The Roth IRA has been around since 1998 as an alternative investment. However, to the average investor, the understanding of the Roth remains limited. As our country takes on the formidable COVID19, it is the duty of those who share my profession to help educate our clients on the various opportunities to help them efficiently navigate to their desired financial goals. The effects of the COVID19 pandemic have had severe consequences on our economy. The anticipated movements in interest rates and taxes as a remedy for the economic devastation are centered around maximizing economic growth and minimizing excessive debt.
The main advantage of the Roth IRA is a compelling one that most investors can appreciate – tax-free distributions¹. Who doesn’t like to hear “tax-free distributions?” But most investors are also familiar with the primary obstacle of a Roth IRA – it’s established with after-tax money. Whether you pay taxes when you convert a traditional IRA, or you open up a Roth with after-tax contributions; it’s after-tax money.
The contribution limit for a Roth IRA is the same for a traditional IRA - $6,000 for individuals ($7,000 if over 50). However, there are income limits to contributing to a Roth IRA - $139,000 for a single taxpayer, and $206,000 for married couple's filing jointly.
To convert a traditional IRA to a Roth IRA, there is no income limitation. However, ordinary income tax is due on the value of the traditional IRA when converted.
In this blog, I will summarize some of the general reasons one should investigate investing in a Roth IRA in today’s financial climate.
¹Once 5-year waiting period of opening Roth IRA is over, and age 59½ is reached.
Probable Higher Future Taxes
Another reason the Roth IRA may not get the attention or consideration of other investments is because the determination of whether opening of a Roth IRA was a wise move won’t be known until well into the future – we can’t determine today. If you can save in future taxes more than what you paid upfront in taxes, well then you made a great financial decision. The missing variable is what our future taxes will look like. To estimate future tax liability, it’s the combination of both projecting an individual’s personal financial situation and what our country’s general tax rates will be. Planning for personal income and expenses during retirement is not as difficult as trying to estimate what general tax rates will be.
Since taxes need to be paid upfront with a contribution or conversion to a Roth IRA, the sooner you can recoup those upfront taxes, the sooner you can enjoy tax-free withdrawals. Therefore, if your tax rate is lower in the future than it is now, it will take longer to recoup the upfront taxes. If your tax rate is expected to be higher in the future than it is now, then you will recoup tax much faster.
The stark reality of our economy is that we’ve reached staggering levels of the national debt – at this writing, close to $24.5 trillion² – the number two, four, five, and then eleven 0’s! Moreover, the need to stimulate the economy will most likely remain a priority for several months which will lead to probable increases in the national debt.
² Source: US Treasury
Aside from political debates on incurring debt to justify economic expansion, or the moral issue of passing on enormous debt levels to future generations, the simple fact is that somehow, someway, that debt will have to be repaid. Since its tax revenue that is our nation’s number one source of income, it is not unreasonable to believe that tax rates will rise in the future.
Current Down Market
When converting a traditional IRA to a Roth, the lower the value of the IRA, the lower the tax liability for converting. For instance, let’s assume the balance of a traditional IRA on Dec 31, is $300,000 but has fallen to $250,000 by March 31, 2020. If there is a belief that the account balance is temporarily depressed, and will eventually regain the $50,000, then converting the traditional IRA at $250,000 will evade the current income tax on the additional $50K ($300K - $250K).
The impact of the COVID19 has potentially created a situation where the recent magnified declines in the market may create an opportunity to take advantage of a lower tax bill and greater tax-free withdrawals in the future.
Benefits of Reducing Taxable Income
The benefit of taking tax-free withdrawals from your Roth IRA is that taxable income is lowered, and consequently, taxes should also be reduced. There are other benefits, however, that are less apparent:
- Medicare B premiums are based on taxable income reported on tax returns two-years prior (click to see chart). For instance, 2020 premiums will be based on the 2018 tax return. By reclassifying your IRA distributions from taxable to non-taxable (Traditional to Roth), you can potentially save hundreds of dollars per year in Medicare B Premiums.
- Certain deductions and credits available on tax returns are based on the amount of taxable income, such as medical expenses, IRA deduction limits, college education credits, etc.
- One of the advantages of waiting beyond your full retirement age to receive Social Security benefits is that annual payments are increased by 8% a year from your full retirement age (age 66 to 67) to age 70. The problem, however, is if someone intends to retire at their full retirement age, they will need to have alternative sources of income to help fund their retirement until Social Security is received. Receiving non-taxable Roth IRA distributions could be an efficient strategy to help pay for expenses until age 70.
Beneficiaries Of Roth IRA Also Receive Tax-Free Distributions
Roth IRA distributions which are tax-free to the account holder will also be tax-free to the account holder’s beneficiaries. Although withdrawals from the Roth IRA are generally tax-free, the length of time to “stretch” out the payments was reduced for some beneficiaries as a result of the SECURE act, passed in the fall of 2019.
A provision of the SECURE Act eliminates the ability of the beneficiary to take distributions over the life expectancy and replaces it with a 10-year rule. The 10-year rule provides that distributions must be made to designated beneficiaries within 10 years from the date of the IRA owner’s death. Certain eligible beneficiaries’ (surviving spouse, disabled or chronically ill beneficiary, an individual who is not more than 10 years younger than the IRA owner, a child of the owner who has not reached age of majority) are not subject to the 10-year rule. For non-designated beneficiaries (charity, estates), the old 5-year rule remains unchanged.
Example: Kenneth, age 78, currently owns a Roth IRA. His granddaughter, Melissa, age 6, is the sole beneficiary. Prior to the Secure act, if Kenneth had died, Melissa would begin distributions by the end of the following year (age 7) and could be “stretched” out for Melissa’s lifetime. But since this is a Roth IRA and its distributions are tax-free, Melissa would most likely would withdraw funds sooner (as a adult). The new rule requires Melissa to withdraw the entire balance of the inherited account by the time she reaches 16 (10 years). Although the withdrawals will remain tax-free regardless of the payout period, this may be problematic for younger beneficiaries who could inherit large sums of money.
Back Door Roth IRA
As long as someone has sufficient earned income, they will qualify to contribute to a Traditional IRA – but whether or not they can deduct the contribution will depend on other factors such as an employee’s adjusted gross income (AGI), marital status, and whether or not they or their spouse are participants in an employer retirement plan. If AGI thresholds are exceeded or any other factor disqualifies the deduction, the contribution becomes an “after-tax contribution” to your IRA because you were not able to deduct the contribution. Many people have after-tax contributions mingled with their pre-tax contributions in their traditional IRA account. The after-tax contributions are eligible to be withdrawn tax-free, but the earnings and gains from those after-tax contributions will be taxed at ordinary income tax rates.
A Back-Door Roth IRA can convert future gains from the after-tax portion of your traditional IRA to tax-free status. The procedure is to:
- Segregate the after-tax portion of your IRA account from the pre-tax portion, and
- Transfer the after-tax portion to a Roth IRA.
Mega Back Door Roth IRA (using 401(K) Plans)
Just like a Back Door Roth IRA, a Mega Back Door Roth is designed to maximize contributions to a Roth IRA by ultimately converting after-tax contributions from a 401(K) plan to a Roth IRA. The main difference with the Mega Back-Door (MBD) is that instead of the after-tax contributions coming directly from a traditional IRA account, the after-tax contributions will be derived from an employer-sponsored 401(K) plan. A lot is involved here, but briefly, the opportunity exists to make much larger contributions to an employer-sponsored plan. The process would go something like this:
- Employee makes pre-tax contributions to 401(K) plan - $26,000 limit for those over age 50. The employer can maximize contribution for an employee by contributing up to $37,500 (max contribution =$63,500) to the 401(K) plan as after-tax contributions (The 401(K) plan would have to allow for this).
- Make “in-service” distributions of 401(K) after-tax contributions to either a Roth 401(K) or a rollover traditional IRA (The 401K plan would have to allow for this).
- Transfer after-tax contributions from either Roth 401K (employer) or traditional IRA to Roth IRA.
There are caveats to watch out for, particularly the anti-discriminatory rules regarding your employer retirement plans. However, if suitable, this strategy can be very powerful in accumulating greater Roth IRA contributions.
As a CPA for the past thirty-two years, I understand that many decisions regarding investments require the consideration of taxes and planning expertise for an uncertain future. As I mention above, the choice to establish a Roth IRA depends on what we believe will happen in the future and the amount of “real” taxes we have to pay today on establishing the Roth IRA. My role is to help you have the confidence of making a careful, deliberated, and financially sound decision. Please feel free to contact us to set up an appointment (we can talk on phone as social distancing is in effect) or if you simply have a question.
Thank you,
Anthony Carr