Funding Your Bucket List Years: The Roth IRA

In our last article in this series, we discussed the importance of accumulating funds into the three different tax “buckets”:  taxable, tax-free, and tax-deferred.  In this article, we’ll focus on the tax-free bucket and, more specifically, Roth IRAs (hereafter referred to as “Roth”).

For individuals with earned income, the tax law allows after-tax contributions directly into a Roth, subject to certain income limitations.  The income limitations for 2019 start at $122,000 for single filers and $193,000 for joint; at these income levels, the eligible contribution starts to “phase out”.  The annual contributions are capped at $6,000 for 2019, for individuals under age 50, and $7,000 if over 50 (increased periodically for inflation) and can be made through April 15^th of the following year.  These same limitations apply to Traditional IRAs as well.

What’s the benefit of accumulating after-tax money in a Roth?  All future earnings grow tax-free.  In other words, the growth on those contributions is never taxed again—the account grows tax-free forever.  The longer the funds sit in the Roth and have time to grow, the larger the potential tax benefit.  Naturally, this is very beneficial for young people; however, we believe the Roth should not be ignored by individuals in their 50s and 60s.

We encourage our clients entering their 50s and 60s to consider a Roth for a few different reasons.  First, to provide them with the “tax diversity” during retirement years, as we discussed in our previous article.  Second, a Roth doesn’t have a required minimum distribution rule forcing money to be distributed at age 70 ½, as Traditional IRAs and other qualified plans do.  This allows for retirees to let Roth money grow well into retirement.  Third, if a Roth owner never “touches” the Roth money during their lifetime, the distributions are still tax-free to the beneficiary—essentially the Roth owner could pass down a tax-free asset to the next generation.

What if individuals are “phased-out” from contributing money directly to a Roth?  Many of our clients are above the income thresholds and prohibited from making contributions directly to a Roth account.  In those instances, we evaluate a “backdoor Roth” strategy.  This strategy allows higher-income individuals, who would otherwise be phased-out,  to still accumulate funds into a Roth account through a Roth conversion.  Congress removed the income limit for Roth conversions, so individuals of any income level can convert money from a Traditional IRA to a Roth, opening the door for this strategy.  Taxes are paid when money is converted from the Traditional to the Roth, unless the money in the Traditional is an after-tax contribution; i.e. it was not deducted in the first place.  The primary goal of the backdoor Roth is to convert after-tax money to the Roth to avoid taxes on conversion.

The typical process of executing the backdoor Roth strategy works like this: an individual contributes money to a Traditional IRA and chooses not to deduct that contribution (anyone can do this, regardless of their income). Next, the individual immediately converts that contribution to a Roth IRA.  The funds converted to the Roth are not taxable since the Traditional IRA contribution was not deducted.  One big caveat to this:  if the individual has other, pre-tax IRA money (say, from an old 401(k) rollover), the Roth conversion must be pro-rated between pre-tax and after-tax contributions.  In other words, we cannot “cherry-pick” the IRA funds we are converting to the Roth and simply count the after-tax contributions we recently made—we must consider all IRA money (including SEP-IRAs and Simple IRAs), as if it were one big IRA, in making the conversion.

While the primary objective is not to pay taxes on the Roth conversion, the strategy may still be preferable; the ultimate goal is to get money into the Roth to achieve tax-free growth from that point through eternity.  In these cases, it is prudent to be on the lookout for years in which taxable income may be lower, so the taxable conversion can be done at a lower tax rate.  As mentioned above, another huge benefit of the Roth is the lack of a required minimum distribution. These Roth conversions would also lower the required minimum distribution amounts from the Traditional IRAs at age 70 ½ and beyond because we are reducing the Traditional IRA account value, upon which the RMD is calculated.  Many of our clients embrace this strategy as a way of attempting to pass more money to their heirs by essentially “pre-paying” the tax on their retirement monies, making it possible for their next-generation of beneficiaries to not have to pay the tax on distributions.

As you can see, there can be many different variables and tax implications to consider regarding a Roth IRA, so it’s imperative you consult with an advisor regarding your specific situation.