As a recovering CPA, I am wired to view financial matters from a tax perspective. In many of my recent planning meetings, the importance of tax planning in retirement has become very evident, especially for those who have used the strategy of pumping as much as possible into their tax deferred retirement accounts during their working years. This is generally where people realize the benefit of funding a ROTH IRA.
Tax Deferred Retirement Accounts
Examples of tax-deferred accounts would be your typical employer sponsored retirement plans (401(k), 403(b), SEP IRA, SIMPLE IRA). Even if you’re not part of an employer-sponsored retirement plan, you can contribute to a traditional IRA and still take advantage of a deduction and tax-deferred savings. These accounts provide an immediate tax benefit but are taxable during retirement when you pull from your accounts. Therefore, if the only savings you’ve accrued over your lifetime has been in tax deferred accounts, then everything you withdraw during retirement is taxable ordinary income. You can see where this could start to cause problems. One of the greatest benefits of a traditional IRA (outside of its tax-free growth and deductible contributions) is the investment options available as well as the flexibility of being able to control what you take or leave in the account.
For example, imagine you’re retired and you find that you and your spouse will need a new car, with all the traveling you’ve been doing. It is important to you to be able to travel safely to see the kids and grandkids. If most of your assets are in the traditional IRA, whatever you pull out for the car purchase, will likely need to be increased by 20% or so to properly withhold for State and Federal taxes. When you started thinking you may need $20,000, you may actually need $25-30k, depending on your tax bracket. This is where having a ROTH IRA becomes very attractive.
Roth Retirement Accounts
Roth Accounts work in an opposite manner than the traditional tax deferred accounts. You will not receive an immediate tax benefit for anything you’re contributing. So, if one of your primary planning concerns is minimizing taxes, then you and your advisor will likely rule that out of the planning process. Just like the traditional IRA, your Roth grows tax free, so you’re not paying capital gains or taxes on dividends and interest on earnings from the Roth IRA. In addition, you also get the same benefit of having a large menu of investment options. However, perhaps the most beneficial part of the Roth IRA is the ability to take advantage of that tax-free growth while being able to withdraw the funds tax free, that’s correct, no tax. Also, as long as the Roth IRA is titled as yours and was not inherited, you are free from having to take required minimum distributions once you reach 70.5. In addition, once you have opened and funded a ROTH IRA, if you are able meet the 5 year rule (another topic for later), then you can draw from the ROTH penalty free without being taxed on earnings (you must meet age requirements and fund/hold the account for 5 tax years). More and more employers are now offering a Roth option for contributing to your employer sponsored retirement plan as well.
Why does this matter?
You may be thinking, this is all information that I know or don’t care to know, so why does it matter? Well, let’s use the example from the beginning and look at it from a tax perspective.
Let’s say you had funded both a Roth IRA and a traditional IRA throughout your working years and have accrued $500k in each account (Total Retirement Savings of $1M). Let’s assume you’re married and you need to draw 5% per year or $50,000, to meet your annual retirement needs. You have combined social security benefits of $30,000 and pension income of $25,000/year. You currently have an annual income of $105,000/year, of which 85% of your social security benefits are taxable. After deductions and exemptions of roughly $20,000, you have taxable income of approximately $80,000 ($100,000 taxable income less $20,000 of deductions). If we use the 2016 tables, you’re looking at having taxable income just over the $75k threshold in which you enter the 25% bracket, and paying taxes of roughly $11,500. This is assuming you have taken all $50k from the traditional IRA. However, since you proactively worked with your financial advisor during the years leading up to retirement, you could drastically change these figures.
If you took $25k from the ROTH and $25k from the traditional, how would that change? Well, your taxable income is now reduced by $25,000 ($55k); keeping you well within the 15% tax bracket and paying a total of $7,500 in taxes, a savings of 35%.
You can see that having the flexibility of using after tax or ROTH funds in retirement can make a huge difference in your overall tax liability, which in effect, will help preserve your nest egg and overall asset growth. And if you happen to draw out emergency funds or money for a new car, you will prevent yourself from taking out more than you need and prevent more funds from going to the government.
Should I open a Roth IRA?
This completely depends on your unique situation and tax rate. The future of tax rates are unknown and we know for a fact we can save in a tax-deferred account today and invest those savings. However, some people may end up in higher tax brackets during retirement compared to working years (not common but there are instances) and drawing from a ROTH tax free in a higher tax bracket would be to their benefit. In addition, Individuals who exceed certain income levels are not permitted to open and fund a Roth IRA, so it’s not a viable planning option for everyone. If you’re interested in opening a Roth or traditional IRA account and would like some more information, please reach out to me or the Scannell Wealth Management Team at (219) 531-4941 and we can help you get started.
John M. Lauer, CPA, MST
(John is a licensed Certified Public Accountant (IL and IN) and has extensive professional tax knowledge, including public accounting experience and experience as a Global High Wealth IRS Auditor)
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