Since early this year, we’ve heard all sorts of ways to describe 2020: interesting, weird, unprecedented and so on. It has been a damaging and frustrating year globally. However, this year has presented some opportunities for certain investors to save and invest differently for the future, including opening the door for more people to consider a Roth IRA as part of their retirement savings strategy. This piece aims to get you thinking about some of the options available to you, depending on your specific situation.
Before we get started, a Roth Individual Retirement Account (IRA) is a retirement account in which a person contributes after-tax money. It has the benefit of having these savings grow tax-free; and when it’s time to make withdrawals, those are also tax-free.
There are rules on when you can make withdrawals, along with some other exceptions to the tax-free treatment, but those particulars aren’t the focus of this article. My focus is on setting out some of the factors you should consider when weighing whether 2020 is an opportune time for you to open a Roth IRA.
Here are some potential scenarios:
1. Your income has dropped, and you are in a much lower tax bracket than prior years.
This might be a temporary situation, and you expect things to become more “normal” as we head into a new calendar year. The idea here is: Maybe you should consider funding a Roth IRA to save for retirement this year versus using a traditional IRA. With a traditional IRA, contributions are deducted against income on your tax return, deferring income tax on that money until you withdraw it in the future.
With a Roth, you are taxed on the earned income in the calendar year; the contributions you make are after-tax. If your income has fallen substantially this year and you find yourself in a lower tax bracket, it might be advantageous to pay the tax now, versus deferring it to years when you may face higher tax rates.
2. You’ve already made a traditional IRA contribution this year, but will not be eligible for a partial or full tax deduction for this contribution.
A saver may find themselves in this situation if they or their spouse are currently covered by a retirement plan at work. If that is the case, then the deduction may be reduced or eliminated if you make a certain level of income. In this case, you should consider recharacterizing all or part of the contribution to a Roth IRA. But keep in mind that doing any recharacterization from a traditional IRA to a Roth IRA requires careful attention to the rules. We strongly suggest you discuss this with your adviser or tax preparer before moving forward. If you choose to do this type of transaction, it cannot be undone.
3. You’ve found that you have extra money to save this year for retirement.
If so, consider a Roth IRA. There are income limits to making a direct Roth contribution, and you will want to make sure your income doesn’t disqualify you. If you find yourself above the income limits, there is a way to make what’s called a backdoor Roth contribution. In a backdoor Roth IRA contribution, you deposit after-tax money into a traditional IRA and then immediately convert the traditional IRA into a Roth. However, be sure to consider whether you have other traditional or rollover IRAs. These may create taxable income that needs to be factored into the decision to make a backdoor contribution. Pursuing a backdoor Roth contribution generally works well if you have little to no money in traditional IRAs.
4. On your tax return, you have operating losses that reduce taxable income.
In many cases, these losses result from owning a business or certain types of investments that lost money, and they could put you into a lower tax bracket than you’d normally be in. Be sure that you don’t confuse this with traditional capital gains or losses from securities. If you find yourself in this position, ask yourself this question: Do I have a tax-deferred retirement account, and should I move some of that money into a Roth now versus getting taxed in the future?
5. You did not need your required minimum distribution (RMD) this year and fall in a lower income bracket now as a result.
Earlier this year, the CARES Act waived requiring minimum distributions from tax-deferred accounts in 2020. You might have chosen not to take a distribution from your IRA as a result, and that could lead to you having lower taxable income in 2020. If you did not take your RMD and your taxable income is much lower, as a result, it might make sense to convert some of your expected RMD to a Roth for future years. This scenario mainly applies to those who can stay in lower tax brackets even after converting some of the funds.
It is important to keep in mind this article is not exhaustive in the factors one needs to consider before pursuing a Roth IRA. There are numerous reasons why you may not want to consider a Roth IRA at this juncture. For example, you might be moving to a no-income-tax state in the future. Or you need to keep your income lower because you’re applying for financial aid for college. Or you don’t have the money to pay the income taxes from cash since the conversion would come with taxes owed.
And yet: 2020 has been disruptive — and it just might have opened an opportunity to you to consider a Roth IRA.
Brian Spinelli is based in Halbert Hargrove (opens in new tab)’s Orange County and Long Beach offices. His responsibilities encompass running the firm’s investment committee as well as advising individuals and institutions on their investment and wealth advisory needs. Brian was named to HH’s management team in 2012. He earned his Bachelor of Arts in Business Administration – Finance from Loyola Marymount University in 2002 and his MBA from LMU in 2005. He is a CERTIFIED FINANCIAL PLANNER™ professional. Halbert Hargrove is the creator of LifePhase Investing and headquartered in Long Beach, Calif.
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