Saving for retirement is essentiual for everyone to start as early as possible. It is when our circumstances change that we need to consider the most effective and tax efficient manner of achieving our retirement goals. Switching from a tradional 401 K IRA to a ROTH IRA may be the answer , but there are various considerations to be taken into account before making the change.
Let us first understand the fundamental difference between a tradional IRA (Individual retirement account) and a ROTH IRA is an Indivudual retirment account named after former Delaware Senator William ROTH, that allows qualified withdrawals on a tax-free basis provided certain conditions are met.
The fundament difference between the two are that with a ROTH IRA contributions are made with after tax Dollars, growth is tax-free, and you can generally make tax- and penalty-free withdrawals after you reach the age of 59½. In the case of a traditional IRA, you contribute pre-tax or after-tax dollars, growtrh is on a tax-deferred basis, and withdrawals are taxed as current income after you reach the age of 59½.
Circumstances under which a conversion to a ROTH IRA makes sense.
- Low taxes (2021 has historically low tax rates)
- Income is reduced (during the pandemic, furloughs, reduced hours and layoffs)
- When taxes become due, you will have the money available.
- Reduced estate taxes so your heirs and beneficiaries don’t get stuuck with a large tax bill.
With a ROTH, the payments you make are with already taxed income, making your withdrawals in retirement non-taxable. What effectively happens when you move to a ROTH IRA, is you pay taxes in the year that you move the money from your traditional IRA to your ROTH IRA. This enables you to set up a tax-free income in retirement.
It is quite common for people to maintain both a Tradiotional IRA (401 K) and a ROTH IRA. The fundamental reason of investing in your 401 K is to defer taxes and take your withdrawals during retirement when you are in a lower tax bracket. ( Be aware that not in all cases) Some people can end up in a higher tax bracket after retirement if a very large amount of money has been saved. If you are a high earner and have saved a significant amount of money, please consult a certified tax consultant for the best advice.
Remember that the maximum $5500 annual contribution limit applies to both, if you choose to make contributions to both the ROTH and traditional IRA, this does not enable you to contribute $11000.
Lower income and tax bracket
During the pandemic, many millions of Americans have experienced pay cuts, job losses or been forced into early retirement. If any circumstances place you in a lower tax bracket, it could be beneficial to convert to a ROTH IRA and pay the tax at the lower rate. This of course is a major benefit but requires you to pay the taxes in the year that you do the conversion, meaning you must have the available cash to pay the taxes.
Once your circumstances change and you are earning in a higher tax bracket, you can revert to a traditional IRA. Any tax saving method should be very carefully considered before you take the plunge by consulting a professional tax consultant. In some cases, you may benefit in the short term but in the future it may be to your detriment. Like anything in life, there is always a positive and negative aspect that needs to be considered.
Other options to consider
The 401 K early withdrawal calculations should also be considered depending on your circumstances. Although a shift from the traditional IRA to ROTH IRA does not constitute an early withrawal, doing the calculations for other reasons could be of great benefit. One should only ever consider early withdrawal in absolutely desperate circumstances.
Every Government has a responsibilty to care for their people and their elderly who are unable to care for themselves. It is our own responsibilty to save for our retirement and in many cases, Governments encourage and incentivize people to save sufficiently for their retirement. The US Government is no different and is encouraging people to save for retirement by offering incentives.