We hear a lot about the need for diversification when talking about our investments. You know the expression “don’t put all of your eggs in one basket.” In the investment world this most often refers to the idea that you shouldn’t put all of your investment in one stock. But what about tax diversification when planning for retirement?
Most of us have, or have had, tax deferred 401(k)s 403(b)s and/or IRAs. These plans are funded with pre-tax dollars. What most people forget is that when it comes time to fund your retirement, the withdrawals from these accounts are taxed as ordinary income. Simply put, it’s like receiving a pay check and Uncle Sam is going to want his cut and who knows where tax rates might be in 30 years. (For related reading, see: The Basics of Roth IRA Contribution Rules.)
Why Diversification Isn’t Just for Investments
This is where Roth IRA comes in. Withdrawals from a Roth IRA are tax free. This type of retirement account is funded with after-tax dollars (from your checking account) so when you retire you can make tax free withdrawals. Some employers even allow Roth contributions in your 401(k) at work.
Roth IRA withdrawals of principal are tax and penalty free. The reason is that contributions are made with after tax dollars. The IRS has already taken their bite with regard to the principal (what you contributed). The earnings are a different story. While there can be exceptions, early withdrawals can be subject to taxes and penalties that are attributable to earnings (not principal).
Early withdrawals are those made prior to age 59 ½. Withdrawals made after age 59 ½ and after having the account for at least five years, allow for withdrawals that are tax and penalty free.
Don't Get into the Prediction Business
There is always talk of tax reform and potentially lower tax rates. I would be very cautious about holding off on the Roth IRA due to potentially lower tax rates. It isn’t a sure thing that your taxes will be lowered even if there is tax reform. If your rates are reduced now, it is possible that tax rates could rise in the future. It is impossible to know what the future will hold. Because of that, it would be prudent to set aside funds that could be used tax free many years down the road.
I’m often asked, “What is better an IRA or Roth IRA (tax free or tax deferred)?” Answering this question requires a crystal ball or the ability to predict whether taxes will be higher or lower in the future. While there are compelling arguments to be made that taxes will be higher in the future, there is no way to know for sure.
Beware of the 5-Year Waiting Rule for Roth IRAs
The five-year waiting rule for Roth IRAs applies in two situations. In order to receive a qualified distribution of earnings (not principal) tax free, the withdrawal must not be within five years of the date of the first contribution. These time periods are governed by the beginning of the tax year for which the contribution applies as opposed to the actual date.
In order to receive a qualified distribution from a Roth IRA that was converted from an IRA without penalties applied to principal, the withdrawal must not be within five years of the date of the conversion.
Diversification isn’t just for investments. It is relevant for tax planning too. Rather than having all of your retirement funds in one tax basket, diversify and allocate some of your savings into tax free Roth accounts. (For more from this author, see: Tax-Deferred vs. Tax-Free Retirement Accounts.)