Using Roth Accounts in Retirement
Roth IRA's and Roth 401k's have become popular investment vehicles to build wealth. They have many facets and rules around them, but ultimately their flexibility to distributions and income planning is something we will discuss. As a follow up from my last blog on Roth IRA history, these have not been around that long. So for many soon-to-be, or already retired investors, there are still opportunities where they can work. So let's dive into how Roth accounts can be used in and through retirement.
The first consideration of Roth accounts is the Tax-Free nature. Meaning if you invested $50,000 over 10 years and grew the account to $100,000, that $50,000 of growth can be accessed Federally and State income tax free! This is without a doubt the primary driver for Roth accounts.
Paying Tax Now - Roth Conversions: A very common tool used for many is the Roth conversion; where an investor can convert money that would be taxable (such as a 401k, IRA or SEP IRA) into a Roth IRA. The trade-off is you report the income now, and include that as taxable income. An example: Investor has $150,000 of an IRA, if they decide to convert $25,000 to a Roth IRA this year, they will show they had $25,000 of income this year. However, then the $25,000 can grow tax-free inside the Roth IRA for future use. But there are some key considerations:
- There is an IRS 5 Year Rule on Roth conversions (especially under age 59 1/2): If you convert a portion of your IRA to a Roth IRA, you have to wait at least 5 years until you can access those funds. There is consideration if you are over 59 1/2, however, you do have to count each conversion seperately (if you convert small portions over several years) in their own 5 year segments.
- There is no annual income limit to converting to a Roth. Any incomes can take advantage.
- Ideally, the longer you can grow money in a Roth IRA, the better, meaning starting earlier at a younger age.
There are many other issues such as total taxable income, capital gains rates, Medicare premiums, and other credits and deductions to be aware of before converting an IRA to a Roth. Please discuss with your tax planning professionals
The One Time Big Purchases: Where I see a lot of retirees taking advantage of Roth IRA's is for bigger one-time expense items, such as buying a new car, home renovations, travel, emergencies, etc. As mentioned before, because this money is tax-free, there is no worry or concern over taking out too much, or wondering what to account for that would be taxable. Most pre-retirees don't have a long time to "Build Up" a large Roth IRA balance, so an investor with even $20,000 or $40,000 in a Roth IRA can utilize this account for bigger expenses, instead of selling stocks/ETFs in a taxable account, or taking distributions from an IRA/401k that would be counted as income.
Living Longer Than you Expect: Another important and valuable benefit to Roth IRAs (and even now Roth 401k's) is that you have no Required Minimum Distribution at any age. Unlike IRA's, whereas the IRS mandates distributions (age based) beginning at 73 or 75 (depending on your age), Roth IRA's can continue to grow as long as you live. This can be a great advantage given people are living longer. As an example, if a Roth IRA has a balance of $150,000 at age 65, and assuming an average growth rate of 7%, that Roth could be worth $600,000 by age 85. Providing a great hedge for investors and retirees to provide for income if they do live longer than they planned (which is highly likely).
Inheritance to Heirs:Most investors and retirees have the goal to leave assets to their children and/or family. But not all accounts are treated the same. IRAs and 401k's left to heirs will be counted as taxable income when distributed. That alone could affect the dollar amount, as well as the overall tax situation of the recipient to the accounts. Thanks to Roth IRAs being tax-free for the owner, the money can be withdrawn tax-free for heirs as well. That alone is why "Which Account" and "To Whom Do I leave it" is an important part of my estate planning with clients. Some heirs would benefit from Roth IRAs more than others, and some would benefit from taxable accounts like IRAs or 401k's.
Not to mention, Roth IRAs can serve as a great vehicle to provide supplemental income throughout retirement. Many investors, like myself, fund Roth accounts to diversify their accounts and how they are taxed. No one can predict tax rates in the future and knowing you have some money that is fully avoiding being included as income, and taxed as such, is a big advantage.
If you ever wonder how your own Roth IRAs or converting to Roth IRAs could benefit you, and if it's necessary, please do not hesitate to reach out to discuss.