How to Avoid a Killer IRA Mistake
Good to Know
Choosing the wrong IRA type is an all-to-common client mistake that can be difficult and expensive to correct. Financial professionals can help clients avoid that mistake by fully informing their clients of the key factors to consider. There tend to be two schools of thought to avoid—in the author’s opinion—when choosing between a Roth or Traditional IRA contribution.
- The “Viva el Roth” group tends to believe that a Roth IRA contribution is almost always the answer; their rallying cry could be “We always love the Roth IRA!”
- The “Analysis Paralysis” group can get so wrapped up in the minutiae of “what ifs” that the onslaught of permutations confuses clients. Their rallying cry could be “We love more analysis.”
Our tongue-in-cheek characterizations notwithstanding, we respectfully suggest that neither school of thought produces the most consistently effective result. We believe it’s more effective to consider how key factors from each IRA type align with a client’s goals and individual situation. The factors we’ll consider in this article include:
- Income tax issues,
- Liquidity,
- Adjusted gross income limits (AGI), and
- Legacy/Creditor protection.
Income Tax Issues
Clients should generally pay their income taxes when marginal income tax rates are the lowest. That concept is represented below.
Use Roth IRA
When current year marginal income tax rate is lower than expected rate in retirement
Use Deductible Traditional IRA
When expected marginal income tax rate in retirement is lower than current year rate
But here’s the potential flaw in this general approach—your client may have goals that are not addressed by generalities. Hence, there are at least three nuances to address in addition to relative marginal income tax rates.
- Income tax rate uncertainty—future income tax rates can only be estimated and can rise (or fall) during retirement. Clients with a need for rate certainty may be attracted to Roth IRAs since contributions are made with after-tax dollars.
- Less obvious benefits—income-tax-free Roth IRA distributions can lower a client’s reported income and AGI. Happily, this can result in less income tax on Social Security benefits, smaller Medicare premiums, and increased eligibility for tax credits or deductions subject to AGI phaseout.
- Rate bracket creep—your client can avoid this stealthy tax increase in retirement by balancing Roth IRA distributions against taxable distributions as their taxable income approaches a higher tax bracket.
Bottom line—relative income tax rates now vs. estimated rates in retirement are a key, but far from exclusive, factor.
Liquidity
Imagine that your client has contributed the maximum annual amount permitted to her Roth IRA over the last ten years. She’s not reached age 59½ but needs liquidity. Unlike contributions to a Traditional IRA, she can withdraw her cumulative Roth IRA contributions of about $60,000 without income tax or penalty. Caveat—as financial advisors and planners, we encourage our clients to tap non-retirement accounts before depleting retirement accounts.
AGI Limits
A client with sufficient earned income can contribute to a Roth IRA only if their AGI is within an annually indexed phaseout range. In contrast, a client with sufficient earned income can generally contribute to a Traditional IRA because there is no AGI phaseout for contributions. However, a client who participates in an employer-sponsored retirement plan can only deduct the Traditional IRA contribution if their AGI falls below or within a phaseout range.
Legacy/Creditor Protection
Legacy—the original owner of a Roth IRA is not required to take distributions during their lifetime. As a powerful legacy opportunity, neither is the original owner’s surviving spouse beneficiary required to take distributions during their lifetime. The spouses’ legacy is a tax-free income stream to their children, grandchildren, or other beneficiaries of their choosing.
Creditor protection—Original owners of Roth and Traditional IRAs are protected from bankruptcy creditors up to $1,512,350.1 Spousal beneficiaries of inherited IRAs are entitled to the same amount of creditor protection. However, non-spousal beneficiaries of inherited IRAs are not automatically protected from bankruptcy creditors.
Takeaways
Unless your client’s goals eliminate the Roth IRA or Traditional IRA as a choice, clients should consider contributing to:
- A deductible Traditional IRA if current year income tax rates are appreciably higher than expected rates in retirement,
- A Roth IRA if income tax rates in retirement are expected to be appreciably lower than current year rates, and
- A Roth IRA if income rates in the current year are about the same as expected income tax rates in retirement.
A canny advisor or planner can impress clients and prospects by understanding the nuances discussed in this article. Get that sound understanding through our CFP® Curriculum when you consider CFP® certification. You’ll discover a select few of the reasons our students’ pass rates are much higher than the national averages.
Disclaimer
The information presented herein is provided purely for educational purposes and to raise awareness of these issues; it is not meant to provide and should not be used to provide legal, identity theft protection, investment, income tax, risk management, retirement, estate, or financial planning advice of any kind. An experienced and credentialed expert should be consulted before making decisions relating to the topics covered herein. There are variations, alternatives, and exceptions to this material that could not be covered within the scope of this blog.
1 April 1, 2022-March 31, 2025, as indexed triennially.
