Unlike a traditional Individual Retirement Account, a Roth IRA is funded with money that has been taxed at the outset – but once funded, the account can grow and (so long as certain rules are followed) is never taxed again. Those tax-free distributions may seem like a huge advantage over a traditional IRA, in which the proceeds are taxed when you withdraw them, but they’re really not. According to financial advisor Michael Kitces, when you compare IRA values in retirement based on the pretax income needed to make the original contributions, the returns are always the same if tax brackets haven’t changed.
By that logic, a Roth makes more sense than a traditional IRA only if you’re likely to pay a higher tax rate in retirement. There are caveats, of course. The requirement to take distributions from traditional IRAs can alter the calculation somewhat, as can making the maximum Roth contribution. Still, writes Kitces, “if the future tax rate is anticipated to decline more than 10% or so, it is unlikely the Roth IRA will be favorable except in the most significant multi-decade deferral periods” — that is to say, over the very longest term.
As with a traditional IRA, the maximum contribution to a Roth account is currently $5,500 a year (with an additional $1,000 catch-up contribution allowed for people age 50 and over). But there are also limits on gross income ($131,000 for a single filer, $193,000 for a married couple) that make it harder (but not impossible, as we’ll see) for high-earning individuals to have a Roth account. In 2010, restrictions on how much money can be converted in a year from a traditional IRA to a Roth account were lifted. Plus, there are no limits on income eligibility for a Roth conversion. These rules essentially open a back door for high earners to contribute to a Roth account by funding one through a conversion from a traditional IRA. (For more on this, see Pros and Cons of Creating a Backdoor Roth IRA.)
You’ll have to pay taxes on the deductible pretax money used to fund a traditional account when you convert it to a Roth. Many advisers recommend adjusting the conversion to your expected income tax bracket, so you don’t wind up bumped into the next bracket. For example, if you’re single, with a taxable 2015 income of $70,000, you’re comfortably in the 25% tax bracket – and you can convert (and pay tax on) $20,750 from a traditional IRA and stay in the 25% bracket. But if you convert, say, $25,000, you’ll pay 28% on the additional $4,250. The tax difference isn’t huge – the extra 3% will cost $128 – but, as any adviser will tell you, every dollar counts.
If a Roth makes sense for you, here are more strategies to make the most of it:
Start Young.By beginning to save with an IRA early in life, you make the most of the snowballing effect of compound interest: Your investment and its earnings are reinvested and generate more earnings, which are reinvested and so on. Especially for Roth accounts, the longer your money has to compound tax-free, the better off you are. And don’t delay getting started if you can’t contribute the maximum amount. “You have to start somewhere,” says Shashin Shah, a financial planner in Dallas. “Even if it’s $25, start with $25. Just so you get into the habit.” Then as you move up in your career, you can increase your monthly IRA deposits.
Don’t Wait Until April 15.When you fund your Roth on tax day, you're missing the chance to grow your contribution for as long as 15 months – and you risk making that year’s entire investment at a market high point. Funding your Roth IRA in a lump sum at the start of the tax year at least allows the contribution to compound for longer, though the risk of buying at a peak remains. Instead Shah recommends dollar-cost-averaging – making equal monthly contributions throughout the tax year, and buying whether the market is up or down. “It takes the guesswork out of timing the market," says Shah. What’s more, regular contributions instill discipline in investing. “One of the big secrets for investing long term at any level is having the consistency,” he says.
Consider Asset Location to Save on Taxes.For people with just one retirement account, your investment goals determine what you invest in. (If you’re investing in equities, advisers typically suggest index or exchange-traded funds with very low expenses and other fees.) But for more sophisticated retirement planning, financial advisers more and more recommend spreading retirement investments across accounts based on how they’ll be taxed, a strategy known as asset location. Traditionally, relatively tax-inefficient income-earning bonds have gone into IRAs while stocks and other assets that generate capital gains, which get a tax preference over income, have been put into taxable accounts.
But in practice, stock strategies aren’t always tax-efficient, according to financial advisor Kitces. What’s more, where you place an asset depends not just on tax efficiency but also on anticipated returns and your own circumstances – high-return but inefficient assets, like an actively managed mutual fund, are better served by an IRA, while index funds, say, might benefit from being in a taxable account. Meanwhile, lower-return assets, like many bonds, can go anywhere. In any event, this type of asset distribution should not alter an overall allocation strategy.
Because all Roth gains are tax exempt, advisers like Shah say it particularly rewards the most aggressive, high-growth investments, especially those that can be held for a very long time – 30 years or more.
Use Roth Money Last.Unlike with a traditional IRA, the original account holder of a Roth never has to take a distribution. That means the assets can continue to compound unabated and grow even larger. The longer a Roth account is untouched, the bigger its advantage over a traditional IRA.
Leave Your Roth IRA to Someone.One day you will die, but your Roth can live on – if you name a beneficiary. If you don’t, your retirement account will be subject to probate fees – and, potentially, creditors, if you have any – and the account must be liquidated in five years. A beneficiary, on the other hand, can stretch out tax deferral by taking distributions based on how long he or she is expected to live. (A beneficiary must take distributions from an inherited IRA, even a Roth.) Also, a spouse can roll over an inherited IRA into a new account and not have to begin taking distributions until age 70½. (A spouse can then leave the account to a beneficiary of his or her own, which recalibrates the distribution requirement.) If you want to name more than one beneficiary, it’s best to divide your IRA into separate accounts, with one for each person named.
The Bottom LineThe tax-free growth of your investment in a Roth IRA already makes it an attractive way to save for retirement. But a savvy investor will use additional strategies to build the biggest nest egg possible. While these strategies may be straightforward, putting them into practice may be anything but. Fill out any forms carefully, and if you have any doubts about the best approach for you, consult with a financial pro.
You may also be interested in reading The Best Strategies to Maximize Your IRA and The Best Strategies to Maximize Your 401(k).
Read more: The Best Strategies to Maximize Your Roth IRA http://www.investopedia.com/articles/personal-finance/112915/best-strategies-maximize-your-roth-ira.asp#ixzz3szhp8mUB
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