On the off chance you missed the news: Taxes, they are a-changin’.
Actually, they already have: Most of the $1.5 trillion tax cut — a wide overhaul of the tax code under President Trump — went into effect Jan. 1.
By lowering individual income tax rates nearly across the board through 2025, the act freshens the lipstick on an already good-looking retirement account: the Roth IRA. The Roth has long been a favorite among investors who expect tax rates to go up by the time they retire, and these tax cuts make that trajectory all the more likely.
If you previously wrote off funding a Roth IRA — and especially if your tax rate is lower under the new code — now’s a good time to reconsider that decision.
The tax benefit of the Roth IRA
The Roth IRA is all about pay now, play later: Because the income you contribute has already been taxed, qualified distributions in retirement are tax-free.
That means you lock in whatever your tax rate is when you make your contributions, and skirt taxes on any investment growth in the account. This is also true of a Roth 401(k), which is increasingly popping up on employee benefit menus.
Other accounts, like a traditional IRA and the standard 401(k), take the opposite approach: You get a tax deduction on contributions, but pay income taxes when you take distributions from the accounts.
Roth IRAs shine when taxes are low
Locking in your current tax rate makes the most sense when taxes are low, of course. And while they have been historically low for some time, the new tax law drove rates down even further and broadened some brackets considerably. For example, a single filer with $80,000 in taxable income is now in a 22% federal tax bracket, down from 25% under the old structure. (Curious how the new code affects you? You can get all the details here.)
“Most people are good enough at math to understand that taxes will likely be higher in the future than they are today,” says David Hays, president and founder of Comprehensive Financial Consultants in Bloomington, Indiana. “So why don’t we pay the tax today at a known rate — whether that’s 12% or 22%, it doesn’t matter — so we never pay the taxes again?”
That’s what you’re doing when you contribute to a Roth IRA. With a traditional IRA, on the other hand, “you have a partner in your retirement account, and that partner is the IRS,” says Hays. “You don’t know what share their partnership is until you need the money.”
That’s not to say a traditional IRA doesn’t have merits — there are valid reasons to push taxes down the road. But today’s lower tax rates do make Roth IRAs worth a second look.
“For anyone who is going to contribute just on straight math, Roth IRAs are a much better purchase right now than traditional,” says Greg Hammer, the CEO and president of Hammer Financial Group in Schererville, Indiana.
Roth conversions deserve a second look, too
The hitch with all of the above is that Roth IRAs have income rules for eligibility. To make the maximum contribution of $5,500 in 2018 (or $6,500 if you’re 50 or older), your modified adjusted gross income must be below $120,000 as a single filer or $189,000 if married filing jointly.
The workaround: a Roth IRA conversion, which allows you to move money from a traditional IRA into a Roth IRA account. When you do so, you pay taxes on the conversion — any contributions you previously deducted, as well as their gains. Those dollars then come out tax-free in retirement as if you had them in a Roth all along.
You can do this even if you’re eligible for a Roth IRA outright — maybe you’ve been contributing to a traditional IRA and now you want to reverse that decision. In fact, Hays urges, investors should “strongly consider repositioning taxable accounts into tax-free accounts.”
There are a couple lines of fine print, though. For one, you may have taxes withheld on a conversion, which means money to pay the tax bill comes out of the converted amount. Avoid this if you can, and pay those taxes with outside dollars. Otherwise, the IRS will consider that withholding a distribution, potentially triggering a 10% early distribution penalty. (For those keeping track: That’s taxes on the money you’re going to use to pay taxes).
And then there’s the one hit the new tax code directs at Roths: These conversions are now a one-way street. Beginning in 2018, you are no longer allowed to recharacterize the conversion back to a traditional IRA if you change your mind.
Opening a Roth IRA is easy
If you’re thinking you want to get in on this action — via contributions or a conversion — you can open a Roth IRA at an online broker or robo-advisor. At most providers, the process is fast and completely online. Once the account is funded, you can begin choosing investments.