Is Your Investment Advisor Wrong About a Roth?
While a Roth IRA can be a tremendous tool, the amount of misinformation regarding their applicability and utility creates a lot of confusion with most investors. Below, we address some of the biggest misconceptions with Roth IRAs, and how you might be able to use them to your advantage.
Roth IRA Tax Benefits Created by the Taxpayer Relief Act of 1997, Roth IRAs are a relatively new creation by investment account standards. While Roth IRA contributions are never deductible entering the account, Roth IRA earnings can be withdrawn tax-free any time after the later of age 59½ and at least five years after opening the Roth IRA. Additionally, amounts contributed to Roth IRAs (principal) can be withdrawn tax-free at any time and are not subject to the 3.8% Affordable Care Act (colloquially, “Obamacare”) payroll tax on personal investment income.
In addition to these tremendous income and payroll tax benefits, a Roth IRA is one of the best legacy assets to leave to children. No distributions from Roth IRAs are required beginning at age 70½, as is true with traditional IRAs. Because of this, the Taxpayer need not tap into his Roth IRA during his lifetime, but can pass the balance down to his children, who can stretch out distributions over their lifetimes, allowing tax-free compounding interest to continue for decades.
Can You Fund a Roth IRA? One of the biggest misconceptions perpetuated by investment advisors is that you cannot contribute into a Roth IRA. While some steps need to be taken to make sure this is done properly and non-business-owner taxpayers may need to calculate the cost-benefit of an initial taxable conversion, every taxpayer can fund a Roth IRA, either directly or indirectly. Taxpayers can make contributions directly into a Roth IRA if their Modified Adjusted Gross Income (MAGI) is below $118,000 (single)or $186,000 in 2018 (married). Higher income taxpayers can make indirect, or “back door” contributions to a Roth IRA.
Under this approach, the tax payer and spouse make the maximum annual contribution ($5,500 per spouse if under age 50; $6,500 per spouse if age 50 or older) into a non-deductible IRA and thereafter convert those contributions into a Roth IRA. This conversion is tax-free if handled as discussed below. Taxpayers who follow our recommended strategies for Roth IRA conversions can achieve federal income tax savings of over $500,000 as shown on the next page. With potential savings of this magnitude, it’s imperative that all taxpayers take maximum advantage of Roth IRAs.
Maximizing Tax-Free Roth Conversions Most Taxpayers have one or more IRAs that contain not only after-tax IRA contributions, but also earnings and rollovers from prior retirement plans. Despite the fact that many taxpayers use Simple IRAs or SEP IRAs in their businesses, both of these accounts are IRAs by definition and will create tax issues if a conversion is attempted without rolling these assets into a 401(k), or another type of retirement plan. We routinely help clients reach tax-free Roth conversions by using the following five-step process:
1) Calculate the cumulative amount of after-tax contributions that have been made to the taxpayer’s IRA. Tax laws require taxpayers to keep a running record of their non-deductible IRA contributions and report them to the IRS on Form 8606 attached to their annual federal income tax return. If the tax payer lacks these records, he or she may be able to obtain this information from the current investment advisor managing the IRA. Otherwise, the taxpayer must simply estimate his or her prior non-deductible contribution(s).
2) Once the Taxpayer has confirmed their total cumulative non-deductible contributions, he or she rolls over the remaining taxable portion of his or her IRAs into a qualified retirement plan, such as a 401(k) or defined benefit plan in which they are participating. If the taxpayer is a small business owner, this is relatively simple, since the taxpayer controls the retirement plan. Otherwise, the taxpayer can confirm with their human resources or benefits department on the ability to do this. Note, the retirement plan document must allow the taxpayer to make the rollover into the retirement plan –this is an elected option that must be confirmed prior to attempting this strategy. Accordingly, the taxpayer must contact his retirement plan advisor to assure that his plan allows this, or if not, is amended to allow it.
3) Convert the regular IRA containing only after-tax non-deductible contributions into a Roth IRA. Since the taxpayer’s tax basis is equal to the cumulative amount of the contributions, there will be no tax due on this conversion.
4) Thereafter, the taxpayer and spouse should make the maximum contribution to their non-deductible IRAs each year. So long as no taxable proceeds are rolled into taxable IRAs from retirement plans, the first year is the only complicated year for shifting proceeds between accounts to avoid triggering taxes.
5) Immediately thereafter, the Taxpayer and spouse should convert these amounts tax-free into their Roth IRAs each year.
Low Cost Roth Conversions Following a Business Sale We work with a significant amount of business owners who, upon selling their business, receive all of their business sale proceeds in cash at closing. After paying the taxes on the sale, mostly at favorable capital gains rates, due to the goodwill treatment of the sale, we recommend that the taxpayer live off the after-tax sales proceeds first. This allows their retirement accounts to continue to accumulate in a tax-deferred environment, and minimizes taxes in the post-sale years.
Even though this creates the best opportunities to generate overall liquid assets, the Taxpayer usually has very little taxable income during these post-sale years, until they begin withdrawing mandatory distributions from their taxable IRA beginning at age 70½. This provides a tremendous opportunity to convert substantial amounts from their regular taxable IRA into their Roth IRA at extremely low income tax rates.
For example, a taxpayer recently sold her oral surgery practice at age 55. Between after-tax investments and practice sale proceeds, we project she will easily be able to live off of non-retirement account assets for 15 years.
Following the practice sale, the retirement plan was terminated and her share of the proceeds rolled over into her regular IRA. Her goal is to accumulate a $2,000,000 Roth IRA balance by age 70, starting from zero. Accordingly, we are targeting for her to convert around $82,116annually ($6,843monthly) to achieve that goal, based on a 6% return.
The $82,116Roth conversion is fully taxable. However, a portion of this income is offset by approximately $50,000 in itemized deductions. As a single taxpayer, she will also be able to convert another $38,700 in the 12% tax bracket or less. This means that she will pay zero dollars in taxes on the first $50,000, 10% on the next $9,525, and 12% on the final $29,175.
While the true total tax savings of what this could potentially save are unknown, her Required Minimum Distributions will place this client in the 35% bracket. All things being equal, the higher balance only adds dollars to the required, taxable distributions at the top marginal taxable rate. Without taking into consideration growth after age 70 on the $2,000,000 balance and using a pure 23% differential (12% v. 35%), she will save $460,000 in income taxes. If we assume a 4% growth rate in the Roth over a 15 year period, this client will have saved over $835,000 in taxes with these strategic conversions.
Whether these conversions are right for you requires intimate planning and precise analysis on what consequences are triggered by making any kind of Roth conversion. However, as illustrated above, there can be significant tax savings when done correctly by a tax-trained advisor who understand the rules surrounding the topic.
By: Andrew Tucker, JD, CPA, CFP®
Andrew Tucker, JD, CPA, CFP®, provides tax and business planning predominately for the dental profession and provides financial consulting advice on a case-by-case basis to non-dental professionals. They publish the McGill Advisory newsletter through John K. McGill & Company Inc., a member of the McGill & Hill Group LLC. Contact Andrew at [email protected] more information
