In a world filled with IRAs, 401(k)s, and brokerage accounts, what is the appeal of a Roth IRA? Unlike a traditional IRA, when funds are withdrawn from a Roth IRA account they are tax free because taxes have already been paid on the money at the time contributions were made. With the traditional IRA, funds are contributed pre-tax so when money is withdrawn from the account it is taxable at ordinary income rates. So the question becomes, pay tax now or later?
Since 1998, individuals have been eligible to make contributions directly to a Roth IRA, however, eligibility has been subject to income limits. In 2016, if a married couple filing a joint tax return had adjusted gross income over $194,000. they would not be eligible to make contributions directly to a Roth IRA. For individuals who may not have been eligible to contribute or have otherwise accumulated traditional IRA funds either by contributions or through a 401k rollover from a previous employer, there is the option of a Roth conversion to create future tax-free earnings and income. As Michael Kitces mentions in an article, “the caveat, of course, is that doing the Roth conversion forces the value of the account to be reported as income today, triggering an immediate tax liability. To come out ahead, the current tax rate at the time of conversion must be lower than what the marginal tax rate would be in the future.”
The good news is that there’s no requirement to convert the entire pre-tax account in one transaction. Individuals can strategically evaluate partial Roth conversions in coordination with tax bracket planning to determine what amount of pre-tax funds may be converted without pushing the individual into a higher tax bracket. This strategy is best used on an ongoing basis to take advantage of filling up lower tax brackets now to potentially avoid higher tax brackets in the future.
If you are considering a full or partial Roth conversion, speak with your financial advisor about an optimal strategy, or call Sharkey, Howes & Javer at 303-639-5100 to set up a complimentary consultation.