Does a Roth Ira Continue to Grow After Retirement
Mo Med. 2015 Sep-Oct; 112(5): 340–343.
To Roth or Not to Roth, That is the Question
Learn some factors to consider and planning ideas for Roth Individual Retirement Accounts
Income tax season is well behind us, and taxpayers are now redirecting their efforts to closing the 2015 tax year. A question often asked by our clients is whether to utilize a Roth Individual Retirement Account (IRA). The answer, as you might expect, is often complex and may differ from person to person. The purpose of this article is to shed some light on the topic of Roth IRAs, and to outline factors that should be considered as you analyze whether a Roth IRA is appropriate for you. Also included are a few planning ideas that may be of benefit.
Background
Individual Retirement Accounts (IRAs) have been around since the mid-1970s. Traditional IRAs came to life as part of The Employee Retirement Income Security Act of 1974 (ERISA), and were designed to promote a tax-advantaged way for Americans to save for their retirement years. At a basic level, the benefit was that a taxpayer would be able to deduct his or her IRA contribution on the current year tax return, with the money inside the account growing tax-deferred over his or her lifetime. Federal and state taxes would not be due until the funds were withdrawn from the account, generally at retirement.
As part of the Taxpayer Relief Act of 1997, Senator William Roth of Delaware added a new wrinkle, introducing the Roth IRA. While there are a number of distinctions between a Traditional IRA and a Roth IRA, two fundamental differences are (1) Roth contributions are made on an "after-tax" basis (no upfront income tax deduction), and (2) withdrawals are typically income tax-free (versus withdrawals from a Traditional IRA which are fully taxable at ordinary income rates).
For 2015, individual taxpayers can make an annual contribution of $5,500 to a Roth IRA ($6,500 for those ages 50 or greater), subject to certain income limitations. Under the current rules, phase-outs for eligibility to make a Roth IRA contribution begin for single individuals when Modified Adjusted Gross Income (MAGI) exceeds $116,000. For joint-filers the limitation begins at $183,000. Once singles reach a MAGI of $131,000 and joint-filers reach $193,000, contributions are completely phased out. (Note that one must have wages or earned income to be eligible to contribute to a Roth IRA, meaning income other than interest, dividends, and capital gains.)
In addition to making annual contributions to a Roth IRA, investors can also convert their Traditional IRAs to Roth IRAs in order to cause future distributions to be tax-free income. When an individual converts from Traditional to Roth, there typically is a tax liability at the point of conversion since no taxes have been paid on the Traditional account to that point. It's not surprising that Uncle Sam and your state taxing authority want their tax money, so if you are considering conversion, be ready to pay-up! Note, years ago there was an income limitation preventing individuals with higher income from converting Traditional IRA monies to Roth IRAs. However, as of 2010, the Internal Revenue Service (IRS) lifted the income cap restriction relating to conversions. Many who were prohibited from even considering such an idea in the past now have the option.
Factors to Consider
Ultimately, the question most individuals ask is, "What's the right answer for me?"
The reality is that there isn't a right or wrong answer. Instead, the goal is to ascertain the best answer given the facts and circumstances. In order to find the answer that fits you best, consider the following general guidelines:
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If your age is less than 40, conversion probably makes sense, because there should be enough time over the remainder of your life for compounded investment growth to easily exceed the "cost" of paying the tax now on the converted amount.
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If your age is between 40 and 50, it is not obvious whether conversion makes sense.
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If your age is greater than 50, it likely doesn't make sense to convert because there is not enough time to allow the Roth IRA growth to exceed the tax cost today.
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Notwithstanding the two previous bullets, no matter your age, if you believe you will never need to draw on Roth IRA assets, it likely makes sense to convert – your heirs will be able to then withdraw after your death income tax-free.
As mentioned, an individual should review the specific facts and circumstances of their situation to determine if conversion makes sense. Some of the arguments and considerations that have surfaced in recent conversations with clients include the following:
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How does my current tax rate compare to what I expect it to be in the future?
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If tax rates increase significantly in the future, money being withdrawn from a Roth IRA won't be impacted (no lifestyle infringement because of an income tax rate increase), whereas Traditional IRA withdrawals will be impacted.
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If tax rates decrease in the future, not converting may be beneficial. Our experience is that many individuals tend to fall in lower tax brackets later in life frequently as a result of increased deductions from medical expenses.
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Roth conversions are not an all-or-nothing proposition – you can do a partial conversion up to the point where you enter the next tax bracket.
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If you are in a low tax bracket, and do not have enough earned income to utilize all of your itemized deductions, a partial conversion may be appropriate.
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Considering a conversion after a severe market drop (like 2008) is prudent since the amount includible in income would be lower. (Wouldn't it be nice to capture any future market recovery in a tax-free manner, not just tax-deferred?)
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Utilizing Roth IRAs (tax-free withdrawals) in conjunction with Traditional IRAs (taxable withdrawals) and personal savings can create "tax diversification."
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Given that Roth IRAs are not subject to the IRS' Required Minimum Distribution (RMD) requirements at age 70 ½ like Traditional IRAs, it's possible that a Roth account can continue to grow tax-free for a much longer period of time.
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Heirs of a Roth IRA, as opposed to a Traditional IRA, receive greater value since they receive tax-free distributions over their lifetimes.
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Roth contributions are accessible immediately, both tax and penalty-free. Roth conversion amounts are accessible both tax and penalty-free five years after conversion (even if not age 59 ½).
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If you don't qualify for making a Roth contribution today, because your income is too high, you could still make a "non-deductible" IRA contribution, then immediately convert those dollars to Roth (in effect it's like making a Roth IRA contribution even though you're not eligible).
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Caveat: All Traditional IRA monies (tax-deferred and not tax-deferred) are viewed as one IRA for purposes of calculating the conversion amount includible as income. In other words, an individual cannot "cherry-pick" the non-deductible monies for conversion. For this reason, it is frequently advisable to only convert non-deductible IRA assets if there are no other "deductible" IRA assets in the individual's name.
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Investors who convert to a Roth IRA are able to re-characterize the assets back to a Traditional IRA, effectively allowing the investor to negate the conversion.
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This is useful when circumstances change substantially from the time of conversion.
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Re-characterization must occur prior to the due date of the tax return for the year the conversion was made (October 15th if extended). This would allow for a "look back" if the converted assets decline substantially in value after conversion.
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Conversion is appropriate for those who have non-IRA assets to pay the tax due on conversion. That is because IRA assets used to pay the tax are subject to the 10% early withdrawal penalty unless the IRA owner is at least 59 ½ when the conversion occurs, or qualifies for an exception to the penalty.
Estate Planning Considerations
Utilizing Roth IRAs presents a tremendous opportunity to transfer wealth to future generations in a tax-efficient manner. This opportunity is particularly attractive for older individuals or those who have accumulated more assets than they anticipate expending during their lifetime. When heirs inherit a Roth IRA, the converted Roth assets could continue to grow tax-free over the beneficiaries' lives. Further, while they would be forced to take out some minimal amount each year, the distributions would be income tax-free. Because there is generally a long investment horizon over the Roth IRA owner's life, and the lives of the heirs, the tax-free growth is likely to overcome the "cost" of paying income taxes at conversion, even if at high tax rates.
Conclusion
As with many financial decisions, there are a number of variables to consider when deciding whether to convert a Traditional IRA to a Roth IRA. And each individual will place varying degrees of emphasis on the different variables. At the very least, this article should create a general framework for guiding that decision. If the benefits outlined here resonate with you, we recommend contacting your financial advisor or CPA for additional information.
Biography
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Michael T. Carpenter, JD, CPA, CFP®, and Robert L. Hehmeyer, JD, CFP®, are Moneta Group Professional Consultants, Family Planner CFOs.
Contact: moc.puorgatenom@retnepracm
Articles from Missouri Medicine are provided here courtesy of Missouri State Medical Association
Source: https://www.ncbi.nlm.nih.gov/pmc/articles/PMC6167242/
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