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 When money is withdrawn during retirement from a Roth IRA, it is tax-free rather than just tax-deferred.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.)
The five-year rules
The contributions you make to a Roth IRA can be withdrawn with no penalty at any time and at any age.
This is because there was no tax benefit on the front end. However, the earnings must be left in the account for at least five years and until the person is age 59.5. There are exceptions (death or disability, qualified first-time homebuyers, higher education, and to pay health insurance premiums for unemployed persons). The five years starts on Jan. 1 of the year of the first contribution. Contributions in later years do not start another five years.
The five-year rule is different for Roth conversions. In that case, the clock starts ticking for five years with each conversion. If you convert in October 2020, your five years began Jan. 1, 2020. If you convert more in 2021, another five years begins on Jan. 1, 2021. The IRS has ordering rules that stipulate that contributions are withdrawn first, followed by conversions, and then earnings.
Beneficiary changes
The SECURE Act that was passed in December 2019 stipulated that if a traditional IRA or Roth IRA is inherited by someone other than a spouse (after Dec. 31, 2019), the beneficiary must liquidate the account within 10 years.
This was a detrimental change for all the folks who were planning on passing traditional IRAs and Roth IRAs to children or grandchildren, and were looking forward to them being able to “stretch” the withdrawals over their lifetimes. Unfortunately, the inherited money must now be withdrawn within 10 years. This will cause some tax challenges for the beneficiaries of large traditional IRAs, because the withdrawals are all fully taxable as income. Roth IRAs must also be withdrawn within 10 years, but the Roth IRA withdrawals are tax-free.
Who benefits?
Roth IRAs are a great way to save for retirement, but they are also excellent for teenagers or college students with part-time jobs. Knowing that the contributions can be withdrawn at any time without penalty makes them attractive for all ages. And grandparents or parents can fund a Roth IRA for a teenager or college student, as long as the young person has earned income that is reported on a tax return.
Roth IRAs – and Roth 401(k)s and Roth 403(b)s – are great for anyone who appreciates tax-free growth and tax-free distributions. They can also help keep taxes low in retirement. For those who fret that our government may start taxing Roth IRAs in the future, this is possible. However, I think it is likely that accounts already established will be “grandfathered” (to keep them tax-free) if the rules change. As stated earlier, a Roth IRA is a powerful tool in an investor’s toolbox.
I encourage you to include a Roth IRA in your investment portfolio.