As investors, our needs change and our financial situation evolves with each phase of our life. Today, I’d like to look at six stages of your life and how Roth fits into each.
Let’s start at the very beginning, you are a newborn, but a precocious one, and are keen on understanding finance. You might already have a Roth, even though you’ve only been around a short time. In your case, it’s not a contributory Roth, it’s an inherited one. I’m sorry you won’t get to know the kind relative who added you as a beneficiary after you were born, but they seemed to have some pretty remarkable timing. You need to understand the rules that apply to you. Even though it’s a Roth, because it’s inherited you have to take RMDs (required minimum distributions) each year. Check out Publication 590, table 1 is what you’ll look at to find your first withdrawal. For example, if you are 2, your life expectancy (according to the IRS) is 80.6 more years. For your first withdrawal, you just divide the prior year December 31 balance by 80.6 and that’s the amount you’ll take this year. You don’t reference the form next year, you just subtract 1, and your new divisor is 79.6. There’s one little issue mom and dad need to know – since this is not earned income, it’s subject to the rules of the Kiddie Tax, and over a small amount, it’s subject to your parents marginal rate. In 2012, it’s any amount over $1900, but that may change a bit in coming years. After they pay the taxes, make sure mom and dad put that money aside for you, it would make a great start to your college education.
In the next phase of your life, you’re actually old enough to understand the value of a dollar, making a bit by babysitting, running a paper route, or doing yardwork for neighbors. Now’s the time to learn the lessons that most adults learned the hard way. Better to learn from other people’s mistakes than to make them yourself. Some will dispute this, nothing like first hand learning. I’ll maintain that if today’s young will learn a few simple things, such as “pay yourself first” and “don’t spend what you don’t have,” that’s a great start. So, my young friend, it’s time to open your first (contributory) Roth IRA, which I fondly call the Kiddie Roth. There’s no age requirement to open a Roth IRA, you only need earned income. The 2012 Roth limit is $5000, so you can deposit up to 100% of your earned income into a Roth and watch it grow for decades. When you go off to College, any money you have in regular accounts is considered available for your tuition, so if while you’re still young, you take advantage of the Roth, you might just find that you still have some money left to your name after you graduate. If you actually need this money sooner, all deposits are available with no tax or penalty, the gains are subject to both, unfortunately. By the way, if you have other money that’s yours, but “put aside for when you’re older,” this is a great time to shift it to the Roth. You see, while you have to have earned income, the money deposited can come from other savings, the IRS doesn’t care where the exact dollars came from, so long as you had more than the deposited amount as earning income.
We’re moving along nicely, and the next phase is the newly graduated earner. If you don’t yet understand Marginal Rates aka ‘your tax bracket,’ now’s the time, graduate. Now is also the time to start that retirement account. If your new employer offers you any match to your 401(k), grab it. By that I mean make the deposits required to get the maximum match. Some companies match dollar for dollar, but only on the first 4 or 5% of your income that you save. That’s fine, after that match put the next $5000 that you are able to save into the Roth IRA. Odds are, your marginal rate will only rise over time as the first decades of work typically show higher raises than for the latter years. (Of course, this depends on the profession, I’m speaking in generalities, now.) Now’s the time to take advantage of that lower tax bracket, pay the tax now, and stash away some Roth funds. You won’t regret it.
Now, we’ll move ahead to the next big milestone, kids. For many, the new bundle of joy brings two things, a new exemption on your tax return (that’s $3800 off your taxable income), and possibly, a spouse taking some time off. This potentially results in a lower marginal rate and that’s an opportunity. Time to consider a Roth conversion. This isn’t a slam-dunk, just something to ponder. Before baby, you and the spouse might have been in the 25% marginal bracket. A projection for the first baby-year might show you’re going to be in the 15% bracket for a year or two, and a conversion might help you out long term. It’s a way of taking money you saved pre-tax in 401(k) accounts that you’ve since converted to IRAs or pre-Tax IRAs while in the 25% bracket and move that money to Roth paying just the 15%. Don’t worry, if you overshoot on the high side, you can recharacterize when you do your taxes for the year.
Wow, we’re in the middle-ages already. The kids are grown and out of the house, you’re making enough so you’re not able to make deductible IRA deposits, but the Roth may still be an option. If you’re above that limit as well, you might be using the Roth IRA Two-Step to sack some more money away. And during all this time, you’ll take advantage of any sub-average years, smoothing your marginal rate by converting a bit from regular IRA to the Roth. As you get closer to retirement, you have a better idea what your income will be at retirement and how much of it will be taxable. Your long term plans are in place to strike a good balance between pre and post-tax investing.
In the first years of retirement, you still have options to consider. You may have a pension whose annual payout increases with a delayed start date. For most of us, Social Security will force us to make this decision, each year after normal retirement age adds about 8% to the monthly check. But beware, (for marries filing joint) if you adjusted gross income plus half your social security is between $32,000 and $44,000, up to half your social security will be taxable, if over $44,000, up to 85% of social security is taxable. This can open the door to the desire for further planning. Perhaps by delaying your benefit, and making larger strategic conversions from your traditional IRA to Roth, you may be able to avoid the social security tax trap. We’ll go into this in more detail in a future post.
A long discussion to be sure, and we’ve not even gotten to the end game. I mean the very end, making sure your beneficiaries are listed on your retirement accounts. The only way they can take withdrawals over their lifetime is if they are proper beneficiaries, a listing in your will won’t cut it. For now, we’re done today. Each stage can, and will, be discussed in greater detail and your questions answered while the discussion continues in future articles.