You can think of retirement investments like a box of rocks. In this analogy, the rocks represent the types of investments in your account, such as stocks and bonds. The box represents the type of account, such as a taxable account vs. an IRA account. In this article, I am going to discuss the type of box without discussing the rocks. When it comes to retirement investing, I believe that the Roth IRA is the ultimate account type. It is the best “box” to hold your retirement investments.
Some people go to great lengths to defer income taxes on investments, such as by entering into a deferred compensation arrangement with their employer or by contributing to deferred variable annuities. Of course, many people defer income taxes in more ordinary ways by contributing to 401(k) plans and Traditional IRAs. Deferring income taxes can be okay if you plan for the income taxes that you will ultimately pay when you withdraw your tax-deferred funds. IRS rules require holders of 401(k) and Traditional IRA accounts to start withdrawing funds at age 70½. I think that many people who have amassed large amounts of tax-deferred funds will be shocked at their income tax bill when they start withdrawals.
The Roth IRA eliminates the issue of deferred income taxes. Once you put money into a Roth IRA account, it grows income tax-free, and no income tax is assessed on future withdrawals as long as the withdrawal occurs after age 59½ and you have held the account for at least five years. Unlike with contributions to 401(k)s and Traditional IRAs, you do not receive an income tax deduction for Roth IRA contributions. For most people, however, I believe that this is a small price to pay for not having to worry about future income taxes at withdrawal. Income tax rates are currently low by historical standards. With growing government deficits, income tax rates could easily rise in the future, even if your level of taxable income decreases during retirement.
For those of you who may not need the money in your Roth IRA account during your lifetime, the Roth IRA has even more benefits. Unlike 401(k)s and Traditional IRAs, there are no required minimum distributions for Roth IRAs during the life of the account owner, even past age 70½. So, you can have your Roth IRA account grow income tax-free for your entire life. If your spouse inherits your Roth IRA account, he or she can treat the Roth IRA account as his or her own account and allow it to continue growing income tax-free during the life of the surviving spouse.
So, how do you get money into a Roth IRA account? If you have taxable earned income and your Modified Adjusted Gross Income is under certain limits, you can contribute directly to a Roth IRA even if you participate in your employer’s retirement plan. If your employer’s 401(k) plan allows, you can designate 401(k) elective deferrals as designated Roth 401(k) contributions. After you change jobs or retire, you can roll over the designated Roth 401(k) portion of your account into a Roth IRA. You can convert a Traditional IRA into a Roth IRA and pay income tax on the conversion amount. If your employer’s 401(k) plan allows, you can do an in-plan Roth conversion. Finally, when you leave your employer, you can roll over any pre-tax qualified retirement plan amounts (e.g., a regular 401(k) account) into a Roth IRA; this will be treated like a Roth IRA conversion, and you will need to pay income tax on the converted amount.