Using a Roth IRA vs Regular IRA calculator to decide how to invest may not be telling you the whole story. The Roth IRA is a great investment and I am NOT telling you not to put money into a Roth IRA, let’s make that absolutely clear from the very beginning. I have most of my retirement money in a Roth IRA and there is a pretty good chance you should to. However, I want you to be aware that when you enter your information into a Roth vs Regular IRA calculator there is one circumstance the calculator isn’t factoring in you should be aware of, especially if you are thinking about getting a solar roof.
What is a Roth IRA
A Roth IRA is an investment account where you put after tax dollars into a retirement account, the funds grow tax free until you retire, and then you take the money out of the account without paying any additional income taxes on that money. In other words, you get no tax benefit now, but you pay no taxes later, which is a huge benefit. When you run the Roth vs Regular IRA calculator, there is a pretty good chance it is going to tell you to go with the Roth. This is especially true if you are under 40 years old or in a low tax bracket.
What is a Regular IRA
In a regular IRA, you don’t pay income taxes on the money you put into your retirement account now, but you pay income taxes on that money when you take the money out after you retire. If you are putting money into a regular 401k account, this means your employer puts the money into your 401k and then calculates the income taxes withheld from your paycheck after that money is subtracted. If you are putting money into a regular IRA account that means you get to take a tax deduction for the amount you contribute up to certain limits.
What the Roth IRA vs regular IRA calculator won’t tell you
What the IRA calculator won’t tell you is that under the right circumstances in a later year you might be able to transfer money from your regular IRA to your Roth IRA by paying a penalty at a lower rate than your initial IRA deduction and in the end wind up with more money in your Roth than you would have if you had just put it into the Roth to begin with. I know that last sentence was hard to follow, so we are going to take this nice and slow.
This whole idea revolves around tax brackets, so we are going to start there. In our tax system the more money you make, the higher tax rate you pay. Let’s say you are married and make a combined income of $100,000. Depending on what state you live in your total income tax rate (federal + state tax) might be around 30%. If in some later year you might make much less money, and if you make less money your income tax rate will fall also. Maybe you will only pay 15% on the money you earn one year later in your life. Everybody with me?
The next thing you need to know is that at any time you can convert your regular IRA to a Roth IRA. All you have to do is pay income taxes on the amount you convert at your current tax rate. So what if your current tax rate is lower than the tax rate you used when you initially put the money in and took the deduction? Profit. The government just paid you to invest money.
Let’s say you put in $10,000 at 30% and got a tax deduction worth $3,000. Now lets say in a later year you convert $10,000 of your IRA to a Roth IRA at a tax rate of 15%. Your going to have to pay $1,500 in taxes. Did you catch that? Your deduction was worth $3,000 but you only had to pay $1,500 to convert it to a Roth. The IRS just paid you $1,500 to put $10,000 into a Roth IRA!
What are the chances you will have special circumstances?
This is the tricky part. What are the chances at your tax rate will go down in future years? I can’t answer that, but think about all the possible reasons you might make less income and pay a lower tax rate in future years:
- You lose a job and it takes a while to find a new one.
- You get married to somebody that doesn’t make a lot of money and go from single status to married filing jointly status
- You divorce someone who makes more money than you do. This is especially relevant if you find yourself in the head of household status and receive child support rather than alimony.
- You take time off work to raise children
- You take time off to take care of a sick relative
- You start a new business that takes a little time before it makes money
- Your business has a bad year
- Your business is bought out and you sign a non-compete agreement that doesn’t allow you to work for a period of time
- You take some time off to do something besides work while you are still young
- You buy a solar roof (See below)
Some of these items might seem unlikely to you but what are the chances that one of them will happen in a future year and take you to a lower tax bracket? The combined likelihood might be higher than you think.
What does any of this have to do with Solar Roofs
As I wrote about in the Tesla Solar Roof article, if you buy a solar roof you might get more in tax credits than you can take on your tax return in a single year. For example if you get a $10,000 tax credit for installing a solar roof and only pay $4,000 a year in federal income taxes you can’t get all of the credit this year. You will have to take $4,000 this year, $4,000 next year, and the remaining $2,000 in 2 years. On the other hand, if you have some money to convert from an IRA to a Roth IRA, you can do that in the year you get your big credit and have let the big credit pay your conversion fee.
So what should I do?
The Roth IRA is a great investment vehicle and I am NOT telling you that you should not put money into a Roth account. But perhaps even if the Roth IRA vs regular IRA calculator tells you the Roth is better you should consider putting just a little into a regular IRA just in case you ever have a chance to use this strategy.
One more thing to keep in mind is that this strategy takes cash. A lot of people who experience drops in income won’t have the extra money laying around to pay the extra tax bill. You are going to want to make sure you have plenty of dough laying around to make this work.
A big tip of the hat to Joe from joetaxpayer.com for first explaining this idea to me. One of my favorite personal finance blogs.
This is a fairly tricky tax strategy and depends highly on your specific information. You should check with your professional tax advisor before doing this. In case you are wondering, no, I am not your professional tax advisor.
Original photo is by opopododo and has been altered.