So now you know all about the good and the bad parts of choosing a ROTH IRA or 401k to invest your money. You might feel that now you have a more balanced perspective of when it can be a great idea, a so-so one, or a bad one. But we’re not done yet. Today I will talk about the top three ugly gotchas you need to look out for yourself, or warn friends about, when looking into a ROTH.
I’m not the only one who doesn’t think the ROTH is a magical, mystical investment that will bring you nothing but tax-free riches. Go Curry Cracker has a great breakdown of when (and why) a ROTH is a bad idea, and Financial Samurai is passionate about the ROTH being a vehicle for government malfeasance.
Too often, I’ll read click-bait style headlines on investment vehicles that read like they’re always great, or always terrible. But every investment option (even whole life!) has some circumstances where it makes sense for someone. What you need to figure out is whether you’re the kind of person it makes sense for. I hope by presenting some of this information, I can help you figure out what’s best for you.
So without further ado, the ugly parts of a ROTH.
ROTH – The Ugly
- High earning years – Remember the discussion in the last post about how if the tax rates are equal in your contributing and withdrawal years, the ROTH and the Traditional come out exactly the same? It was important that you know this, because I see people recommending ROTHs to people in their highest earning years. And that’s just not a good idea, unless you’ve already maxed out your pre-tax investment space.
- Do people really do this? In a word, yes. I have a friend that earns a high income (probably 250k per year household income) who was not maxing out his traditional 401k, but was playing around with doing a backdoor ROTH because he heard Jim Cramer talking about what a great idea it was. I’ve also seen people in online forums talking about how they’re trying to get their parents who are about to retire to contribute to a ROTH. Said parents are not high income earners, didn’t max out pretax, and will be likely living off of social security and minimal savings in retirement. Meaning they’re going to be in a lower tax bracket.
- For a high earner who will likely be in a lower bracket in retirement, you need to max out your pretax investment options before starting to think about a ROTH. After you’ve maxed pretax, ROTH can be a great option. Or if you’re early in your career and your income will just go up, you’re good to go. But if you’re in your highest earning years, don’t go straight to the ROTH.
- Backdoor Gotchas – Same friend who watches Jim Cramer wasn’t aware of the biggest backdoor ROTH gotcha. You can’t really do it if you have any traditional IRA’s hanging around.
- OK, you actually can do it, but you need to watch out. If you have any traditional IRA’s, the IRS says that you can’t just convert your after-tax IRA. No, you have to act as if your conversion comes from all your IRA’s.
- Lets say you have $95,000 in a traditional IRA, and $5,000 in an after tax IRA. You can’t just tell the IRS you want to convert your $5,000 to the ROTH. No, the IRS will tell you that 95% of your conversion will be treated like it came from your traditional, so you have to pay taxes on it. Only 5% of your contribution will be treated for tax purposes like it came from the after-tax IRA
- Is there a way around this? Yes, you can roll your traditional IRA into your companies 401k, assuming that you’re currently employed. Then you’ll be clear to do your conversions. Check out this Forbes article for more info.
- Inheritance-The original version of this article had a disadvantage to inheriting a ROTH as I had understood you couldn’t spread withdrawals over your lifetime, like you can with a traditional. After a comment from a reader I checked all the rules again and found out you can spread it. See this link from Schwab for more details.
So What To Do?
The answer is simple – it depends. When it comes to personal finance and investing, there unfortunately is rarely a perfect, one-size-fits-all answer. It’s actually one of the things people find frustrating. They may want a clear-cut, yes or no answer, or someone to just tell them what to do so they can go do it.
But there’s no right answer. You have to evaluate your specific situation-your income, future income prospects, retirement strategy, age, net worth, etc. – and the pros/cons of different investment options to make the most optimal decision in your specific situation. If you don’t want to do this for yourself, you’re best off hiring a fee-only financial planner to ask them to do it for you.
What I would ask of you is if you read a simple article that seems to be saying there’s some magical, perfect investment that will save taxes, grow your wealth exponentially, and make you a beautiful supermodel (OK, probably not the last one) you dig deeper to find the downsides. They’ll be there, and you don’t want to get hit with a surprise gotcha just because someone online wrote a too-simplified piece of advice.
So what do you think of the ugly parts? Anything surprising in here, or did you already know about them? I hope you enjoyed the series! Let me know in the comments.
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