"It's mine, all mine!" cartoon character Daffy Duck wails, spit flying and lisp in full effect as he stuffs Bugs Bunny down a rabbit hole in hopes of keeping the pile of treasure all to himself.
For baby boomers, there's a lesson to be learned from the wacky duck of their youth — think of the pile of gold coins as your Individual Retirement Account.
Traditional IRAs are funded with pre-tax dollars, which can help lower your taxable income, and contributions also grow tax free.
But Uncle Sam still gets his piece of the pie — and that happens when you begin taking money out, usually in retirement or at least at age 59½ to avoid early withdrawal penalties. Taking a page from our friend Daffy, that means the money in your IRA isn't all yours.
For this reason, financial advisors suggest clients also consider a Roth IRA, which is funded with post-tax dollars. The contributions also grow tax-free, but unlike a traditional IRA, withdrawals are not taxed.
"Say you're at that 24 to 25 percent tax bracket, all those dollars belong to you," said Dan Yu, managing principal of EisnerAmper Wealth Advisors in New York. "Whereas in a [regular] IRA, nearly one-third of that is going to go to the government. Once that is explained appropriately to a client, the light bulb goes off."
Hedge your bets
The idea isn't to choose one type of IRA over the other — but to use them together to mitigate taxes now and in retirement.
"No one knows what future tax rates are going to be. So a strategy that looks great now with today's tax regulations could fall apart 20 years down the road," said Patrick Stark, a certified financial planner with RS Crum wealth management in Newport Beach, California.
The best approach, said Stark, is to split your money into buckets: tax-deferred accounts such as a 401(k) or traditional IRA, a tax-free Roth, and taxable accounts, which would be a brokerage or savings account.
"Having assets in all three buckets provides tremendous flexibility to choose where to withdraw funds to take advantage of whatever tax laws may exist in the future," he said.
Getting around the limitations
Unfortunately not everyone can open a Roth IRA due to IRS income limits. For this year, couples making more than $196,000 and singles making $133,000 are unable to directly open Roth accounts.
If you can't open a Roth because of these rules, you may want to consider a conversion — where you move the money from your regular IRA to a Roth. But beware that the amount will be taxed at your ordinary income rate, so the decision needs to be made with lots of planning.
A sign it's time to make the switch
The best time to convert to a Roth IRA is during a period of reduced or no income. Say you are taking a leave of absence from work, are between jobs or have recently retired. All could be good opportunities because your tax bracket may be lower.
"A client in her early 60s may have not yet begun to receive Social Security and is living off a portfolio which is providing her income which generates very little in taxes," said certified financial planner Chad Hamilton with Mariner Wealth Advisors in Denver.
"Take advantage of these years when taxable income is particularly low to reduce the amount held in traditional IRAs."
Slow and steady
In most cases, it's up to you to decide how much money to move from a regular IRA to a Roth in any given year, and that flexibility will help limit the tax hit.
"Conversions should be done over time to prevent being thrown into a higher tax bracket, as the additional converted income is considered taxable income," said Alina Parizianu, with ACap Asset Management in Encino, California.
Think about the kids
The tax differences between Roth IRAs and their traditional counterparts can also make them an attractive estate planning tool, which is why Ryan Payne of Payne Capital Management in New York advises clients to do a Roth conversion if they want the money to go to their heirs.
"If they inherit a Roth, they can take money out over their lifetime, and that's a long time to get that money tax free," he said.
