The COVID-19 pandemic has shifted how you work, shop for groceries, and have fun in your spare time. Now there's good reason to consider revising your retirement savings strategy as well.
COVID-19 first appeared in the U.S. in January. By April, much of the economy was on lockdown and millions of U.S. workers had lost their jobs. Even as those millions leaned on expanded unemployment benefits, debtors and landlords saw repayments and rent income dip as households had trouble keeping the bills paid.
One thing was clear: Americans were sorely short on emergency funds. The federal government tried to bridge the gap by sending out stimulus checks and by freeing access to funds locked in retirement accounts.
As the adage goes, hindsight is always 20/20. After the 2008 financial crisis, for example, Americans got motivated about paying down their debt balances. Total household debt in the U.S., including mortgages, student debt, auto loans, and credit cards, declined steadily from 2008 until 2013. In the 2020 economic meltdown, the lesson learned should be about the importance of having ample emergency cash on hand.
Roth contributions to supplement emergency funds
That's where Roth IRAs and Roth 401ks can help. Because contributions to a Roth account are made with after-tax dollars, you can withdraw those contributions at any time without penalty or tax implications. It's true. Only the earnings in your Roth are temporarily untouchable -- those earnings are not available for tax-free withdrawals until you reach age 59 and a half.
That means you could use Roth IRA or Roth 401k contributions as supplements to your emergency fund. Withdrawing from your Roth accounts is still a last-resort option, but it's a better last resort than pulling from a traditional 401k. Even with the lessened restrictions on 401k withdrawals in 2020, you still have to pay income tax on those withdrawals or repay the money in full within three years.
The question of taxes
Plus, your qualified Roth distributions in retirement are fully tax-free. And having a tax-free source of income is a nice layer of protection against future income tax increases. That's not to say taxes will definitely rise, but it is a reasonable possibility. Trillions in federal funds have been spent on coronavirus stimulus programs, and those funds need to be recovered somehow. As well, 2020 is an election year, which always throws the future of income taxes into question.
Contributing to a Roth IRA or 401k
The first thing to know is that Roth IRA contributions are subject to income limitations. Meet those income requirements and you can deposit up to $6,000 in a Roth IRA this year, or $7,000 if you're 50 or older. Single filers have to make less than $124,000 in Adjusted Gross Income (AGI) to qualify for the full contribution. Partial contributions are available for single filers with income between $124,000 and $139,000. Married joint filers can contribute fully when their AGI is $196,000. They can make partial contributions with income above $196,000 but below $206,000.
If you have access to a Roth 401k or designated Roth account within your traditional 401k, your contribution limits are much higher. There are no income restrictions, either. In 2020, total 401k contributions, including Roth and traditional deposits, are capped at $19,500, or $26,000 if you're 50 or older. Your employer-matching contributions don't count against those limits.
If you can't make Roth 401k contributions and your income is too high for Roth IRA contributions, there is another option. You can contribute to a traditional IRA and then convert that account into a Roth IRA.
There's a big caveat here, though. Your Roth IRA conversion will very likely have pricey tax consequences. That shouldn't be too surprising, since you're converting pre-tax contributions into after-tax ones. Any deductions you've already claimed on converted funds have to be repaid. You'll also owe taxes on any gains earned from those converted funds.
You may even owe taxes if you make a nondeductible contribution and immediately convert it. That's because the IRS looks at your aggregate IRA balance to determine how much of that conversion is taxable. Say you already have $15,000 in deductible IRA contributions in one account, and you make a nondeductible contribution of $5,000 in a new account this year. If you roll the $5,000 into a Roth IRA, the IRS assumes that your rollover consists of 25% after-tax dollars and 75% pre-tax dollars. In other words, you'd pay taxes on $3,750 of your rollover.
Roth contributions, for security and tax diversity
If this pandemic has exposed a lack of emergency funds on your balance sheet, your first order of business is to start building up your cash savings. You can supplement that effort by increasing retirement contributions to a Roth account.
Hopefully, the next crisis is decades away and you won't have to dip into those contributions until your senior years. But then, go ahead and dip away without tax consequences. Whether or not tax rates go up, you'll like having the flexibility to manage those pesky income taxes in retirement.