07-28-2014 09:00 AM
Content provided courtesy of USAA.
Tax-free income in retirement: That's what Roth retirement accounts are all about. And that's why, when you're choosing an IRA or enrolling in a retirement plan, you should consider what a Roth could do to brighten your retirement picture.
The Roth Rundown
First, it's important to understand their appeal.
"That starts with the fact that qualified withdrawals are completely free from federal income tax," says Sean Grindall, assistant vice president for USAA retirement and wealth solutions.
That means every dollar in your Roth can be used for your retirement needs — unlike traditional IRAs and 401(k)s, where withdrawals generally come with a tax bill attached. Roth IRAs also boast these benefits:
- No required minimum distributions. Most tax-favored retirement accounts require you to start withdrawing money — and paying taxes — once you reach age 70½. That's not the case with Roths, which means your money can be left to grow.
- Tax-planning flexibility. With their ability to allow tax-free withdrawals, Roths give you a powerful tax tool in retirement. For example, if your total income need for one year threatens to boost your tax bracket or trigger taxes on your Social Security benefits, you can dip into your Roth instead for funds that won't add to your tax bill.
- A way to leave a potentially tax-free legacy. Beneficiaries of traditional retirement accounts don't just inherit your money — they inherit a tax bill. With Roth IRAs, you might be able to leave an inheritance free from income tax. "With proper planning, Roth IRAs can even stretch tax-free income over multiple generations," Grindall says.
How to Add a Roth
Interested in adding a Roth to your retirement mix? Here are three ways to do it:
- Contribute to a Roth IRA. For both 2013 and 2014, you can contribute 100% of your taxable compensation up to a maximum of $5,500; if you'll be 50 or older at year's end, the limit is $6,500.
- Participate in a Roth employer plan. Historically, most employee contributions to work-related retirement plans have been made on a pretax basis. Today, many employers provide a Roth option. Like contributions to their Roth IRA cousin, a Roth 401(k), 403(b) or Thrift Savings Plan doesn't reduce your taxable income, but each offers potentially tax-free withdrawals in retirement.
- Convert. Anyone can move money to a Roth IRA from a traditional IRA or a 401(k) from a previous employer. Recent tax-law changes also permit employers to offer Roth conversions to their plans' participants. If you're interested, check whether your employer allows in-plan conversions. You'll pay a price for the potential of future tax-free income: Generally, you'll owe income tax on the money you convert to a Roth.
- Crunching the numbers. Converting typically makes sense when you'll be in a higher tax bracket after you retire than at the time of the conversion. Having a mix of both Roth and pretax retirement money may help you avoid investing all your money in a way that bets on a single assumption about future tax rates.
Before converting, Grindall advises considering:
- Your ability to pay the taxes. Since converting to a Roth generally triggers a tax bill, you need funds available to pay the IRS. Generally speaking, converting only makes sense if you have money outside of your IRA to pay the taxes.
- The impact on your tax return. Conversions raise your adjusted gross income, which affects other parts of your tax return. For example, a higher income could reduce your ability to deduct large medical expenses. "Fortunately, you don't have to convert your entire balance," Grindall says. "If this is part of a long-term plan, you may want to convert gradually over the coming years."