just involves some extra steps to do so.
First, you make a non-deductible traditional IRA contribution. We like to have investors do this as a one-time maximum lump sum contribution annually; it makes the forms much easier to deal with.
It’s important to make this contribution into a clean, empty traditional IRA (not an existing account that already has pre-tax money in it). We designate these specifically as “pass-through” IRAs that are only used once a year as a conduit for the backdoor Roth contribution. Again, we like clarity and simplicity here.
Next, you immediately convert that amount to a Roth IRA. You don’t want to invest the money in anything while it is going through the pass-through IRA. If you do, you will have to figure out the losses or gains while it was in there, which can create a taxation headache. So, we just don’t do it. When it comes in, leave it in cash and then convert immediately.
Lastly, at tax time, you’ll need to make sure you report this properly on your taxes. You’ll likely get one form showing the contribution, another showing the distribution/conversion, which can get confusing. If you work with a knowledgeable tax professional, they should be able to help you report this properly so that there’s no question about taxation when you take it out later. After that’s done, you can sit back and let your Roth grow tax-free.
Sometimes people ask me, “is this legal??” Sure is. In 2018, the IRS stated that “The ‘backdoor’ Roth method – which involves contributing to a traditional IRA and then converting to a Roth IRA – is allowed under the law.”
Myth #2: Roth IRAs are only appropriate for young people.
The logic behind this comment is usually that the only point of a Roth is for the tax-free growth feature. While this is a key reason to have a Roth, it is not the only reason. Roth IRAs can be appropriate for older folks due to some of their other attractive features.
For example, Roth IRAs are not subject to Required Minimum Distributions (RMDs). This is the amount that the IRS makes you take out from your tax-deferred investments after you reach a certain age (for most people now, this starts at age 73). It doesn’t matter if you “need” the distribution or not; the IRS requires you to take the money out and pay the taxes on it. This can be annoying or downright contrary to clients’ wishes in their 70s and 80s.
Since you don’t have RMDs from a Roth IRA, Roth conversions can be potentially attractive in this case. Furthermore, if clients don’t ever end up needing or wanting the money out of the Roth, they are also building a tax-free gift for their heirs. Tax-free money is an undeniably generous legacy.
Myth #3: You should only invest in a Roth IRA if you think your tax bracket will be higher in retirement.
This is an interesting one because you can certainly make the math work to support this argument. And it’s not necessarily bad advice, but it is a bit short-sighted. This comment assumes that both tax brackets and tax laws will remain relatively constant from now until you retire. It is unlikely this will be the case. Ed Slott, “America’s IRA Expert” who studies tax law, says it best: “Roth IRAs remove the uncertainty of what future tax rates might be.”
We just don’t know for sure if your tax rates will be higher or lower in your retirement years. Not only does it depend on the whims of the economic and political environment; it also depends on where you end up in retirement. Your personal economic situation could be quite different from today or from what you imagine. It may overturn the math that originally fueled this assumption.
I also observe that the psychological and emotional value of a Roth IRA should not be ignored or downplayed. What you consider valuable and important changes quite a bit after retirement. In working with retirees, I find that removing uncertainty can be essential to peace of mind and comfort.
As one retiree commented to me: “Laura, I like to look at the money in my Roth IRA and know that the entire balance is MINE. I don’t need to do a bunch of mental math to figure out what part of it I owe in taxes.” Simplicity and clarity in retirement = priceless.
Bottom Line
Roth IRAs have numerous advantages that you need to be aware of and consider in your financial plans, regardless of your age, career stage – or what you have been told in the past. Let us know if we can help you evaluate how a Roth may work for you.
*If you want to hear 4 more bonus reasons to consider a Roth IRA, tune in to last month’s webinar, here! Should I Save Into A Roth?
