Regardless of your age or income, financial experts say there’s a place in your investment planning for the retirement savings tool known as a Roth IRA. And now is the perfect time to contribute one.
If you’re not familiar, it’s important to note the differences between a traditional IRA and a Roth IRA. The biggest one comes down to when the investor pays taxes: With a traditional IRA, you can take a deduction when you contribute, and pay taxes when you withdraw money during retirement, similar to a 401(k). With a Roth, it’s the other way around. You pay taxes up front, and then the contributions grow tax-free forever, assuming you meet a few requirements, like withdrawing the money after age 59 and a half.
The difference makes the Roth method a favorite among financial planners and policymakers, says IRA expert Ed Slott, who recently published the book The pension savings time bomb is ticking louderTax diversification is not only important during retirement, but many people may not realize how large the tax bill will be that they face in their later years if the majority of their assets are tied up in accounts like traditional IRAs and 401(k)s.
However, a Roth means you don’t have to worry about taxes later. And given how low tax rates are now, and the fact that they could rise back to pre-2018 levels in a little over a year, it makes a lot of sense to contribute now.
“To me, it’s the promised land, the holy grail,” Slott says. “It’s the best possible retirement account that anyone can own.”
The trade-off, of course, is that to get all those benefits, investors now have to pay taxes on contributions, which many people don’t like to do. But that’s the wrong way to think about it, Slott says. He argues that taxes have to be paid at some point, and that rates are “on sale” now and will likely go up at some point in many Americans’ lives, especially given the national deficit.
Slott adds that many people expect to be in a lower tax bracket in retirement than they were during their working years, making a traditional IRA a better deal. Often, that’s not the case.
So it’s an ideal time to pay it forward and enjoy compound returns for decades to come. Slott even calls it the “tax deal of the century.” (There’s no guarantee about future rates, though.)
Another advantage of Roth: Unlike a traditional IRA, there are no lifetime minimum distributions, or RMDs, the requirement that you withdraw a certain portion of your retirement account after a certain age. That means it benefits not only you, but potentially your heirs as well. And because you’ve already paid taxes on the contributions, you can withdraw them (no gains, mind you) at any time for any reason without penalty.
“The Roth is clearly the best retirement account to own, it’s all about how much you’re willing to pay to get it,” he says. “Anytime you’re not using those low brackets, they’re wasted.”
How to Switch to a Roth IRA
To contribute directly to a Roth IRA, investors must not earn more than $161,000 in adjusted gross income (or $240,000 for couples). But higher-income earners can still reap the benefits through a conversion from a traditional IRA. Any pre-tax funds from a traditional IRA that are converted will be taxable, but because you choose to make the conversion, you have more control over how big of a tax bill you’ll get, Slott notes. Just remember that Roth conversions cannot be reversed.
“As long as you pay taxes, it’s growing for the rest of your life, with no income tax. All that compound interest is growing for you, you don’t have to share it with Uncle Sam anymore,” he says. “That’s what you get for paying rock-bottom prices now.”
To start the conversion, you’ll need to open a Roth IRA with a brokerage or other financial institution if you don’t already have one. Next, you’ll need to contact the administrators of both accounts to see what needs to be done to make the conversion (it varies by institution, but if both accounts are held in the same place, this will be easier). Finally, fill out the appropriate paperwork and select which assets you want to convert.
If you convert tax-deductible, tax-free contributions from a traditional IRA, the entire amount you convert will be taxed as ordinary income that year. So make sure you have enough cash on hand to pay those taxes. People often spread Roth conversions over multiple years to lower their tax bill. Think about it this way: If a single person reports $100,000 in income this year, she falls into the 22% tax bracket. If she converts $25,000 to a Roth, nearly all of it will be taxed at a 24% rate.
If you made contributions that were after-tax or non-deductible, “that portion will not be taxed again when you convert it to a Roth IRA. However, the proceeds from those contributions will be subject to regular income taxes in the year of the conversion,” says Jaime Eckels, a certified financial planner with Plante Moran Financial Advisors.
When tax time comes (the following April), your account custodian will send you Form 1099-R, which details the company’s distribution to you, and you’ll need to file Form 8606 with the IRS, which simply reports the conversion. While you can do all of this yourself, it can be helpful to work with a financial advisor or other tax professional, since taxes can be complicated.
One question clients often have, Slott says, is how they can be sure that the Roth’s tax treatment will remain as it is. Of course, it’s impossible to say: Congress can change the rules at any time. But Slott believes that the government depends on the direct income it gets from the Roth, when Americans essentially pay taxes up front. He doesn’t think that will change anytime soon.
“Tax laws are written in pencil,” he says. “But Congress depends on that Roth money. So I don’t think they’ll ever touch it.”
According to some research, Americans certainly have it figured out, especially younger generations. The percentage of households headed by people in their 20s that invest in a Roth IRA nearly tripled from 2016 to 2022, from 6.6 percent to 19.2 percent, according to data from the U.S. Federal Reserve analyzed by the Center for Retirement Research (CRR) at Boston College.
This story originally appeared on Fortune.com
