Roth it? Really? —— Should I Pay Tax Now on Purpose?
Is it time to consider a Roth IRA?
When does it make sense to accelerate your obligation to pay more taxes electively? General answer: NEVER
The general rule of income tax planning is to defer income (into the future) and accelerate deductions (into this year) to lower your income tax bill. So, when does it make sense to pay taxes early in total contradiction to this general rule? Answer: when the tax-free growth on your Roth IRA far exceeds the cost of paying taxes early. Further, do you think that you will be in a higher tax bracket or tax rates will increase significantly over the years? Did you know that the highest income tax rate in 1981 was 70 percent as opposed to today’s highest rate of 37 percent?
What is a Roth IRA? What is a Roth IRA Conversion? What is a Backdoor Roth IRA?
Roth IRA: A Roth IRA is like a traditional IRA; however, the contributions are made with after-tax dollars. The funds in the Roth IRA are allowed to grow tax-free, and when you withdraw the original contributed funds or the growth on the original funds, the distributions are also tax-free. It is truly amazing. For young people in a low-income tax bracket, this is a boondoggle, especially if there is a very long time horizon before having to take out the funds from the Roth IRA.
Roth IRA Contribution Limitations: Note: there are caps on how much an individual can contribute to a Roth IRA each year. The cap for 2019 is $6,000 (or $7,000 for a catch-up contribution if you are over 55). Further, there is a prohibition on high-income earners contributing to a Roth IRA. The income limit is $137,000 for a single taxpayer and $203,000 for a married taxpayer. If you fall into this category, then you may wish to consider a Backdoor Roth IRA discussed below.
Finally, please note that under certain circumstances, you may make Roth IRA contributions for a spouse (this is a well-kept secret).
Roth IRA Conversion: If you have built up a traditional IRA and you wish to switch all or any part of it to a Roth IRA, you may do so. This switch is called a Roth IRA Conversion. The only catch is that you must immediately pay the income taxes on the value of your converted funds (with your next quarterly estimated income tax payment).
Note: the calculation of the tax due is very complicated and requires a unique calculation if you are retaining any other retirement accounts. Please seek the advice of your tax professional(s).
There is no income or net worth limitation on who may use this conversion opportunity; therefore, it is often utilized by high-net-worth individuals who will not need to touch their IRA for a very long time. Non-IRA assets should be used to pay for the tax that triggers upon conversion (to avoid additional income on the funds withdrawn to pay the taxes).
Roth IRA Distribution Rules - The beauty behind the Roth IRA: The Roth IRA grows tax-free precisely like a traditional IRA but, the Roth IRA does not have the same Required MinimumDistributions rules (RMD). Therefore, you can leave the IRA funds invested longer and allow the funds to continue to grow tax-free without forced out distributions (i.e., RMD). The Roth IRA can also pass to a spouse without taxation exactly like a traditional IRA, except the spouse does not have any RMD either. Therefore, the IRA funds can continue to grow tax-free throughout the surviving spouses’ lifetime.
Note: the non-spouse beneficiaries (children and grandchildren) will have an RMD but, the inherited Roth IRA will continue to grow tax-free, and the distributions will all be tax-free. Note: the RMD will be based on the beneficiaries’ life expectancy unless the new proposed Secure Act legislation passes.
Backdoor Roth IRA: If you earn more than the current income limits, you will not be eligible to contribute to a Roth IRA. For these high-income-earners, there is a well-known solution. It is referred to as a Backdoor Roth IRA. That is the nickname; it is nothing more than a contribution to a traditional IRA, which subsequently converts to a Roth IRA. Please ask your tax professional(s) to elaborate if you are in this fortunate category.
Conclusion: Integrate your IRA distribution planning into your existing financial plan - run “what if” scenarios. Here are the issues that you should address with your advisors:
- Does the tax-free growth of the Roth IRA combined with the tax-free distributions far exceed the cost of paying extra taxes now?
- Can you leave the resulting Roth IRA alone for many years to let the tax-free growth outpace the lost accumulation of wealth in the old traditional IRA that you converted?
- Do you have non-IRA funds to pay the tax instead of withdrawing more taxable IRA funds to pay the tax?
- Are you considering using your taxable IRA funds to make a qualified charitable gift?
- Do you believe you will be in a higher tax bracket or that tax rates will soar between now and the time you are required to start taking out your Traditional IRA distributions (i.e., your RMD beginning date)?
Impact of the Secure Act(pending legislation) on Roth IRA planning:
As discussed in our Special Report on the Secure Act, if this proposed legislation passes, then the so-called stretch IRA will be eliminated. The non-spouse beneficiaries (e.g., your children, grandchildren, or nieces and nephews) of your IRA will be required to withdraw the entire balance of your IRA within a short ten year period after the death of the survivor of you and if married your spouse.
This Elimination of the stretch IRA will have a very negative financial and tax impact on your heirs. Notably, the potential dissipation of your lifetime IRA savings in ten years.
In our special report, we discuss a couple of alternative solutions.
Roth IRA after the Secure Act:
The Roth IRA under the Secure Act proposal will also be subject to the 10-year required distribution. The good news is that the distributions are still income tax-free. Therefore, the distributions can be placed in your trust and accumulated for future distributions to your heirs over an extended period.
The Roth IRA Conversion can be a way to control the timing of the tax on your traditional IRA ... How?
By commencing the conversion of your traditional IRA ten years before your life expectancy (or the life expectancy of your spouse), you can spread out the taxation from ten years after your passing to a period of twenty years (ten years before you pass and ten years after your passing).
A combination of several ideas may all be utilized to obtain a very successful tax and financial planning result. For example, combine a charitable remainder trust, a life insurance trust, and a partial Roth IRA to reach all of your estate planning goals.