Radnor News / Blog


Mon
8/10/20

posted by: Radnor Financial Advisors

A Tax-Efficient Planning Strategy – Roth IRA

IRA Plus.. or Roth IRA?

A Delaware Senator named William Roth and an Oregon Senator named Bob Packwood proposed the idea of an “IRA Plus” in 1989.  The proposed retirement account allowed individuals to invest up to $2,000 of after-tax earned income with no upfront tax deduction; however, the bypass on the upfront deduction would allow for an intriguing 0% tax once that account was distributed during retirement.  Senator Roth eventually became the chief legislative sponsor, leading the Roth IRA (formerly IRA Plus) to be included in the Taxpayer Relief Act of 1997, which started the pipeline for Roth strategies.  In 2000, roughly 46.3 million individuals held IRA accounts with $2.6 trillion of assets (according to the IRS), with only $77 billion held in Roth IRAs.  In 2007, the IRS reported that there were over $800 billion in Roth IRA accounts.

Required minimum distributions

You may have heard of IRA required minimum distributions (RMDs), which are required distributions beginning at age 72 (recently increased from age 70 ½ as part of the SECURE Act) for individuals who have stocked away monies in workplace retirement plans (excl. Roth plans) or tax-advantaged retirement accounts (i.e. IRAs).  If timely RMDs are not taken, one is subject to a 50% penalty on the “lapsed” distribution.  The CARES Act passed in March 2020 in response to the COVID-19 pandemic waived RMDs for 2020, which may create attractive opportunities for an individual in terms of converting the RMD they would have otherwise taken in 2020 to a Roth IRA, depending on their tax circumstances.

Please note, Roth IRAs are NOT subject to IRA RMDs, which is just one of the perks of utilizing this type of retirement savings strategy; however, many high-earners are phased-out due to income above the AGI threshold and thus are not eligible to make Roth IRA contributions.  A single filer is not eligible to make a Roth IRA contributions if they have modified adjusted gross income (MAGI) of $139,000 or greater for 2020 ($206,000 for joint filers).

 

 

 

 

  

*Table and phase-out information courtesy of irahelp.com/2020

Contribution limits

Roth IRAs and traditional IRAs share the same contribution limits.  For 2020, those under age 50 are permitted to contribute up to $6,000 of earning income if eligble to a Roth IRA and/or traditional IRA.  Those older than age 50 are permitted to make an annual $1,000 catch-up contribution in additional to the $6,000 contribution ($7,000 total).  This can be a disadvantage for someone who is eligble to contribute and wants to accelerate retirement savings but is hindered by the contribution allowance.  We suggest that you consult with your financial/tax advisor to determine if you can accelerate contributions by making a 2020 and 2021 contribution (which is also permitted in 2020 as part of the CARES Act) immediately to jump-start your retirement savings.

Roth conversions

Before you “throw out” the idea of a Roth strategy, keep in mind that one can make Roth IRA conversions without being restricted by phase-outs.  A Roth conversion is a phrase used to elucidate the strategy of converting pre-tax assets held in a traditional IRA to a Roth IRA.  The downside is that converted assets are immediately subject to ordinary income taxes (therefore careful tax planning must be examined), but will not be subject to taxes when distributions are later taken post age 59½  and will not be subject to RMD rules.  If you are considering this strategy, you should consult with an experienced and credentialed financial/tax advisor with expertise in tax planning.

Further tax planning

An opportunistic investor may wish to capitalize on reduced investment values within their portfolio during a bear market by converting monies to a Roth IRA.  Essentially, assets converted could be invested in the Roth IRA in the same manner at a lesser value due to a decline in equity markets (which would result in a lower tax bill).

For example, say an individual holds a retirement account with 1,000 shares of ABC Mutual Fund worth $100 per share in January of 2020 ($100,000 account value).  If the said individual was to convert 100 shares of this investment and was in the 24% marginal tax bracket, they would be subject to a federal tax bill of ~$2,400.  If the said individual capitalized on an equity market with lower valuations (20% unrealized loss), they would convert the same 100 shares at $80 per share and be subject to a $1,920 tax bill and have the same quantity of assets converted resulting in higher appreciation/recovery potential.

Elimination of the “STRETCH IRA”

The SECURE Act included provisions which eliminated eligible IRA beneficiaries from taking inherited IRA distributions over their own life expectancy, therefore requiring most beneficiaries (i.e. children) to distribute the full value of the inherited IRA within ten years.  For large inherited IRAs, this can impose significant tax consequences for the beneficiaries.

The new legislation further increased the attractiveness of Roth IRAs given that the ten year distribution window is still required for non-spouse beneficiaries who inherit IRAs; however, inherited Roth IRA distributions are excluded from federal taxes.  Essentially, assets left to heirs in a Roth IRA will likely not cause substantial tax liabilities as distributions are taken.

Key advantages of a Roth IRA:

  • May lower future taxes – tax free withdrawals
  • Distributions of contributed amounts can be taken at any time for any reason
  • Monies can grow tax deferred for a longer – not subject to required minimum distribution rules
  • Tax-free inheritance to heirs

Key disadvantages of a Roth IRA:

  • Immediate tax consequences in the year of the conversion
  • You may not benefit if your tax rate is lower in the future
  • You must wait five years to take tax-free withdrawals (regardless of age)
  • Complications in tax determinations for SEP/SIMPLE IRA conversions
  • Somewhat restrictive contribution limits for those looking to jump start retirement planning

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Derrick J. Goodenow

Financial Planner

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