The Roth IRA (“Roth”) is an excellent tool to help provide for retirement funding. Here are 3 Proven Reasons You Need a Roth IRA. The Roth is a younger investor’s best vehicle to use. Unlike the IRA, the Roth is not income tax deductible. This means contributions to a Roth are made with after tax dollars. Why invest in the Roth if there’s no income tax deduction? Good question. With the Roth, if the account has been opened for at least five years and the taxpayer is over age 59 ½ when they start taking distributions, then all of the earnings are tax-free. This is a very big deal. Unlike the IRA, qualifying distributions from a Roth aren’t tax-deferred, they’re tax-free. Remember the maximum that can be put into an IRA, Roth or any combination of them is $5,500 in 2016. The annual catch-up contribution of $1,000 is also allowed for people over age 50. Unlike the IRA, contributions can be made to a Roth even if when someone is an active participant in an employer sponsored retirement plan like a 401(k) plan.
There are only two requirements to be eligible for a Roth. First, a taxpayer needs to have earned income, at least up to the amount of the contribution. Earned income can be from wages or perhaps self-employed earnings. Second, there is an income limitation. The following schedule is used to determine who is eligible to contribute to a Roth based on their modified Adjusted Gross Income (“AGI”) for 2016:
$184,000 – $196,000 $117,000 – $132,000
For example, a married couple filing a joint tax return is eligible for a Roth if their modified AGI is less than $184,000; they aren’t eligible when it’s over $196,000. When their modified AGI is between these amounts a partial contribution is allowed. For a single person the modified AGI limit is $117,000 and is fully phased out at $132,000.
One big advantage the Roth has over the IRA is that it isn’t subject to the Required Minimum Distribution (“RMD”) rules, during the owners’ or surviving spouse’s lifetime. This allows the account to continue to grow income tax-free. This makes the Roth an effective tool to transfer wealth to the next generation. A non-spousal beneficiary however, like a child, of a Roth however is subject to the RMD rules upon the death of the owner. The RMD rules require investors to begin taking annual withdrawals from their IRA by April 1st of the year following the year they turn 70 ½. The IRS has a table that requires IRA owners to take distributions over their life expectancy. Some investors might want to Consider Taking Their RMD early.
Another benefit to the Roth, for taxpayers that have earned income, is that contributions can be made even after age 70 ½. Contributions aren’t allowed to an IRA after this age. Finally, with the Roth an investor can withdraw their contributions at any time without paying any income taxes or penalties.
Additionally the Roth could be used as a backup plan to help pay for college. This is one of the things that make the Roth so wonderful. Contributions to a Roth can be withdrawn at any time without any income taxes or penalty and they are considered to be withdrawn first. Only the earnings can’t be taken out, at least until the account has been opened for at least five years and you are over age 59 ½, to avoid the 10% premature withdrawal penalty.
A Roth Conversion (“conversion”) is when a taxable distribution is made from an IRA and converted to a Roth. When a conversion is done, income tax is due on the IRA distribution. The 10% premature distribution penalty on distributions made before age 59 ½ however is not due on conversions.
Because there’s income tax due on the conversion, the money will need to be available from other sources to pay this income tax.
It’s important to understand that a conversion doesn’t need to be an all or nothing decision. Taxpayers don’t have to decide to convert their entire IRA or not. Partial conversions are allowed. This means taking only a portion of an IRA and converting it. So the question isn’t whether you should do a conversion or not. The key question to ask is what can you afford to convert? For example, if someone had $100,000 in an IRA and they were in the maximum tax bracket of 39.6%, the federal income tax on a conversion would be $39,600. To convert this IRA they would need to have the money to pay the taxes from another source. If they didn’t have this much money available they wouldn’t be able to convert their entire IRA. For example, if they had $3,960 available to pay the income taxes, they could afford to convert about $10,000 from their IRA. With limited exceptions, any amounts distributed from an IRA prior to age 59 ½ that aren’t converted are subject to both income tax and the 10% penalty.
Doing a conversion is counterintuitive. Almost every other facet of tax planning revolves around two simple ideas, accelerate tax deductions and defer income. The strategy is to defer taxes into the future. This approach has served taxpayers well over time. A taxpayer that does a conversion however is accelerating the income tax. Accelerating income taxes may not make sense to some people. The benefit of this however is that after the Roth is open five years and the taxpayer is over 59 ½ then all of the distributions are income tax free.
Who should consider a conversion? First, people who have the money to pay the tax on the conversion. If you don’t have the money to pay the taxes then a conversion doesn’t’ make sense. Taking the money from the IRA to pay the taxes doesn’t make sense. Wealthy Connecticut taxpayers should consider the 3 Reasons Affluent Connecticut Residents Should Consider a Roth Conversion.
Younger people should also consider a conversion. Why? It’s our old friend again, time. The tax-free growth of the Roth over a long period of time is where the real benefit comes in. Younger people can avail themselves to this long time horizon.
Keep in mind, a conversion shrinks an investor’s taxable estate. The income taxes paid on a conversion reduce a taxpayer’s taxable estate. For example, let’s say a taxpayer had $500,000 in an IRA and wanted to do a conversion. Assuming a federal tax bracket of 35%, the federal income tax on the conversion would be $175,000. Paying the income taxes on this conversion reduces their taxable estate. A conversion can be an effective technique for taxpayers with an IRA that want to decrease their taxable estate.
With all of these choices, what should an investor do? Higher income earners should fund their 401(k) plan to the maximum allowed. This is because the 401(k) plan offers several benefits that IRA’s don’t. First, a higher income earner will likely be in a high tax bracket while they are working. When they retire they may be in a lower tax bracket when they start taking distributions. Defer the taxes in a higher tax bracket and tax these distributions when perhaps, you’re in a lower bracket. Second, many employers will match a certain percentage of the employees 401(k) plan contribution. Employees eligible for this plan need to make sure they get this fringe benefit. Third, not everyone is eligible for a tax deductible IRA or a Roth. For people that aren’t eligible for either of these their 401(k) plan becomes even more important. Finally, some 401(k) plans allow plan participants to borrow against their account. If the plan allows for loans, participants can borrow up to the lesser of one half of the account balance or $50,000. This loan provision is not available with IRA’s. I’m not advocating borrowing from your 401(k) plan to buy that brand new, fire-engine red BMW 750i you have had your eye on for the past six months. It’s a nice feature if the loan option is available with your 401(k) plan; just don’t use it to go out and buy more stuff. This loan feature might be used as a backup plan for college funding.
Let’s look at a married couple both over age 50 that works for employers that offer a 401(k) plan. Each of them can contribute $24,000, $18,000 plus the $6,000 catch-up to their 401(k) plan in 2009. They could also contribute $6,500 each to their Roth, if they were eligible. The total contributions allowed to retirement accounts for this couple could be $61,000 a year. That’s a lot of money. Perhaps more annual savings for retirement than many people can afford. Depending on their cash flow; many people may not be able to fund up to the maximum annual contribution allowed. Which account should they fund first if this is the case? There are a couple of considerations. First, is their employer providing a match in the 401(k) plan? If so, they should fund the 401(k) plan first, at least up to the amount eligible for the employer match. Many employers will typically match of 50% on the first 6% contributed by the employee, which works out to a 3% match. Employees should contribute enough money to the plan to get the employer match, it’s free money. In this example, by contributing to the 401(k) plan and getting the employer match you’re getting a 50% rate of return. It is hard to find investments with this type of return.
Which account should be funded next? Put more money into the 401(k) plan or contribute to a Roth? For people that aren’t eligible for a Roth the answer is easy, put more money into the 401(k) plan. This is their best option for tax-deferred investing. If you are eligible for a Roth, which account should you fund? This depends on your age, tax bracket, and expected tax bracket in retirement and life expectancy. You’ll have to calculate whether putting more money into the 401(k) plan or a Roth is better suited for your situation. Given the choice, I would suggest funding the Roth to the maximum allowed. Yes, the income taxes are paid up front instead of deferring them when investing in a 401(k) plan or IRA. Keep in mind, income tax rates are near historic lows. Theoretically income tax rates can go down, stay the same or go up. With the federal government continually running massive annual deficits it appears that tax rates would only head in one direction, up. Funding a Roth makes even more sense for younger people. Why’s this? It’s their old friend, time. Younger investors have more time. The tax-free growth of a Roth over a long period of time is hard to beat. Additionally it is likely that younger investors just starting their career are at the low end of their earning capacity. This means they will likely be in a low income tax bracket. Pay the income taxes up front with a Roth at a lower tax bracket. Then having many years of tax-free compounding makes a lot sense.
The biggest advantage with the Roth is the tax-free earnings.
Remember, there are only two criteria to have all of the distributions from a Roth be income tax-free. Have the Roth account opened for at least five years and be over age 59 ½ before taking any distributions. After this, there is no more income tax due. Additionally, there is no requirement to begin withdrawing money from a Roth for the account owner or their surviving spouse during their lifetime.
This material is provided for educational purposes only and does not constitute investment advice. The information contained herein is based on current tax laws, which may change in the future. Raymond James cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided in this publication or from any other source mentioned. The information provided in these materials does not constitute any legal, tax or accounting advice. Please consult with a qualified professional for this type of advice.