When Does It Make Sense To Switch Retirement Investment Contributions From 401(k) To Roth IRA?
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The Roth IRA is not available to everyone. According to the Internal Revenue Service in 2014, anyone contributing to a Roth IRA is “phased out” when their income exceeds $60,000-70,000 and they are single or the head of the household. The same rule applies if they are married and filing jointly if their combined incomes exceed $181,000-191,000. If they are married and filing jointly they are phased out if their income is $0-10,000. The point is, not everyone can contribute to a Roth IRA.
When money will be taxed becomes the last major consideration. Because contributions are made with money that has already been taxed it is wise to make sure that it will be withdrawn when the marginal tax rate will be higher. This cannot be determined with complete accuracy because tax policy changes from time to time, however, many working people are in a very low marginal tax bracket. These tax payers often are taking deductions for children, mortgage and a variety of other reasons.
More mature tax payers don’t always have those deductions available.
“Qualified distributions” from a Roth IRA are not includable in gross income. Even the earnings are tax-free. In a traditional IRA they are “tax-deferred.”
A qualified distribution can be made after the plan has been in effect five years beginning with the first taxable year for which the individual made a contribution to a Roth IRA and the distribution meets the following requirements:
1. It is made on or after the date on which the individual attains the age of 59.5.
2. It is made to a beneficiary (or to the estate of the individual) or after the death of the individual
3. It is attributable to the individual’s being disabled (see IRC Section 72(m)(7)
4. It is a qualified first-time homebuyer distribution (subject to IRC rules.)
It would appear that younger tax payers in low tax brackets should consider putting money into a Roth IRA. Because retirement seems to be a distant dream many young people are reluctant to start a Roth IRA, however, there is great wisdom in doing so. These younger tax payers are also more likely to have incomes that are below the limits mentioned previously.
A distribution of a regular IRA is subject to taxation as ordinary income and may be subject to penalty tax if the distribution doesn’t meet specified criteria. A distribution from a Roth IRA is considered a return of premium and not subject to income tax. Income taxation only becomes an issue if the amount returned exceeds that which was deposited. If specified criteria are met, even the growth or interest in the Roth IRA is also free of income tax.
Distributions from most retirement plans are taxed as ordinary income. It is very helpful to have a source of tax free distributions. This is the role that the Roth IRA can play.
A Roth IRA can accept “rollovers” from other qualified plans. In these events immediate income tax must be paid on the amount being transferred to the Roth IRA. The money is treated as ordinary income at the time of the rollover. These provisions may provide significant opportunities for retirement income planning.
Most people start to consider the Roth IRA when they reach age 45. They realize then that they will want the tax free benefit of the distribution. While it is never too late to start it would be to the interest of most tax payers to start earlier.