Clients Don’t Care About Roth vs. Traditional IRAs. So What?

Many financial advisors will object to the headline of this article, but advisors represent an incredibly small percentage of all taxpayers. Very few taxpayers care to be able to describe the difference between a Roth IRA and a traditional IRA. What they want to know is which option is right for them and what action they should take.

Here are some things advisors should keep in mind when helping their clients sort through the tax implications of their IRA accounts:

— The key is communication.

— A few key numbers.

— Going through the backdoor.

— Adding value for clients.

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The Key is Communication

For financial advisors committed to delivering massive value to the taxpayers they serve, the focus should be on simplifying these concepts. Instead of citing tax code and legal precedent or showing endless charts and graphs with complex calculations, great advisors use straightforward analogies that help guide decision making.

One classic example is to compare traditional and Roth IRAs to farming:

Let’s imagine that you are a farmer with four bags of corn seed that you could use to plant and then eventually harvest four fields of corn. In this example, the tax rate is 25%, but you have the option to either pay tax on your bags of seed now or on the fields when you harvest. If you wait to pay the taxes, you will be able to plant all four fields, and then the IRS will take one field at the end and you will only have three fields left.

If instead you pay your taxes up front, you will only have three bags of seed to plant and you will still only end up with three fields of corn. This is how the math works out on traditional vs. Roth IRAs if tax rates do not change between the time you plant and the time you harvest. Or between the time you contribute to a traditional or Roth IRA and the moment you start distributing funds.

On the other hand, if tax rates go up, by paying your taxes up front you have taken away the IRS’ ability to change the game along the way. If, between planting and harvest, tax rates go to 50%, the farmer who paid taxes up front will still get to keep all three fields they planted, and the farmer who opted to wait to pay taxes will have to give two of their four fields to the IRS.

Using an example like this to illustrate the difference between traditional and Roth IRA provides a framework for having a conversation about taking action instead of needing to provide a lesson in advanced mathematics.

There is absolutely a place for academic research that explores the range of possible outcomes based on changes in tax rates and market returns over time when comparing asset location in tax-deferred (IRA), tax-free (Roth) and taxable (pretty much everything else) accounts. That place is not a conference room table.

After laying this groundwork, a financial advisor can simply ask a taxpayer if they expect to be in a higher tax bracket in the future, whether that is because they expect to have more income or because they think it’s possible that Congress will increase tax rates. After all, tax rates can only do one of three things: go up, go down or stay the same.

[Read: A Guide to Your IRA.]

A Few Key Numbers

While it’s not necessary to give a math lecture when explaining the differences between tax-deferred and tax-free investing, there are certain key numbers that need to be remembered:

$6,000 ($7,000 for those 50 and older). The amount that can be contributed to IRA and Roth IRA accounts each year per person. This is a combined total between the two types of accounts. So a taxpayer can contribute $4,000 to a traditional IRA and $2,000 to a Roth IRA, but not $6,000 to each.

$20,500 ($27,000 for those 50 and older). The amount that can be contributed to a 401(k) or 403(b) account each year per person. This limit is separate from the IRA/Roth IRA limit above, so a taxpayer can contribute the maximum to each separately. This limit also does not include employer contributions to these accounts, which significantly increase the amount that can be contributed.

59½. The age at which there is no longer a penalty to distribute money from an IRA or Roth IRA. Distributions from an IRA are still subject to ordinary income tax rates, but distributions before the age of 59½ are subject to an additional 10% penalty in most cases.

$214,000 for married filing jointly ($144,000 for single filers). The modified adjusted gross income ceiling for being able to contribute to a Roth IRA. Over this amount, taxpayers can no longer conventionally contribute to a Roth IRA.

There are other numbers to consider, but these come up most often. An important reminder on communicating to prompt action is to talk about contributing to an IRA or Roth IRA in terms of what it can mean over time, not in a single year. For most people, an extra $6,000 is unlikely to change their retirement. Instead, frame the conversation around making the contributions every year over 10 or 20 or 30 years. Talking about $60,000, $120,000 or even $180,000 helps illustrate the power of these accounts.

Going Through the Backdoor

Roth IRAs can be an incredibly powerful tool in building wealth for the future, but as mentioned above, there are income limits on who can contribute directly to a Roth IRA. Once a taxpayer exceeds the thresholds mentioned, there are extra steps required to put money into a Roth account. This process is known as a “backdoor Roth” contribution. The name may imply that it is less than reputable, but it has been acknowledged as an acceptable strategy by the IRS. The name comes from the fact that the strategy was created by accident by Congress.

To make a backdoor Roth contribution, a taxpayer makes a non-deductible contribution to a traditional IRA and then converts the balance to Roth as a second step. There are landmines that have to be carefully navigated in this process, but it is a strategy that is successfully carried out by numerous great advisors every year. IRS form 8606 is a key reporting tool for making these contributions and converting them into Roth accounts. The form should be well understood by an advisor before recommending this strategy to a client.

Adding Value for Clients

Traditional vs. Roth may seem like low-hanging fruit when it comes to financial planning, but low-hanging fruit needs to be picked, too. This topic makes for easy headlines, so many of your clients are bombarded with information that does not answer the question of what they should do in their specific situation. They are left wondering what action is right for them and whether anyone is looking out for them on this topic.

Great advisors can set themselves apart by educating their clients, recommending a course of action and then reviewing that action plan each year. Even in years where no changes are needed, make sure clients know you have taken the time to review their situation and ensure they are still making the best decision. Providing peace of mind has value.

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