Twenty years! That's how long Roth IRAs have been around. In the year 2000 only about $77 billion was invested in these types of accounts but by 2017 it is estimated that there is almost $3 trillion in Roth IRAs. While these accounts have enjoyed explosive growth over two decades, many things are not fully understood about this tax-free retirement account.
The history: When the Taxpayer Relief Act of 1997 (TRA 97) was passed, Roth IRAs were created as an alternative means for people to save for retirement. The idea was to eliminate the tax deduction that typically is the result of a traditional IRA, and to allow those funds to grow tax-deferred and possibly tax-free for the account holders. It was aimed at baby boomers in hopes they would flock to the idea of tax-free income in retirement. The contribution limits were set at the same level as traditional IRAs but the adjusted gross income (AGI) limits were set higher to allow more people to benefit. TRA 97 also permitted the conversion of traditional IRAs to Roth IRAs. This "conversion" made the account taxable in that year but had the promise of future tax-free growth if held for at least five years and until age 59½. However, income limitations were placed on conversions that prevented many Americans from being able to take advantage of them. So initial growth in Roth IRAs was slow. Then in 2005, Congress passed legislation that allowed income limits to increase and eventually disappear in 2010, opening the floodgates to conversions for everyone.
The good and bad: Most items between Roth and traditional IRAs are the same but a few important differences exist. A Roth IRA does not provide a tax deduction when contributions are made each year. A traditional account does. A traditional account grows tax-deferred but distributions taken during retirement are taxed at ordinary rates. A Roth IRA grows tax-deferred and distributions are tax-free if held for at least five (5) years and until age 59½. Distributions before this time can still be tax-free up to the amount of contributions made to the Roth IRA. When you reach age 70½, the IRS forces traditional IRA account holders to begin taking required minimum distributions (RMDs). There is no RMD requirement for the owner of a Roth IRA (beneficiaries must take RMDs similar to traditional IRAs). So the main tradeoff for IRAs is that a Roth has no upfront tax deduction but provides backend tax-free income.
Planning point: The ability to convert a traditional IRA to a Roth is a complex decision. How old is the account holder and are they in good health? Does the account holder have other funds available to pay the tax on conversion? Will the account holder need these funds immediately in retirement or are other funds available? Conversions are the simplest way to jump start a Roth IRA but can be prohibitive because of the answers to these questions. Another way to start this process is by simply making Roth contributions. The AGI phase out limits for 2018 are between $120,000 and $135,000 for single individuals, and $189,000 and $199,000 for married couples. Even if the income limitations become a problem, a little known work around called a "backdoor" Roth IRA conversion is available. In this plan, an individual makes a nondeductible traditional IRA contribution of up to $5,500 ($6,500 if age 50 or older). There is no income limitation for a nondeductible contribution and they can be made even if the person participates in a qualified retirement plan at work. The nondeductible IRA can then be converted to a Roth IRA. Any earnings prior to the conversion within the nondeductible IRA will be taxable to the holder in the year of conversion. But the nondeductible contributions could be tax-free in the conversion.
Planning perils: When planning any conversion, care must be taken to make sure the outcome has the desired effect. The IRS put in place a rule for conversions that prohibits an individual from picking and choosing which IRAs or IRA funds to be converted. If an individual owns several IRAs (which also includes SEP and SIMPLE IRAs) the IRS requires you to take the ratio of nondeductible contributions to the total value of all IRAs into account when a conversion is done. If I convert a nondeductible IRA to a Roth IRA with $20,000 nondeductible contributions, but have another $80,000 in another traditional IRA, the result is a majority of the conversion will be taxable. The tax-free conversion is $4,000 (computed as follows: [($20,000 / ($20,000 + $80,000)) x $20,000]). I will be taxed on the remaining $16,000 at ordinary tax rates. Not the outcome I would have anticipated.
Roth IRAs can be a huge benefit to individuals in retirement. The tax-free income does not reduce Social Security payments in retirement, nor does it move an individual into a different tax bracket. Making these types of accounts part of your retirement strategy makes sense on many levels and should be something you should discuss with your financial advisors. Contact us at one of our many locations.
Wednesday, April 24, 2019 | 7:30 AM – 9:30 AM EDT | The Hartford Club