You have been talking to your financial advisor or heard in the news how great Roth IRAs are and that you should be contributing to a Roth IRA. This makes sense to you, as you have heard that Roth IRA earnings are tax-free, while the earnings of any other type of IRA would be taxable down the road. So, tax-free has to be great, right? Who wants to pay taxes if they don’t have to?
Well, before I get into why a Roth IRA contribution may not be your best option, let me first say that I am not against Roth IRAs. Roth IRAs, like any other retirement vehicle, can be a good option depending on your circumstances. My concern is that many folks contribute to Roth IRAs just because they hear how great Roth IRAs are without fully analyzing the tax implications and what they might be giving up.
The best way to explain it is with a real situation. While preparing one of my client’s tax returns last year, I noticed that he had contributed $5,000 to a Roth IRA. I also noticed that he was eligible for a deductible traditional IRA contribution and, if he had made the contribution, his tax liability would have been about $1,500 less. When I asked my client why he had elected to contribute to a Roth IRA, his answer was, “Because my financial advisor recommended it.”
My next question was, “If you had known that a traditional IRA contribution would have reduced your tax liability by $1,500, would you have still contributed to the Roth IRA? “Absolutely not!” was his immediate answer At this point, my client was quite upset as he realized that, by contributing to the Roth IRA rather than to a traditional IRA, he had “given up” $1,500.
At this point, you might be thinking, “But any earnings on his Roth IRA contribution are going to be tax-free.” And you are correct that his Roth IRA earnings are likely to be tax-free. But will that translate into $1,500 or more in tax savings down the road? We really won’t know that answer until we get “down the road.” All I do know is that he will need at least $1,500 in savings down the road just to “break even” on his decision to contribute to a Roth IRA, as compared to a traditional IRA.
My main point here goes back to what I mentioned earlier, which is that you should fully understand your options and what you “might” be giving up before deciding which type of IRA is best for you. If my client had done so, he would certainly have contributed to a traditional IRA instead of a Roth.
And, in case you’re wondering, my story does have a happy ending. It was not too late for my client to change his Roth IRA contribution to a traditional IRA contribution and still be able to take the deduction. All he needed to do was contact his Roth IRA trustee and request that they change his Roth IRA contribution to a traditional IRA contribution, which he did the next day. Changing one type of IRA contribution to a different type of IRA contribution is called a recharacterization, which can be done by the due date of your tax return (including extension). He was then able to claim the IRA deduction on his tax return, which resulted in him receiving a tax refund!
So, before you decide to contribute to a Roth IRA, be sure you understand all the tax implications of your options and what you might be giving up. Then, if it still makes sense for you to contribute to a Roth IRA, go ahead and contribute to one. You should also keep in mind that there are different qualifications and income limits for a Roth IRA compared to a traditional IRA, so make sure you qualify for the type of IRA you are contributing to.