Benjamin Franklin had it right when he wrote in 1789 that “nothing is certain except death and taxes.”
However, just because taxes are inevitable does not mean that we cannot manage them wisely.
The Tax Cut and Jobs Act that took effect on Jan. 1, 2018, was a gift to large corporations – reducing the maximum corporate tax rate from 35 percent to 21 percent. For the average taxpayer, the tax law changes were less favorable.
To keep your future taxes low, I recommend you consider the many benefits of using three different tax buckets and maximizing your Roth IRA bucket.
Bucket #1 has been the preferred way to save for retirement for the past 45 years. It contains the traditional IRA, 401(k) and 403(b); and the earnings are tax “deferred.” This is a great strategy as long as you assume you will be in a lower tax bracket when you retire, but this is often not the case.
Social Security benefits and pensions are taxed, and when you turn 70½, you are forced to take Required Minimum Distributions (RMDs) that are taxed as income.
The most common mistake I have seen in my 20 years as a financial planner occurs when people save consistently in Bucket #1 (their 401(k) or IRA), but they do not have a Bucket #2 or #3. Many people never think about saving in a taxable bucket (Bucket #2) even though this offers tax benefits because capital gains (the earnings on investments in taxable accounts) are taxed at a low 15 percent for most people. Many people have a small bank account, but they do not have a taxable investment account.
Bucket #3 has only been available for 21 years, so many retirees do not have a Roth IRA. In recent years most corporations have started offering a Roth 401(k) or a Roth 403(b) for their employees, and this is a great way to fund a Roth if you are still working.
In my view, Roth IRAs, Roth 401(k)s and Roth 403(b)s are preferred over other investment accounts. The earnings are tax-free (as opposed to tax-deferred in traditional IRAs). Roths do not provide a tax benefit when they are funded, but the future years of tax-free growth and tax-free withdrawal make them far superior to traditional IRAs.
Funding a Roth IRA has income limitations. For 2019, a single person can earn up to $122,000 and a married couple can earn up to $193,000 and still fund a Roth IRA.
If you are under age 50 you can contribute $6,000 for the 2019 tax year, and if you are age 50 or over, you can contribute $7,000.
However, a Roth 401(k) or Roth 403(b) offered by your employer does not have income limitations. I strongly recommend you fund the Roth version rather than the traditional 401(k) or 403(b). If possible, I suggest you fund it to the maximum allowed in 2019, which is $19,000 for someone under age 50 and $25,000 for someone who is 50 or over.
The Roth IRA has many benefits in addition to being tax-free when withdrawn. Unlike a traditional IRA, which requires an RMD each year beginning at age 70½, the Roth IRA does not require any distributions during the owner’s lifetime. This allows the Roth IRA to continue growing tax-free for a longer period.
Another great way to fund a Roth is to convert a traditional IRA to a Roth IRA. There are no income limitations for doing a conversion, but the amount converted each year is added to the taxable income for that year. This may push you into a higher tax bracket, making the Roth conversion less attractive. However, keep in mind that you can convert a small amount each year.
Roth IRAs are great for young people, and parents and grandparents can fund them for children and grandchildren. The only requirement is that the young person must have earned income that is reported on a tax return equal to the amount contributed to the Roth (up to $6,000 for 2019).
Retirees cannot fund a Roth IRA if they do not have earned income, but they can convert from a traditional IRA to a Roth IRA at any age. The only requirement is that they must take their RMD first (in the year they are doing a conversion) if they are over age 70½.
For details on the five-year rules pertaining to contributions or conversions, and on “back-door Roth IRAs,” see thejoyoffinancialsecurity.com/taxes.pdf.
Roth IRAs offer benefits over many years, and they are a valuable tool in saving money on future taxes. Start filling Bucket #3!
Bucket #3 in action
My favorite example of converting gradually into a Roth IRA involves one of my clients.
We began converting her traditional IRA to a Roth IRA in 2003 and completed it in 2017. We managed her tax rate along the way. She now has a Roth IRA that is over $600,000, and she no longer has a traditional IRA – therefore, she no longer is required to take an RMD each year.This has reduced her taxes considerably, and the tax benefits will continue for the rest of her life. If she wants to take a withdrawal from the Roth IRA, it will be tax-free.
She has named her children as beneficiaries for the Roth IRA, and inheriting a Roth IRA provides tax benefits to beneficiaries.