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How to Maximize the Roth IRA to Your Tax Advantage
- By Travis Echols
- •
- 29 Jul, 2017
Originally written on 4/11/2016 with updates for 2020.
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If you qualify, shouldn't you participate in arguably the best tax-saving opportunity that our benevolent representatives in Washington have ever granted us--the Roth IRA? (Half sarcasm, half sincerity).
A Roth IRA is an individual retirement account, similar to a traditional IRA, but the contributions are not tax deductible. However, the qualified distributions are tax free, unlike the pretax traditional IRA.
Many people have asked me how a Roth IRA is invested. A Roth IRA is a tax vehicle in which the assets can be invested in whatever you want based on the IRA custodian's available investments. When thinking about IRA types, don't think investments; think tax treatment.
Even if you have already filed your taxes, you can contribute to a Roth IRA. (Since Roth IRA contributions are not deductible, after-the-fact contributions will not likely affect your tax return numbers. Though it is best to report since some low income earners may qualify for the retirement savers credit.) Also, even if you have maxed out a traditional IRA already, if you are married, your spouse (wage earner or not) may be able to make a spousal contribution to their Roth IRA.
If there is a good chance you will use the money for retirement, make the contribution. If you think you may need the money sooner, but not likely, you can leave the assets in a money market in the Roth account until you decide that you can invest it for long term goals. You can always get your principle out penalty-free at any time, but the opportunity to contribute for this year will never occur again.
Here are some of the advantages of a Roth IRA.
- Control your income taxes during your retirement years
- Shelter more ($6000 Roth IRA contribution is all yours, versus $6000 shared with Uncle Sam in a traditional IRA)
- Avoid Required Minimum Distributions at age 72 (vs. traditional IRA)
- Maximize your Roth contributions while maxing out your 401(k) (Since Roth IRAs are not deductible, they do not compete for deductibility with qualified plans like traditional IRAs do)
- Access your principle before age 59.5 (vs. traditional IRA)
- Avoid the unfair impact of costly estate taxes (vs. traditional IRA)
- Create large amounts of tax-free money immediately by converting a traditional IRA to a Roth IRA
- Stretch tax-free growth and income for your spouse's lifetime and maximum of 10 years for non-spouse beneficiaries
The chart below illustrates three major account types. Since tax-deductible IRA and 401(k) assets are taxed as ordinary income when withdrawn, this can put a heavy tax burden on you in your retirement years. Having tax-free assets (which is superior to taxable) can give you greater tax control in the future, which can save you thousands in taxes over time, not to mention the fortune you can parlay to future generations through stretching the Roth IRA as long as possible (the full 10 years with a Roth, since the distributions are not taxable).
Chart 1. Tax Control Triangle
There are two ways your money can get the Roth IRA tax treatment: contributions and conversions.
Contributions
Typically, those in moderately high tax brackets contribute to traditional IRAs to defer taxes until retirement when it is supposed their tax burden will be lower. (High tax bracket earners are not eligible for deductible IRAs or Roth IRAs.) The ideal situation is to max out contributions to tax deductible plans like 401(k)s and 403(B)s ($19,500 with a $6500 catch-up for workers 50 and older)while maxing out contributions to Roth IRAs ($6000 per person for ages under 50; $7000 for ages 50 and older). So, with a spousal IRA, an older couple can contribute up to $14,000 in Roth IRAs per year, assuming they are eligible.
Table 1. 2020 Adjusted Gross Income (AGI) Annual Dollar Limits compared with 2019
There is a five-year rule associated with contributory Roth IRAs that applies to the gains. A person must wait until age 59.5 and a minimum of five years before the gains can be withdrawn tax and penalty free. Fortunately this five-year rule applies only to your first IRA contribution. Future contributions are on the same schedule as the first contribution so a separate five-year countdown does not apply to each subsequent contribution. So if you do not have a funded contributory Roth IRA in your name, start today (no matter how little it is) in order to start the five-year clock to ticking. And if you have confident foresight, the best time to contribute is January of the contribution year rather than waiting 15.5 months until April the following year.
Conversions
A Roth
conversion is basically a rollover from a traditional, SEP or
SIMPLE IRA to a Roth IRA, which is subject to
ordinary income taxes the year it is converted. Conversions are not
restricted to the small annual contribution limits ($6000/$7000).
There is a five-year rule for Roth conversions too, but it applies to
access to the principle. Before age 59.5, the principle from a
conversion cannot be accessed without a 10% penalty until five
years have elapsed from the year the conversion was made (which could be
as short as four years and a day)-unless you turn 59.5 during the
five-year period. As soon as you reach 59.5, all converted
assets are immediately penalty-free and tax free. Each conversion has
its own five-year clock, until you reach age 59.5.
Some
advantages to conversions are the unlimited amounts you are allowed to
convert, no income eligibility restrictions.
The ability to re-characterize a conversion in the same calendar year is no longer applicable. This recharacterization feature wasrepealed in the TCJA of 2017.
There are many Roth conversion strategies for retirees and pre-retirees. Here is one that can be advantageous for certain individuals who have mostly taxable assets and 401(k)/traditional IRA assets. After retiring from work, instead of immediately taking Social Security or drawing down 401(k)/IRA assets, spend from your taxable assets for a year or two or three. During these low income years, convert big pieces of your traditional IRA to Roth. This can do two things: 1)greatly boost your future Social Security income bydelaying benefits until full retirement or age 70, and 2) increase your future tax-free income.
See Roth IRA eligibility requirements and consult your tax adviser and financial adviser before deciding.
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Investment Advisory Services offered through JT Stratford, LLC. JT Stratford, LLC and Echols Financial Services, LLC are separate entities.
- Liquidity--Retirement assets are not being locked up or annuitized such that capital is not available for emergencies.
- Income—Using an optimized withdrawal rate, an increasing income is produced to combat inflation (unlike many pensions, bank and insurance strategies that are not inflation-adjusted).
- Growth--assets that can combat inflation over a 20 to 30-year period, giving the retiree more income and upside potential under normal and good economic times.
- Safety--manages the myriad of investment risks like market risk, inflation risk, and credit risk. Under worst-case scenarios, if withdrawal amounts are adjusted by using guardrails, the portfolio can still provide a lifetime income.
Here is an executive summary of how to build up a portfolio for retirement in seven steps.
1. Values clarification and goal-setting . Figure out the income objective and capability of your retirement assets in lifestyle terms, then financial terms. In other words, set realistic, specific, financial goals based on your core life values.
2. Asset allocation glide path . Figure out how to diversify your retirement assets among stocks, bonds, and cash, based on your age, risk tolerance, retirement goals, and changing market values.
3. Valuation-dependent efficient frontier . Figure out which areas of the markets are historically inexpensive, and which are historically expensive. Don’t take on more volatility than you need to for the growth you need or desire.
4. Multi-asset class approach . Diversify one more step for more growth and less volatility. Put more money in the specific market areas that are less expensive and less money in the specific market areas that are more expensive.
5. Tax-aware asset location and distribution . Save as much on taxes as possible by figuring out which type of investments should be held in which types of accounts. If you are drawing an income from your assets, figure out the least-costly order for making withdrawals.
6. Investment selection based on account type (qualified, nonqualified) and asset-class propensity and magnitude of outperformance (passive, factor, managed, etc. ). Figure out what kind of investment to use (index mutual fund, factor mutual fund, actively managed mutual fund, single factor ETF, multifactor ETF, passive ETF, individual stocks, individual bonds, Unit Investment Trust, closed-end fund, etc.) based on the account type, asset class, and growth and income needs.
7. Rules-guided rebalancing based on retirement glide path and multi-asset-class approach . Readjust the investment mix based on your changing personal situation and changing market values.
Sign up to receive my free monthly email articles...because you want to make the most out of your retirement
.
Here is a summary of the details backing this approach. Also, click here for more background information regarding my investment philosophy.
1. Values clarification and goal-setting
Investment planning for (or in) retirement starts with retirement planning. You start with thinking about your life goals...your dreams...your ideal life in retirement. It could involve doing no work, working part-time, or doing seasonal work. Your ideal life could be going back to school, spending more time with family, traveling, ministry, etc.
Ask yourself questions like, "What would I want to do if I
didn't need to work for money?" or "What are the most important
dangers, opportunities, and strengths I need to address?" or“Ten years from now, if I am looking back on a successful
ten years, what will I have achieved?”
This conversation allows you to create specific
goals around your most cherished values. And your goals will be unique to you.
You then design an investment plan to help you live your ideal life.
This kind of goal-focused, plan-driven approach minimizes the
chances of making bad investment choices based on current events and emotions.
Instead, you can choose and maintain the
specific mix of investments that can best deliver the results you need--using a
disciplined, research-driven approach.
2. Asset allocation glide path
The next major question is what kind of investments do you need to meet your goals. All investments have risk. Even "safe" investments over long periods have inflation risk. No single investment delivers growth, high income, and safety of principal. The key is designing a portfolio that balances them in a way that supports your retirement objectives.
And this mix may change over time. For example, for most people, it makes sense to gradually decrease their exposure to high-growth, high-volatility assets like stocks (i.e., equities) as they approach retirement. In retirement, it is usually best to maintain a flat equity glide path, dynamically adjusted for valuation. This approach protects you from the retirement-danger-zone risks of portfolio size effect and sequence risk, while allowing you to take advantage of bear markets and market corrections. See How to Navigate the Retirement Danger Zone .
- Liquidity--Retirement assets are not being locked up or annuitized such that capital is not available for emergencies.
- Income—Using an optimized withdrawal rate, an increasing income is produced to combat inflation (unlike many pensions, bank and insurance strategies that are not inflation-adjusted).
- Growth--assets that can combat inflation over a 20 to 30-year period, giving the retiree more income and upside potential under normal and good economic times.
- Safety--manages the myriad of investment risks like market risk, inflation risk, and credit risk. Under worst-case scenarios, if withdrawal amounts are adjusted by using guardrails, the portfolio can still provide a lifetime income.
Here is an executive summary of how to build up a portfolio for retirement in seven steps.
1. Values clarification and goal-setting . Figure out the income objective and capability of your retirement assets in lifestyle terms, then financial terms. In other words, set realistic, specific, financial goals based on your core life values.
2. Asset allocation glide path . Figure out how to diversify your retirement assets among stocks, bonds, and cash, based on your age, risk tolerance, retirement goals, and changing market values.
3. Valuation-dependent efficient frontier . Figure out which areas of the markets are historically inexpensive, and which are historically expensive. Don’t take on more volatility than you need to for the growth you need or desire.
4. Multi-asset class approach . Diversify one more step for more growth and less volatility. Put more money in the specific market areas that are less expensive and less money in the specific market areas that are more expensive.
5. Tax-aware asset location and distribution . Save as much on taxes as possible by figuring out which type of investments should be held in which types of accounts. If you are drawing an income from your assets, figure out the least-costly order for making withdrawals.
6. Investment selection based on account type (qualified, nonqualified) and asset-class propensity and magnitude of outperformance (passive, factor, managed, etc. ). Figure out what kind of investment to use (index mutual fund, factor mutual fund, actively managed mutual fund, single factor ETF, multifactor ETF, passive ETF, individual stocks, individual bonds, Unit Investment Trust, closed-end fund, etc.) based on the account type, asset class, and growth and income needs.
7. Rules-guided rebalancing based on retirement glide path and multi-asset-class approach . Readjust the investment mix based on your changing personal situation and changing market values.
Sign up to receive my free monthly email articles...because you want to make the most out of your retirement
.
Here is a summary of the details backing this approach. Also, click here for more background information regarding my investment philosophy.
1. Values clarification and goal-setting
Investment planning for (or in) retirement starts with retirement planning. You start with thinking about your life goals...your dreams...your ideal life in retirement. It could involve doing no work, working part-time, or doing seasonal work. Your ideal life could be going back to school, spending more time with family, traveling, ministry, etc.
Ask yourself questions like, "What would I want to do if I
didn't need to work for money?" or "What are the most important
dangers, opportunities, and strengths I need to address?" or“Ten years from now, if I am looking back on a successful
ten years, what will I have achieved?”
This conversation allows you to create specific
goals around your most cherished values. And your goals will be unique to you.
You then design an investment plan to help you live your ideal life.
This kind of goal-focused, plan-driven approach minimizes the
chances of making bad investment choices based on current events and emotions.
Instead, you can choose and maintain the
specific mix of investments that can best deliver the results you need--using a
disciplined, research-driven approach.
2. Asset allocation glide path
The next major question is what kind of investments do you need to meet your goals. All investments have risk. Even "safe" investments over long periods have inflation risk. No single investment delivers growth, high income, and safety of principal. The key is designing a portfolio that balances them in a way that supports your retirement objectives.
And this mix may change over time. For example, for most people, it makes sense to gradually decrease their exposure to high-growth, high-volatility assets like stocks (i.e., equities) as they approach retirement. In retirement, it is usually best to maintain a flat equity glide path, dynamically adjusted for valuation. This approach protects you from the retirement-danger-zone risks of portfolio size effect and sequence risk, while allowing you to take advantage of bear markets and market corrections. See How to Navigate the Retirement Danger Zone .
Protecting your lifetime retirement savings from excessive taxes is a crucial part of holistic financial planning. This involves protecting your IRA, 401k, lump sum pension rollover, Social Security, and any other type of retirement account or income stream from crushing tax rates.
So let's be sure to differentiate tax preparation
from tax planning
.
Tax preparation , also called tax return preparation, looks backward, one year at a time, to get the numbers right to accurately calculate your tax liability (and how much you owe or overpaid).
Tax planning on the other hand looks at taxes in the context of your overall financial picture. A tax planner not only looks in the rear-view mirror but will look forward 20 to 30 years at your projected tax liability and ask what can be done to lower your lifetime tax bill.
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If you have savings outside of pretax retirement accounts invested in capital assets (like stocks, bonds, ETFs, mutual funds, precious metals, jewelry, and real estate) which have large unrealized capital gains, this article is for you. You may be missing the opportunity to pay zero taxes NOW instead of 15% or higher rates in the future. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
.
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Originally written on Aug 2, 2018 and updated for tax law changes.
If you are no longer working and have reached the age of 72,
you probably know about Uncle Sam’s rule for you to take a Required Minimum Distribution
(RMD) from your traditional and rollover IRA(s) each year for the rest of your life. You can always withdraw more,
but this requirement is the minimum
you must take or be severely penalized. Fortunately,
this rule does not apply to Roth IRAs. (The SECURE Act of 2019 changed the starting RMD age from 70½ to 72 starting in 2020, but fortunately you can still make a Qualified Charitable Distribution (QCD) starting the year you turn 70½.)
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.
If you have delayed paying taxes in your pretax IRA, 401(k), or 403(b), etc, there comes a time when the IRS wants their taxes. And if you don’t give them their taxes based on their required withdrawal schedule, you'll get hit with a 50% penalty on top of what you owed.
Along with Social Security and other retirement income, this RMD can significantly raise your tax rate. Also read How to Dodge the Social Security Tax Torpedo . There are not many ways to reduce this tax burden. In the past, retirees have used various deductions including charitable cash contributions and gifting of highly appreciated assets to charities. (The latter not only gives you, the donor, a deduction but also avoids a long-term capital gains tax bill.)
However, with the passing of the Tax Cuts and Jobs Act of 2017 (TCJA) , with its almost doubling of the standard deduction, itemizing deductions won’t make sense for near as many retirees. Ah, but there is still a strategy. But first let’s better understand the RMD.
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The latest book I am reading is “ The Psychology of Money ” by Morgan Housel. Chapter 3 is entitled “Never Enough”. In this chapter, Housel talks about when rich people do crazy things. He tells stories of wealthy people who never had a sense of enough and wrecked their reputations, families, freedom, and happiness because of it. I have also talked to older couples who tell me they once had a much better retirement in view, but the quest for more led them to make unwise investment decisions that left them financially crippled in retirement. The importance of knowing when you have enough is not only vital to when you retire but also how you retire. It can affect how you invest, how you withdraw, and your overall satisfaction before and during retirement. Be sure to read to the end where I summarize a few key takeaways. Housel makes the four following observations in chapter 3 of his book. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
.
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Whether you do mini-Roth conversions over several years or big Roth conversions in a few strategic years, the Roth conversion strategy could save you tens if not hundreds of thousands of dollars over your retirement. This article will get deep into the issues of Roth conversions for retirees and the ten steps to take to be sure it is done properly. Be sure to scan or read to the end where I will give you the simple answer to getting your Roth conversion questions answered. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
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Making big financial decisions immediately following the death of a close family member can be dangerous. It is often best to allow some time before tackling big financial decisions. On the other hand, some people find getting immersed in the finances is helpful in coping with the loss. Whatever way is best for you, you will need to give it your
careful attention to avoid big financial mistakes. The different types of accounts have different rules. I'll address the most common types. In the case of the death of a parent or anyone other than your spouse in which you are a non-spouse beneficiary, there are many rules that you must know to make the best decision for you and your family. (In this article, I use the common parent-child inheritance, but the planning strategies can apply to other non-spouse situations.) Your decisions can have major tax and investment consequences, both now and in the future. And some of these decisions have time deadlines keyed to your parent’s date of death. Also, some of these decisions are irreversible. You can download my free Estate Planning Survivor Checklist here
.
So, you don’t want to rush in and make decisions without knowing the rules, and you don’t want to wait too long and be stuck with fewer options. (In this article, I am not addressing estate taxes. As of 2021, only estates valued at $11.70 million or more are subject to federal estate tax. But there are plenty of other tax pitfalls to navigate around. I am also going to focus on liquid savings like investment and retirement accounts, versus real estate which will be for another time.) Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
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Delaying Social Security makes a lot of sense for many retirees; but there are common pitfalls that can cost you a bundle. As you know, the longer you delay your Social Security Retirement benefit, the higher your lifetime monthly payments are figured to be. This increase in delaying continues until age 70, after which there are no further increases for delaying. This increase for each month that you delay filing is not small, especially considering the current low interest rates. Even after full Social Security age, your payment goes up by 8% per year until age 70. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation . Here are the five big mistakes of delaying your Social Security retirement benefit. |
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Investment Advisory Services offered through JT Stratford, LLC. JT Stratford, LLC and Echols Financial Services, LLC are separate entities.
Serving Cumming, GA, Forsyth County, and the surrounding areas of John's Creek, Alpharetta, Milton, Duluth, Buford, Suwanee, Flowery Branch, and Gainesville
