Consider Roth IRA’s to Balance Your Retirement Savings Strategy

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Roth IRA PebbleRoth IRAs are more popular than ever according to a new analysis by the Employee Benefit Research Institute (EBRI). Roth IRA balances increased 16.6 percent from 2010 to 2012, compared with 7.9 percent for owners of traditional IRAs. This is more than double the rate of traditional individual retirement accounts according to data in EBRI’s report “Individual Retirement Account Balances, Contributions, and Rollovers, 2012” published in the May 2014. EBRI’s IRA database contained information on 25.3 million accounts owned by 19.9 million unique individuals, representing total assets of $2.09 trillion.

There are a number of factors contributing to the growth of Roth IRAs. First, Roth IRAs generally have smaller average balances than traditional IRAs so contributions are magnified. Secondly, more Roth IRA owners contribute each year than traditional IRA owners. Approximately 6 percent of traditional IRA owners contributed to their IRA in any one year compared to 25 percent of Roth IRA owners contributing in any one year covered by the study. Finally, Roth IRAs generally contain a higher weighting of equities than traditional IRAs which account for faster growth in good markets.

The overall average balance increased each year—from $95,431 in 2010 to $106,205 in 2012. Increases occurred across each owner age group and IRA type, except for owners ages 70 or older who are subject to required minimum distributions (RMDs). Roth IRAs are not subject to RMDs but traditional IRAs and employer sponsored plans such as 401(k)s and 403(b)s are.

Rollovers are a much bigger factor than new contributions in terms of dollars. The number of accounts receiving contributions outnumbered rollovers almost 2 to 1. However, the total dollar amount of rollovers was 10 times the amount of contributions.

The report did not mention the potential impact of tax law changes from the American Taxpayer Relief Act of 2012 which became effective in 2013. The incentive for upper income taxpayers to make Roth conversions before higher tax rates could have played a role in the growth of Roth IRAs. It will be interesting to see if the growth of Roth IRAs continues at the same pace in 2013 and beyond.

Another important factor not mentioned was the ability for upper income taxpayers to make Roth conversions. Income restrictions on Roth conversions were lifted in 2010 allowing anyone to convert a traditional IRA to a Roth. The income limits for Roth contributions are still in place. However, through the conversion process, it is still possible for upper income taxpayers to contribute to a Roth IRA. The strategy takes advantage of the nondeductible IRA, which does not have an income limitation. A traditional IRA can hold both deductible and nondeductible funds. The hassle will be maintaining records of non-deductible contributions and documenting this on your tax return each year a contribution is made.

The strategy calls for making nondeductible IRA contributions when your income is too high to contribute directly to a Roth. There are income limits phasing out a taxpayer’s ability to contribute. Single taxpayers and heads of household who are covered by a retirement plan at work begin to phase out contributions when modified adjusted gross income (MAGI) is between $60,000 and $70,000. Joint filers in which an IRA contributor not covered by a retirement plan and is married to someone who is covered phase out when MAGI is between $181,000 and $191,000. Once the non-deductible contribution is made, the taxpayer converts the IRA to a Roth IRA. Since 2010, there are no income limitations for Roth conversions. This allows upper income taxpayers to indirectly contribute to a Roth account that would otherwise be off-limits.

The Roth IRA and traditional IRAs got a raise in 2013 for the first time since 2008. Cost-of-living adjustments affecting dollar limitations for pension plans and other retirement-related items kicked in during 2013. The limit on annual contributions to traditional IRA and Roth IRAs rose to $5,500 ($11,000 per married couple), up from $5,000 in prior years. The annual amounts are increased to $6,500 ($13,000 per married couple) for taxpayers 50 and older. Cost-of-living adjustments will continue but only in increments of $500.

The Roth IRA is an integral part of the New Three-Legged Stool strategy for tax efficient retirement planning. It provides the tax-free leg which is vitally important for controlling taxes during retirement. Make sure you aren’t missing the band wagon by contributing to a Roth every year you are able.

Rick’s Tips:

  • Taxpayers contributed to Roth IRAs at more than double the rate of traditional individual retirement accounts from 2010-2012.
  • Rollovers dwarfed contributions in dollar terms by nearly 10 to 1.
  • Upper income taxpayers can contribute to a Roth indirectly by first making a non-deductible IRA contribution and then converting it to a Roth IRA.

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