Roths for tax savings, no matter how much money you make

Though Roth individual retirement accounts have been around for almost two decades, they are still underutilized, say financial advisors. Just 12 percent of the money invested in IRAs is parked in Roths.

"People are still confused," said Scott Bishop, director of financial planning with STA Wealth Management. "I still have people who don't understand what the difference is."

But using Roth accounts in retirement can lower your tax bills, keep a bigger portion of your Social Security untaxed and hold down Medicare premiums.

The big difference between Roth and traditional IRAs is when your money is taxed. With Roths it's taxed when you make your contribution, and withdrawals are tax-free. Contributions to regular IRAs, on the other hand, are tax-deductible, but withdrawals are taxable.

ROTH IRA
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"Roths allow you to eliminate a future tax obligation," said David Littell, professor of taxation at The American College of Financial Services.

There are now Roth versions of both IRAs and 401(k) savings plans.

Retirement is full of unknowns, and one's future tax burden is a big one (along with health-care costs and longevity). First, it's hard to know a retiree's future tax bracket . Many assume they'll be in a lower tax bracket when they stop working. But that's not always the case, especially for high earners who have managed to build up their retirement nest eggs.

The second unknown is future tax rates, which — it was once assumed — would inevitably go up but now may not, depending on the policies championed by the incoming administration of President-elect Donald Trump.

"If we're going to have social programs like Social Security and Medicare at current level of support, then tax rates across the board are going to have to rise," said certified financial planner and CPA Theodore Sarenski, CEO of Blue Ocean Strategic Capital.

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By diversifying, retirees can stay tax nimble, Littell explained. "You want to have accounts that have different tax consequences, because then you can adjust to different tax rates," he added.

Should taxes rise, drawing money out of a Roth keeps taxable income low. But if a retiree finds him or herself in a lower bracket, then withdrawals from a traditional IRA or 401(k) are a low-cost way to bide your time while your Roth assets continue to grow. Roths are also a good source of funds for making big-ticket purchases without getting slammed with higher, taxable income that could push you into a higher bracket for the year.

"The only time I don't recommend a Roth is if someone is in a high tax bracket and they need the tax deduction now," said John Madison, a CPA with Riverpine Services.

For young workers, a Roth is a no-brainer. The tax deduction they might receive for a traditional IRA contribution isn't worth much when they are just starting out and in a low tax bracket, said Sarenski of Blue Ocean. "I'd like to see them doing a Roth as much as they can early on," he said. "As their tax rate increases, they could switch over to the deductible IRA."

To increase the proportion of your Roth assets, you can convert a tax-deferred IRA to a Roth. Bear in mind, though, that any amount that's converted is considered taxable income. "When I did this a few years ago, I found it painful," conceded Littell of The American College.

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You can take some of the tax sting out of conversions with careful tax planning, however.

"There are times in your career when you're in a low tax bracket, maybe during a period of time when you're not working or you've started a business and you're not making much of a profit the first couple of years," said Littell.

Early retirement is also a good time, said Bishop of STA. "If you have someone who retired at age 60 and they haven't started their Social Security yet, their average tax bracket might be 10 to 15 percent."

Remember, conversions don't have to be done all at once. It's possible to convert a little at a time.

The tax law provides some flexibility in squeezing the most tax savings out of conversions. If the investment you converted drops in value, you can change it back to the original IRA and not pay tax.

Here's how this works. Say you converted $5,000 into a Roth and the money was invested in one fund. Shortly after the conversion, the value of that investment falls sharply and it is then worth only $3,500. Why should you pay tax on $5,000 for something that's worth only $3,500?

Do-overs and deferrals

The IRS gives you a redo — but only once during a tax year. You'll have to wait until the following tax year to attempt the conversion again.

Though high earners can't invest directly in a Roth IRA because of income limits, they have some workarounds. First, Roths are now available in 401(k) form and there are no income restrictions on contributions. More than half offer this option now.

The Roth version works the same way other 401(k) plans do, with the same contribution limit of $18,000 (or $24,000 for those 50 and older), but paid for with after-tax dollars.

Bear in mind that any employer contribution will still be deposited in a tax-deferred account, and you will need to pay taxes when you make a withdrawal.

High earners can also get a Roth IRA by first contributing to a nondeductible IRA and then converting to a Roth. "Leave the [contribution] in a money market fund," Bishop recommended. "Since there are no gains, no tax is owed on the conversion."

— By Ilana Polyak, special to CNBC.com