In the years leading to retirement you face a decision, whether to fund a Traditional IRA or a Roth IRA.
- Tax-free withdrawal. This you already know, however another major advantage of a Roth is that withdrawals are not included in any “income” calculations, including Social Security benefits or the current 3.8% surtax on net investment income above $250k for joint returns.
- No minimum distribution. Have a sizeable IRA in retirement is both great and a problem. The problem is that at age 70 ½ you must begin a Minimum Distribution from an IRA, and if you do the math, it isn’t so “minimum”. If you really don’t need this money, you first pay taxes on it as ordinary income, then you invest it into a taxable account and continue to pay taxes on it. The Minimum Distribution possibly raises your tax rate on your Social Security benefits. The Roth is 100% tax free after the age of 59 ½ with no requirements to ever distribute it.
- Penalty free withdrawal. If you fund a Roth IRA you can withdrawal your contribution with no tax penalty. A withdrawal from an IRA before 59 ½ incurs both income tax and a 10% penalty. A Roth can become an emergency fund if necessary.
- Estate planning. With a Roth you can pass your account to your heirs and other than an annual tax free withdrawal the account could continue for decades all tax free. The power of compounding could turn a modest account into a 7 digit account in no time. A Traditional IRS can be left to heirs but they must pay taxes on the annual withdrawals.
- Conversion flexibility. Let’s say that in January you convert $100,000 of Apple stock from a IRA to a Roth, you immediately incur a tax liability for $100,000 of income. Unfortunately by October 15th the market has dropped substantially and this investment is worth only $75,000. You can actually reverse the conversion (still only $75,000) and eliminate the tax on $100,000. This protects you in a down market. Of course if the market goes up as in the last few years you are even further ahead with a conversion.