Senior Comments: Roth IRA

health insurance and Medicare

“What I’m saying is, we have now what we have always needed, real partnershipwith government.” Hyman Roth, Godfather II

Coppola had no idea how foretelling those words were and that an IRA with the same name would be incredibly valuable. This preview of the 5 Acts is so readers don’t gloss over this, thinking it is of little value to them.

Prologue

A ROTH IRA is funded with after-tax, non-deductible contributions or taxable conversions from other retirement plans. However, unlike most other retirement plans or traditional IRAs, the growth and earnings are totally tax-free, not merely tax-deferred. There are now some ROTH IRAs of those involved in IPOs that are worth hundreds of millions of dollars, income tax-free. Also, there is no required minimum distribution to the primary owner or surviving spouse (more on this later).

PART I: Everyone should have a ROTH IRA where possible.

A ROTH IRA funded with original contributions needs to age for 5 years before its true benefits are realized. The 5 years is from the initial contribution; it does not reset as more money is contributed. It can even sit dormant. Under this strategy, it is there should it ever be needed. There are different rules for conversions to ROTH.

PART II: This applies to children and grandchildren as soon as they have wages.

There is no age limit, low or high, for having an IRA. A child can even be claimed as a dependent and contribute. The ROTH is so ideal here because of the child’s low or nonexistent tax bracket. Parents or grandparents can even gift money to fund the ROTH.  This can grow for college, a house down payment, or retirement many decades in the future.

PART III: During the working years there is much planning to be done.

While working, there is a great opportunity to utilize a Roth.

  • Some employees can have a ROTH 401(k) instead of a traditional 401(k) with no income restriction.
  • If income is less than $161,000 single or $240,000 married, then a ROTH IRA contribution is allowed.
  • If income is too high, all may not be lost! There is a trick called a “backdoor ROTH,” wherein a non-deductible IRA contribution is made and soon after converted to a ROTH IRA. Provided there are no other IRAs, rollover IRAs, or SEP/IRAs, then this is a tax-free transaction. If there are other IRA equivalents, this becomes much more complicated with some cost. An inherited IRA is not considered for this purpose, nor can it be converted to a ROTH IRA.

PART IV: In retirement, there is tremendous planning to be done.

Now, the fun begins.

  • In retirement, lower income may make conversion to a ROTH less costly.
  • In years with large medical deductions, passive losses that get freed up, or a whole variety of tax situations, there is an opportunity to convert at lower tax costs.
  • Partial conversion to a ROTH IRA reduces required minimum distributions (RMD).
  • Full conversion to a ROTH IRA eliminates required minimum distributions (RMD).
  • However, each conversion has its own 5-year period to qualify.

PART V: Epilogue and Generational Wealth

  • “Deathbed estate planning” includes converting an IRA into a ROTH IRA. If your estate will be taxable at federal and/or state levels, conversion reduces the taxable estate by income taxes on conversion and saves the heirs from paying income taxes.
  • Even if the 5-year period from conversion (or contribution) is not met, all is not lost. The IRS allows contributions to be taken out first and then converted to principal. Income is the last to come out. There are monies that can be taken out immediately by heirs with no tax cost.
  • A surviving spouse may be able to use their own ROTH IRA aging with a spousal rollover when the inherited IRA is less than 5 years old. A surviving spouse with a contributed ROTH IRA that has “aged to 5-year perfection” may result in an instant qualification. These rules get more complicated when affected by age and other options, but they may be very beneficial.
  • If your IRA is going to charity, conversion is probably not the best option.

Side Note: Always make sure you have more than adequate assets for living costs before conversion to a ROTH. It is often best to pay the tax burden from other funds while converting the entire amount into the ROTH IRA (not withholding taxes on the conversion).

Trivia: Although David Lee Roth, former lead singer of the band Van Halen, at age 70, is now considering all the “ROTH” ideas, the ROTH IRA actually got its name from William Roth, Jr, a Democratic senator from Delaware.

As always, if you have any questions or if this affects you, please contact your Friedman+Huey team.

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