There are a variety of options available to investors that can help them maximize and stretch their individual retirement account income during their golden years, providing greater financial health, flexibility and longevity.
The key to successfully stretching assets is pre-planning and strategic decision-making during working (accumulation) years. The following are a few strategies investors could consider when thinking about maximizing their IRA income.
Traditional versus Roth. Most savers are aware of the differences between traditional IRA and 401(k) accounts and Roth IRA and 401(k) accounts. While there are many distinct differences that should be carefully discussed and reviewed with an accountant prior to making a decision, a key distinction is that traditional accounts are funded with pre-tax dollars whereas Roth accounts are funded with post-tax dollars. This means that savers in a traditional retirement vehicle get a current tax year benefit in addition to long-term compounding without the impact of annual taxes.
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Distributions from a traditional account are taxed as ordinary income the year in which they are taken. By contrast, Roth contributions are post-tax dollars so they do not provide a current tax year benefit, but these accounts also accumulate without the impact of annual taxes. Moreover, qualified distributions from these accounts are completely tax-fee.
A simplistic way of thinking about Roth contributions is that you are pre-paying the taxes by funding the account with post-tax dollars, so you can remove that uncertainty and tax expense later when you withdraw.
There are numerous free calculators available online to help savers decide which type may be best for them from a savings perspective; however, there is another important difference that should be considered as part of that evaluation, and most calculators fail to incorporate it. Traditional IRA accounts have required minimum distributions (RMDs) whereas Roth accounts do not. This means that an investor who reaches age 70½ does not have to take funds out of their Roth account unless they want or need to. This means that, provided they have other income streams to use, they can let these Roth funds accumulate indefinitely.
Purely for illustration’s sake, imagine that an investor lives to age 80 or even 90, an additional 10 to 20 years. Growing without the impact of annual taxes or RMDs, these Roth funds have the potential to double, or even more than double, during these years. Even if they are tapped prior to age 80 or 90, the fact that the saver wasn’t required to take RMDs allows the account to further grow and therefore stretch, providing greater financial freedom and flexibility.
Pre-planning during the accumulation years is a key part of stretching an investor’s retirement accounts. Naturally, choosing which annual contribution path (traditional versus Roth) is critical. Saving early and often in a Roth account — should that prove to be the optimal strategy for the saver based upon their needs, income level, taxes, etc. — is important to growing a substantial Roth balance.
However, there are both income and contribution limits to these accounts that preclude many from taking advantage of this valuable benefit. For tax year 2018, couples who are married and filing jointly are unable to contribute to a Roth if they make $199,000 or more. So does that mean this account option is completely closed for higher net worth families? Surprisingly, no.
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The back-door Roth IRA. While the newly passed Tax Cut and Jobs Act of 2017 did not remove the adjusted gross income qualification limits mentioned above for Roth contributions, it did continue to allow a valuable back-door Roth opportunity for higher income families by expressly allowing the conversion of traditional IRA assets. This means that higher income families still have the ability to store away nuts for winter in a Roth.
It’s important to note that any conversion of retirement assets should be thoroughly evaluated with an accountant or tax expert since the conversion of pre-tax traditional contributions to post-tax Roth contributions will create taxable income in the year in which they are done. However, investors can work with an advisor to strategically plan out how to spread the tax burden over multiple years by converting in stages, and if income fluctuates widely from year to year, they can take advantage of lower income years for potentially larger conversions, as they may be in a lower than normal tax bracket.
While the back-door Roth is not a new strategy, it was expressly preserved in the 2017 tax law when many had expected the door to be slammed shut. In thinking about the back-door Roth IRA option, the most significant restriction which investors should know about is the five-year rule for Roth IRA withdrawals. In short, an investor must have owned their Roth IRA for five years in order to withdraw earnings tax free during retirement. This rule applies not just to Roth contributions but to Roth conversions as well, and the five year “clock” starts from the tax year of the conversion.
Ultimately, the type of IRA you choose can have a significant impact on your long-term retirement savings and future financial goals, which is why understanding the differences and benefits between IRA options is critical.
One of the many benefits of working closely with a financial advisor is the ability to craft a financial plan to thoroughly explore and understand savings options while there is still time to take advantage of them. Whether retirement is decades away or right around the corner, improved financial health and agility is possible, but only with advance preparations.
[See: 7 Classic Inflation Hedges and Their Thorns.]
D.A. Davidson & Co. is not a tax advisor. Before investing in any IRA, consult with your personal tax advisor about the specific tax consequences and advantages of your situation.
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How to Maximize Your IRA Income originally appeared on usnews.com
