Broker Check
A Closer Look at Roth IRAs

A Closer Look at Roth IRAs

March 25, 2021

With renewed concerns over higher future tax rates, Roth IRAs are being given a closer look by many investors. As the tax code can be a landmine to navigate, there are a number of traps to avoid with regards to Roth IRAs. We take a closer look at some strategies to get additional funds into a Roth IRA even if you are retired or believe your income is too high as well as the considerations you should make to maximize your tax-free growth potential.

Would you rather pay taxes on the seeds or the harvest?

Perhaps the single biggest decision point for retirement savers lies in whether to take an up-front tax deduction and make a Traditional IRA contribution (which will be taxed later when withdrawn) or to forgo the deduction in exchange for the ability to tap into tax-free withdrawals (after potentially many years of compounded growth). One way to think of this dilemma is asking yourself the question, "Would you rather pay taxes on the seeds or the harvest?"

It may be tempting to reduce our current tax burden by taking the tax deduction but creating more tax-free income may be better for our overall financial health in the long run. Three factors you should consider when making this decision are: your current and expected tax rate, how long will the funds in the Roth IRA be able to grow, and what growth rate you anticipate for your investments inside the Roth IRA. A longer timeframe and a higher growth rate would favor saving into a Roth IRA instead of a Traditional IRA.

I would also contend that paying your tax liability now provides you with more certainty as it is a near impossibility to determine what your exact tax rate will be many years into the future. As it stands, we know that individual tax rates will increase automatically in 2026 if Congress fails to extend or make permanent the reductions that took effect in 2018 as part of the Tax Cuts and Jobs Act.

A potential drawback to Roth IRAs is the 5 Year Rule for making tax-free distributions. In order to meet the requirements for a tax-free distribution, 5-years must have passed from the first tax year for which a contribution was made to a Roth IRA account for your benefit.

Additionally, not everyone is eligible to make Roth IRA contributions if their income exceeds certain limits or if they no longer have earned income. You can review Roth IRA eligibility by visiting the IRS website here. Below are a couple of strategies to get money into Roth IRAs if you don't currently meet these qualifications to contribute.

Roth IRA Conversion

Anyone who has funds in an IRA can convert those monies to a Roth IRA. Assuming that the funds in the IRA are all pre-tax dollars, the amount of the conversion will be added to your income and you will owe income taxes in the year of the conversion. Because Roth IRA conversions can no longer be undone, it is important to understand the financial and tax ramifications of making a conversion ahead of time. Figuring out how you will pay the taxes due upon the conversion can be another dilemma. Sometimes folks choose to withhold taxes from the conversion amount, although this will reduce the amount of dollars that get moved into the Roth IRA, thus diminishing some of the benefits.

For example, let's assume you convert $50,000 of your IRA and withhold 20% or $10,000 for federal income taxes due, only $40,000 will move to the Roth IRA. If have the cash available to pay the taxes when they come due or can take the money from a non-retirement investment account with little tax consequence this is usually the preferrable choice.

For those that have contributed to Traditional IRAs for which they didn't or were unable to take a tax deduction, they can also convert these accounts to a Roth IRA. In such a case they will only have to pay taxes on the growth and not the amount originally contributed. As an example, let's assume Lynda Carter has previously made $10,000 in IRA contributions for which she did not take a tax deduction. Several years have passed and the IRA has now grown to $20,000. She can convert the entire balance of $20,000 and she will only owe income taxes on the difference ($20,000-$10,000) or $10,000 which is the growth.

It is important to note that there is a separate 5 year test with regard to Roth Conversions. This IRS rule states that 5 years must have passed before accessing Roth conversion principal. You should also keep in mind that if conversions have occurred over multiple tax years, each conversion must separately meet the 5 year test. The IRS considers withdrawals from Roth IRAs to be taken as contributions first, then conversions, then growth.

Two Step Roth IRA

Because there is no longer an income limitation to making Roth IRA conversions this created an opportunity for some who may not otherwise qualify to make a Roth IRA contribution because they exceeded the income limits. In order to take advantage of this, you would have to follow the two-step process below.

  1. Make a non-deductible contribution to a Traditional IRA.
  2. Convert Traditional IRA to a Roth IRA

If there has been no growth from the time the contribution was made and when it is converted it will be a tax-free conversion assuming you don't run afoul of the IRA Aggregation Rule.

Watch out for the IRA Aggregation Rule

It is important to note that if one has other IRAs then these dollars will be aggregated due to the IRA aggregation rule which will cause any conversions to be taxed on a pro-rata basis. An example of the calculation is shown in the example below.

Rodney Tidwell has $1 million divvied up over five IRAs, with one of them holding $50,000 in nondeductible contributions. If he converted $50,000 from any of those IRAs, part of that conversion is deemed to come from nondeductible contributions. You will divide the nondeductible contributions by the total balance held in the five IRAs to figure the tax-free ratio, and apply that to the distribution. In this example, 5% of the distribution/conversion would be tax free, or $2500 of the $50,000.

$50,000 / $1,000,000 = 5% tax-free ratio.

*Remember the individual must file and keep track of Form 8606 for all nondeductible contributions. IRA Aggregation applies to SIMPLE, SEP, and Traditional IRAs but not 401ks.

Locate Investments with Highest Growth Potential in Roth IRAs

As we discussed, Roth IRAs tend to be more favorable when you have a longer timeframe to stay invested and expect to have the benefit of many years of compounded growth. As such it may be desirable to locate those holdings that have higher expected returns like US and Non-US Stock investments in your Roth IRA. For more information on this strategy, you may want to refer to our previous blog "Fine-Tune Your Taxes for 2020 and Beyond".

Additionally, it may make sense to spend down your Roth IRAs after all other IRAs and investment accounts. Not only are these accounts exempt from taxes and required minimum distributions but their tax-free nature makes these a good way to transfer wealth to the next generation. Those inheriting Roth IRAs can wait up to 10 years to deplete the account due to the new 10-year rule for Inherited IRAs.

Taking advantage of Roth IRAs to their fullest can be beneficial in the long-run, but it is critical to avoid traps along the way. As the tax code is complex and constantly changing you deserve advice tailored to your situation. Having a tax professional and financial advisor working together on your team can lead to better results.


Disclosure

Visionary Horizons, LLC nor any of its representatives provide tax preparation or advice. Please consult with a tax professional prior to implementing any strategy. Registered Investment Advisory Services are custodied at Schwab Institutional, a division of Charles Schwab & Co., Inc. ("Schwab") Member SIPC., TD Ameritrade Institutional, a division of TD Ameritrade, Inc. ("TD Ameritrade") Member SIPC.

Securities offered through Purshe Kaplan Sterling Investments, member FINRA/SIPC, Headquartered at 80 State Street Albany, NY 12207. Purshe Kaplan Sterling Investments and Visionary Horizons, LLC are not affiliated companies.

NOT FDIC INSURED. NOT BANK GUARANTEED. MAY LOSE VALUE, INCLUDING LOSS OF PRINCIPAL. NOT INSURED BY ANY STATE OR FEDERAL AGENCY.