The IRS has recently moved the federal tax filing deadline to May 17, and if that doesn’t get you excited, here’s something that will: The extension also allows you another month to make your 2020 Roth IRA contribution. The benefits of contributing to a Roth are quite valuable, as money invested in a Roth grows tax-free forever and stays tax-free when you withdraw it in retirement. For a variety of reasons, this may be the best time ever to contribute to a Roth. We’ll explore the “why” below.
You simply have more time
Yes, the IRS has pushed back the tax deadline. Why does this matter? Instead of scrambling to get your tax documents together by April 15, you have a short reprieve. But perhaps more importantly, you have more time to complete your 2020 Roth contribution.
Keep in mind, this is your 2020 contribution we’re talking about. Typically, you have until April 15th of the following year to make your Roth contribution for the preceding year; for 2020, you’ll have an extra month.
If you can manage it, it’s also a great time to make both your 2020 and 2021 contributions. You are eligible to contribute up to $6,000 for each year — meaning a $12,000 contribution to invest and grow tax-free forever if you deposited both today. Those 50 or older can add an extra $1,000 per year for a total of $14,000.
The beauty of this is that you don’t need to contribute the maximum for 2020 for it to still make a big difference in your financial plan, and you still have until next April (that’s 2022) to contribute the maximum for 2021.
The Roth IRA will be increasingly valuable
Not only will the Roth IRA grow in value over the long term (especially if you’re investing in passively managed, low-cost index funds), but you also have the chance to enjoy its tax-free status along the way. Money held in other popular retirement accounts, like a 401(k) or 403(b), will be heavily taxed upon withdrawal. And withdrawals also have the impact of increasing your overall taxable income, which — gasp — could push you into a higher tax bracket down the line.
Without speculating too much, there is reason to believe that tax rates now are as low as they might be for a long time. We’ve just passed a much-needed $1.9 trillion dollar Rescue Plan, which had the impact of increasing the national deficit, and there’s already been a great deal of discussion around President Biden’s upcoming tax plan, in which tax rates are expected to rise.
If you believe tax rates are slated to increase in the future, a Roth contribution today makes a lot of sense. By making a Roth contribution, you’re voluntarily agreeing to pay today’s tax rate in exchange for never having to pay tax on the same money ever again. I’m not one to read the tea leaves, but this exchange, on its face, seems like a very good deal.
Not much downside
Let’s say you deposit post-tax money in a Roth IRA this year, and it turns out that tax rates rise in future years. Great job! You’ve made a solid financial decision, and you’ll have avoided paying tax at higher rates down the line.
In an intermediate scenario, let’s say tax rates stay the same. Agreeing to pay tax at today’s rates would be neutral; you’d be completely indifferent to tax now as opposed to tax later.
However, let’s say the world turns upside down and tax rates actually fall in the future. In hindsight, yes, a Roth contribution today would have made less sense than a 401(k) contribution — but you’ll still have a future tax liability of zero, and money growing in a Roth IRA. Not exactly a bad combination.
A key wealth-building tool
The Roth IRA is one of the most common “levers” you can pull to immediately improve your overall financial situation. Further, its tax-protected status, assuming tax rates do in fact rise over the coming years, makes it an even more valuable arrow in your quiver.
Before contributing to a Roth IRA, it’s very important that you review your previous years’ income as well as your anticipated income for the upcoming year to ensure that you’re eligible to contribute directly. If you’re not eligible, you might consider a backdoor Roth IRA, subject to other limitations.
Like with any financial transaction you are considering, review your Roth IRA contribution in the context of your broader financial situation to determine its suitability for your unique set of circumstances. If it does make sense for you, there’s never been a better time to do it.