Roth accounts can be a great way to save for retirement—and
it is getting easier to use them. Roths include both tax-sheltered individual
retirement accounts and company-sponsored 401(k) savings plans, and, as with
traditional versions of these accounts, assets grow tax-free. In many other
important ways, though, Roths and traditional plans vary considerably.
The biggest
difference: With traditional IRAs and 401(k) plans, savers typically
contribute pretax dollars and then owe tax at ordinary income rates on
withdrawals made after age 59½. But savers using Roth IRAs and Roth 401(k)s put
after-tax dollars instead of pretax ones into their accounts. Making the right choice depends on multiple
factors, including income, future tax rates and changes Congress could
make in the law. Here’s what you need to know.
Easier Access
Until recently, many affluent savers didn’t have access to
Roth accounts. Income limits set by Congress kept many people from contributing
to Roth IRAs, and Roth 401(k)s weren’t widely available.
Now that is changing. According to benefits firm Aon Hewitt,
millions of workers have the option of putting some or all of their 401(k)
dollars into a Roth 401(k). Out of nearly 400 large and midsize firms surveyed,
more than half now offer such an option, compared with only 11% in 2007—and Aon
Hewitt expects the number to grow.
In addition, the Internal Revenue Service recently issued a
ruling making it easier for workers to move after-tax dollars in a 401(k) plan
into a Roth IRA. And in 2010, Congress removed an income cap so that all
taxpayers can convert part or all of a traditional IRA to a Roth IRA. These
expanded options are likely to boost the trend toward Roth accounts. Although
traditional IRAs hold about $6 trillion—more than 10 times the assets that Roth
IRAs do—Roths are growing much faster.
Tax Breaks
In essence, savers have to decide whether it’s better to get
a tax break now for putting dollars into a traditional IRA or 401(k) plan, or
to put after-tax dollars into a Roth account and take tax-free withdrawals
later—perhaps in several decades.
The short answer:
If you expect your tax rate on withdrawals will be higher than or the same as
your current tax rate, a Roth account is often the better choice, experts say.
In general, many young savers should opt for Roth accounts. For
savers in their peak earning years, it often makes sense to grab the upfront
break a traditional IRA or 401(k) plan offers. Many savers appear to understand
this rule of thumb. At Vanguard, people under 30 are putting 92% of their IRA
contributions into Roth accounts.
At the same time, conversions of traditional IRAs into Roth
IRAs, which are fully taxable, peak between age 65 and 70 at Vanguard. Many of
the converters are probably retirees whose tax rate has recently dropped.
Tax Diversification
Many savers will find it hard to guess what their tax rates
will be in a decade or two, or to predict how Congress will revise the rules on
tax-sheltered retirement accounts.
In that case: First, make sure to reap whatever matching
funds an employer offers for retirement savings. Then, with tax consequences in
mind, apportion contributions over time among different buckets: one with
savings in Roth IRAs and 401(k)s, another with pretax savings in traditional
IRAs and 401(k)s, and perhaps a third with after-tax cash or investments.
Each bucket has different tax characteristics, and having
money spread among them can enable taxpayers to make tax-efficient withdrawals
in retirement.
Getting In
More people now have ways into a Roth account than just a
few years ago. Here is a rundown of the options:
Some people can contribute directly to a Roth IRA. For 2014,
savers can put in up to $5,500 (plus $1,000 if they are 50 or older). As with
many tax breaks, including traditional IRAs, there are income limits. Roth IRA
eligibility phases out for most married joint filers with adjusted gross income
above $181,000 and singles above $114,000. Unlike with traditional IRAs, the
ability to contribute to a Roth doesn’t end when a worker reaches 70½.
Savers also can convert all or part of their traditional
IRAs into Roth IRAs. As the transfer is fully taxable, experts recommend that
people do Roth conversions in years they will owe at lower rates and in amounts
that won’t push them into higher brackets—say, after the account owner’s
retirement, or when he is between jobs.
The good news with Roth conversions is that if circumstances
change, the taxpayer can undo them, up to a point. Savers who earn too much to
contribute directly to a Roth IRA can sometimes choose a “backdoor” Roth IRA.
To do this, the saver contributes after-tax dollars to a “nondeductible” IRA
and then converts it right away to a Roth IRA—so that there will be little or
no tax on the conversion.
One hitch: If the
saver has other IRAs holding pretax money, the conversion amount could be partly
or mostly taxable because the conversion is prorated among all the taxpayer’s
IRAs. One way to avoid this problem is to move pretax IRAs into a company
401(k) plan—assuming it is a good one—so that the backdoor Roth conversion can
be tax-free.
According to benefits firms and retirement-plan sponsors,
more employers now offer Roth 401(k)s that allow workers to put in all or a
portion of their retirement savings, up to $17,500 for 2014 (plus $5,500 for
those 50 and older). Contributions are made in after-tax dollars, while any
company matching is in pretax dollars. When the worker leaves and wants to do a
tax-free rollover, the Roth contribution and its earnings go into a Roth IRA,
while the company match and its earnings move into a traditional IRA.
Recently the IRS issued a ruling benefiting employees who
contribute after-tax dollars to a traditional 401(k) plan. When the worker
leaves and wants to do a tax-free rollover, the after-tax contribution goes to
a Roth IRA, but the company match, its earnings and earnings on the worker’s
after-tax contribution go into a traditional IRA.
The deadline for putting money into 401(k) plans is
generally Dec. 31, but savers can contribute to traditional and Roth IRAs for
2014 through April 15, 2015.
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