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Roth IRAs are complicated, but often worth it

Roth IRAs are a powerful tool in an investor’s toolbox.

Created in 1998, Roth IRAs are now over 20 years old. Fortunately, many employers started offering Roth 401(k)s and Roth 403(b)s in recent years.

Traditional IRAs and 401(k)s have been used for saving for retirement for many years. After IRAs were introduced in 1974, many retirees saved diligently in these accounts.

Annual required minimum distributions (RMDs) begin at age 70.5, but this was recently changed – by the SECURE Act on Dec. 20, 2019 – to age 72 for persons who turn 70.5 after Dec. 31, 2019.

Taxes are deferred in traditional IRAs until distributions begin, and distributions can begin – without penalties – at age 59.5. All distributions are taxed as income.

The rationale for traditional IRAs was that a person’s tax rate would be lower after retirement. But this is often no longer true. Social Security began being taxed in 1984 and many retirees are now in a high tax bracket due to pensions, RMDs from IRAs and investments.

Roth IRAs – in my view – are the best thing since sliced bread. When money is withdrawn during retirement from a Roth IRA, it is tax-free rather than just tax-deferred. And there are no RMDs required each year from a Roth IRA beginning at age 70.5 or 72. This allows an investor to let the account grow for many years tax-free. The rules are more complicated than with traditional IRAs, which is why many people are not taking advantage of the powerful Roth IRA.

Because Roth IRAs have several important details, this article is being divided into two parts. Part Two will appear in Outlook on Monday, July 13, and will cover the five-year rules, changes for beneficiaries, and information about who benefits from a Roth IRA.

Artwork by Mark Weber

Let’s review the rules.

Contributing to a Roth IRA: Anyone with earned income can fund a Roth IRA. Retirees on Social Security or receiving pensions (with no earned income) cannot. If a single person has modified adjusted gross income of less than $124,000 or a married couple of $196,000, they can fund a Roth IRA with up to $6,000 if they are under age 50 in 2020, and $7,000 if they are over age 50. This can be done any time until April 15, 2021, for the 2020 tax year. (The income limits change each year with inflation; see www.irs.gov for details.)

Contributing to a Roth 401(k) or 403(b): Now that Roth 401(k)s and Roth 403(b)s through employer retirement plans have become prevalent, they are becoming a great way to fund a Roth. There are no income limitations for participating in an employer’s Roth 401(k) or Roth 403(b). The maximum contributions for 2020 are $19,500 for persons under 50 and $26,000 for persons over 50.

Money invested in a Roth IRA, Roth 401(k) or Roth 403(b) is not deducted from taxable income in the year of the contribution, so there are no tax benefits on the front end. This is very different than funding a traditional IRA, 401(k) or 403(b), which provide tax benefits in the year of the contribution. However, in most cases, the immediate tax benefits of funding a traditional – tax-deferred – 401(k) are less than the long-term benefits of funding a – tax-free – Roth 401(k). See your tax adviser for details on your situation.

A person can fund a Roth IRA and a Roth 401(k). Both can be funded concurrently.

Converting a Traditional IRA to a Roth IRA: Anyone – any age and any income level – can convert a traditional IRA to a Roth IRA. The downside – and it is a serious downside – is that whatever amount you decide to convert is added to your income that year for taxes. It is best to have the money outside of an IRA to pay the taxes on the conversion each year. The key is to manage the tax rate while converting, and you can convert any amount you choose. I have had clients convert a traditional IRA to a Roth IRA over many years.

The CARES Act (which originated from the COVID-19 crisis) resulted in all RMDs from traditional IRAs being waived for 2020. This only impacts persons over age 70.5 who were taking RMDs. If a person is using their RMD for living expenses, they may choose to not make any changes during 2020. However, for persons who do not need their RMD, 2020 may be an opportunity for a Roth conversion.

I have clients who are doing a Roth conversion because they are not required to take their RMD. The RMD would be taxable income, so they are choosing to do a Roth conversion of roughly the same amount. The taxes are the same. (Another detail – in years other than 2020, the RMD must be withdrawn first, before a Roth conversion can occur. The fact that the RMDs are waived in 2020 eliminates this issue.)

Read next week’s Business Outlook section for the remainder of this article on the powerful Roth IRA.

Donna Skeels Cygan, CFP, MBA, is the author of “The Joy of Financial Security.” She has been a fee-only financial planner in Albuquerque for over 20 years, and is the branch manager for the Mercer Advisors office in New Mexico. Contact her at dscygan@sagefuture.com. For the full version of this column, email dscygan@sagefuture.com.

 

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