Roth IRA’s – An Underutilized Financial Tool

 

Many people are aware of the significant benefits of Roth IRA’s compared to traditional IRA’s, but there are several ways to take advantage of them that are often overlooked.

Let’s first look at the basic differences between the two types of IRA’s.  The rules described below are generalizations and there are exceptions and added restrictions in some cases so you should check with your financial advisor.

 

 

Roth IRA vs Traditional IRA

A taxpayer with wages or is self-employed is allowed to deduct up to $5,500 ($6,500 if over 50) in contributions to a traditional IRA.  Once in the account the earnings are tax deferred until distribution.  When the taxpayer reaches 59 ½ he can distribute amounts at his choice without penalty and pay tax on the entire amount at that time.  Once he reaches 70 ½ he must begin making annual Required Minimum Distributions (RMD’s) according to an IRS table.

A Roth IRA on the other hand allows the taxpayer to contribute the same amount of $5,500/$6,500 if his income is below certain thresholds on an after-tax basis.  Once in the account the earnings are tax-exempt upon distribution.  When the taxpayer reaches 59 ½ (and the Roth IRA has been in existence for at least 5 years) he can distribute amounts tax free without penalty, and there are no RMD’s starting at 70 ½ unlike a traditional IRA.

One can see that there are definite advantages to a Roth IRA over a traditional IRA in many situations.  For example, if a taxpayer is expecting to be in a higher tax bracket in the future, contributing to a Roth IRA may be better than a traditional. Likewise, if you expect to have a high RMD starting at 70 ½ from a traditional IRA you may want to consider contributions to a Roth IRA or converting to a Roth IRA.


Overlooked Strategies



 Non-deductible IRA Contribution and Subsequent Conversion

While some taxpayers participate in a company 401(k) plan and think they cannot contribute to an IRA, they can make a non-deductible traditional IRA contribution.  Once made they can later make an IRA conversion to a Roth IRA and achieve a Roth contribution in an indirect method with no additional tax cost.  This strategy can also apply to a spousal IRA assuming the other requirements are also met.  There is a potential problem with this conversion if the taxpayer has another traditional IRA already, but if all they have is the non-deductible IRA then this is likely a good strategy.



Contribute Additional Non-Deductible Contributions to Company 401(k) Plan

 Many employees are not aware of a recent IRS rule change in 2014 which allows them to roll post-tax 401(k) contributions to a Roth IRA.  Employees are able to contribute up to $18,000 (24,000 if over 50) of tax deductible contributions to their 401(k).  However, many plans allow employees to contribute more than these amounts in additional post tax contributions.  There are limits however when employee and employer contributions combined reach $53,000 ($59,000 if over 50).  Typically, an employee can make additional post-tax contributions under these limits which allow the earnings to be tax deferred while in the 401(k).  But more importantly, the recent IRS rule change allows the employee to roll these additional post-tax contributions to a Roth IRA at the same time he rolls the pre-tax contributions to a traditional IRA (usually this is at retirement but some plans allow partial rollovers while still employed).



Roth IRA Conversion in Low Tax Years before 70 ½

IRS rules allow converting some or all of a traditional IRA into a Roth IRA by paying the taxes at the time of conversion.  If a taxpayer is in a low tax bracket in retirement but anticipates a large RMD distribution in years after 70 ½ which will put him in a higher tax bracket, then he should consider converting some of his traditional IRA to a Roth IRA in the lower tax years.  Not only is he lowering his tax bracket by the early conversion, he is also eliminating all RMD’s on the Roth IRA amounts.  However, one should consider the collateral effects of a larger amount of taxable income on such things as Medicare premiums, itemized deductions, and taxation of social security benefits.



Contribute to Roth IRA once you reach 70 ½

Taxpayers who have otherwise qualifying earned income can no longer contribute to a traditional IRA once they reach 70 ½.  However, one can contribute to a Roth IRA after 70 ½, so make sure you make the switch at that time.

Roth IRA’s have a very strategic place in a well-constructed financial plan as they provide tax free income to the individuals or ultimately tax free income to their kids.  One should take all opportunities to create or enlarge Roth IRA’s to optimize their tax situation.


 
 
 
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published by sam swisher

JD, CPA, CFA

IRA'sVictoria Haidar