Tax-free income is a dream of every taxpayer. And if you save in a Roth account, it is a reality. Roth’s are the youngsters of the retirement savings world. The Roth IRA, named after the late Delaware Sen. William Roth, became a savings option in 1998, followed by the Roth 401(k) in 2006. Creating a tax-free stream of income is a powerful retirement tool. These accounts offer big benefits, but the rules for Roth’s can be complex. Here are ten things you must know about adding a Roth to your nest egg.
- You Pay Uncle Sam Now Instead of Later
Roth’s turn traditional IRA and 401(k) rules on their head. Rather than getting a tax break for money when it goes into the account and paying tax on all distributions, with a Roth, you save after-tax dollars and get tax-free withdrawals in retirement.
By accepting the tax breaks for traditional accounts, you accept the government as your partner. If you are in the 24% tax bracket, for example, 24% of all earnings will effectively belong to the IRS to be collected when you withdraw the money. With a Roth, 100% of all future earnings are yours.
The Roth strategy of paying taxes sooner rather than later will pay off particularly well if you are in a higher tax bracket when you withdraw the money than when you passed up the tax break offered by the traditional account. If you are in a lower tax bracket, though, the Roth advantage will be undermined.
- There Are Limits to Contributing to a Roth IRA
To be able to contribute to a Roth, you must have earned income.
In 2020, you can stash up to $6,000 in a Roth IRA and an extra $1,000 if you are 50 or older.
But higher-income taxpayers are barred from contributing to a Roth IRA. For 2020, the ability to contribute to a Roth phases out if your adjusted gross income is between $196,000 and $205,199 for joint filers and between $124,000 and $138,999 for single filers.
You can make a 2020 Roth IRA contribution as late as April 15, 2021. You can contribute to both Roth and traditional IRAs, but the total cannot exceed the annual limit.
- Your Company May Offer a Roth Option
Many companies have added a Roth option to their 401(k) plans. After-tax money goes into the Roth, so you will not see the immediate tax savings you get from contributing pretax money to a traditional plan. But your money will grow tax-free. (Any employer match will go into a traditional 401(k) account.)
For 2020, you can stash up to $19,500 a year, plus an extra $6,500 a year if you are 50 or older, into a 401(k). Contributions must be made by December 31 to count for the current tax year, and the limit applies to the total of your traditional and Roth 401(k) contributions. A Roth 401(k) is a good option if your earnings are too high to contribute to a Roth IRA.
- You Can Do a Roth Conversion
Another route to tax-free earnings inside a Roth is to convert traditional IRA money to a Roth. In the year you convert, you must pay tax on the full amount shifted into the Roth. That is the price you pay to buy tax freedom for future earnings. (If you have made nondeductible contributions to your traditional IRA, a portion of your conversion will be tax-free.)
If you expect your tax rate to be the same or higher in the future, converting could make sense; if you expect your future tax rate to be lower, it might not.
You will want to pay the tax owed on a conversion with money outside of the IRA. Drawing money from the IRA to pay the tax will result in an additional tax bill, and a penalty if you are under age 59 1/2.
- A Conversion Could Trigger Other Tax Events
Look at the big picture if you plan a conversion. The added taxable income could boost you into a higher tax bracket. A big jump in income could trigger other taxes, too, such as the 3.8% surtax on net investment income. For Medicare beneficiaries, a rise in adjusted gross income could result in premium surcharges for Part B and Part D.
A series of small conversions over several years could keep the tax bill in check. For instance, you may want to convert just enough to take you to the top of your current tax bracket.
- You Must Pass the Tests for Tax-Free Earnings
Because there is no tax deduction for Roth contributions, you can retrieve that money at any time free of taxes and penalties, regardless of age.
But for earnings to be tax- and penalty-free, you must pass a couple of tests. First, you must be 59 1/2 or older. You will get hit with a 10% early-withdrawal penalty and taxes if you take out earnings before you hit age 59 1/2. And you must have had one Roth open for at least five years. If you are 58 and opening your first Roth IRA in 2020, you can tap earnings penalty-free at age 59 1/2, but you will not be able to tap earnings tax-free until 2025.
There is a different rule for conversions. Read on.
- There Are Two Five-Year Rules
If you make a conversion, you must wait five years or until you reach age 59 1/2, whichever comes first, before you can withdraw the converted amount free of the 10% penalty. Each conversion has its own five-year holding period. So, if a young account owner does one conversion in 2019 and a second conversion in 2020, the amount from the first conversion can be withdrawn penalty-free starting in 2024 and the amount from the second starting in 2025.
Earnings on a converted amount can be withdrawn tax- and penalty-free after the owner reaches age 59 1/2, if he or she has had any Roth IRA opened at least five years.
- There is an Order to Withdrawals
The rules for determining the source of money coming out of a Roth work in the taxpayer’s favor. The first money out is considered contributed amounts, so it is tax- and penalty-free. Once contributions are depleted, you dip into converted amounts (if any). This money is tax- and penalty-free for owners 59 1/2 and older or younger ones who have had the converted amount in a Roth for more than five years. Only after you have cashed out all converted amounts do you get to the earnings. Once the account owner is 59 1/2 and has had one Roth for at least five years, earnings, too, can be withdrawn tax- and penalty-free.
The ability to tap money in a Roth IRA without penalty before age 59 1/2 allows for flexibility to use the Roth IRA for other purposes. For example, the account could be used as a fallback for college savings.
Once you reach retirement, having a pot of tax-free income to draw upon may allow you to lower your tax bill. Roth money does not count in the calculation for taxing Social Security benefits, for example, or in the calculation for the new tax on investment income.
- You can be more aggressive with Roth’s since there is no RMD.
Unlike Traditional IRA accounts that have a required minimum distribution (RMD) which begins at age 72, a recent change thanks to the passing of the SECURE ACT, Roth IRA accounts have no RMD at all. This usually means that this account has the longest time horizon of any retirement accounts a retiree owns. Since the time horizon is so long an investor can take advantage of this by taking more investment risk in the account. This is a case-by-case decision of course and not a one size fits all solution.
- A Roth Can Benefit Heirs
There were many provisions in the SECURE Act – including raising the age for required minimum distributions for retirement plans – but one of them was key for beneficiaries of IRAs.
The new law changed how much time many non-spouse beneficiaries of an IRA can take before they must empty the account, and they now must close out an inherited IRA within 10 years.
The timing to investigate a Roth conversion is especially critical now, before the current tax legislation sunsets at the end of 2025. Given the COVID-19 relief provided by the government and the increased budget deficit, it is highly likely that income taxes, including capital gain rates and estate taxes, could increase in the future.
Under the old plan, distributions from an inherited IRA could be taken over the beneficiary’s lifetime. While inheritors had to take a required minimum distribution each year, they could stretch those distributions over a longer time frame. In a traditional IRA, that meant a beneficiary could minimize withdrawals and therefore the tax impact and let the account grow over time.
Now with just 10 years until inherited IRAs must be closed out, a beneficiary must realize income from a traditional IRA more rapidly and take a tax hit on it. However, new distribution rules do not require annual minimum distributions, only that the IRA be empty at the end of 10 years.
The result will most likely be a quicker depletion of the inherited IRA but also more of the inherited IRA going to taxes, especially if the beneficiary is working during the time in which they must spend down this IRA.
Converting Traditional IRA accounts to Roth IRA accounts could lessen the tax burden on your heirs even though the account must be emptied out in 10 years.
Kowal Investment Group and its advisors do not offer tax or legal advice. You should discuss any tax or legal matters with the appropriate professional.
Any opinions are those of Kowal Investment Group. This material is being provided for informational purposes only and is not a complete description, nor is it a recommendation. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Investing involves risk and you may incur a profit or a loss regardless of strategy selected. Prior to making an investment decision, please consult with your financial advisor about your individual situation.
Kowal Investment Group, LLC (“Kowal”) is a Registered Investment Advisor (“RIA”). Kowal provides investment advisory and related services for clients in State of Wisconsin and other states. Kowal will maintain all applicable registration and licenses as required by the various states in which Kowal conducts business, as applicable. Kowal renders individualized responses to persons in a particular state only after complying with all regulatory requirements, or pursuant to an applicable state exemption or exclusion.
