Roth IRA’s Made Simple(r)

Roth IRA’s continue to be one of the best tax structures for saving retirement money. I also believe they are one of the best assets to pass along to the next generation. Additionally, there are no Required Minimum Distributions (RMDs) due at age 70 1/2. However, getting them funded has been a challenge for many. First, you must have earned income to contribute (not convert; more on that later), and that income has a limit before you are completely phased out of eligibility. Those limits, for 2018 are $135,000 for single filers and $199,000 for married couples filing jointly.

In recent years and tax updates, a few other means by which to create Roth assets have come about. For one, many company sponsored retirement plans have a Roth 401(k) feature which allows you to contribute up the maximum deferral limit ($18,500 for 2018) on an after-tax Roth basis. The money is tracked separately and retains all the tax benefits of a Roth IRA, and can be rolled directly to a Roth IRA upon separation of service. This is one way to build significant Roth IRA assets over time.

In 2010, tax legislation made it easier for more people to get money into their Roth IRA’s. The income limitation of $100,000 was removed in order to be allowed to convert pre-tax IRA assets into your Roth IRA. When converting, you simply agree to pay tax on the converted assets that have never been taxed to date. Not only were income limits removed to validate eligibility, but there is no limit to how much you can convert, as long as you’re willing to pay the related tax liability. This rule change created what has become known as the back-door Roth IRA contribution.

Anyone, regardless of income has always been allowed to make a nondeductible (after-tax) IRA contribution up to the allowable limits, $5,500 for 2018 ($6,500 if over the age of 50). Prior to 2010, this money would be invested in a Traditional IRA and the earnings would accumulate in a tax-deferred manner, and taxed at ordinary income tax rates when withdrawn during retirement, but each withdrawal would include a pro-rated portion that represented the after-tax contribution, thus giving the account owner a taxable and non-taxable distribution. The evolution of the law in 2010 now allowed someone to make a nondeductible contribution, then subsequently convert it to a Roth IRA, only leaving them a tax liability on the earnings (or growth) portion of the converted amount. Let’s look at a quick example:

On January 30, 2015 you made a nondeductible contribution of $5,500 to your Traditional IRA. You invested in an S&P 500 index fund and over the next year, it had a 10% rate of return. On February 1, 2016 you converted your entire $6,050 balance to your Roth IRA. At that time, you would have claimed $550 of ordinary income on your 2016 tax return, representing the earnings that were converted. Further assume you are under the age of 59 1/2. The great news is that you do not owe the normal 10% IRS penalty for early withdrawal, as this is dubbed a conversion of IRA assets, and not a normal distribution. From this point forward, all future earnings receive the favorable tax treatment afforded to all Roth IRAs. The IRS began to look at these transactions and suggest that if they chose to, they could enforce the Step-Transaction Doctrine, which says that you took a roundabout way to circumvent the spirit of our rule. i.e. they implemented a rule to overcome their own shortsightedness in the original law they wrote. (You need to be aware of the rules involving all outstanding IRAs when making a conversion that involves after-tax contributions and multiple IRAs – here is an in-depth review of that rule)

The concerns over the Step-Transaction Doctrine being enforced brought about great debates in the planning community as to how long was “long enough” for the assets to be invested in the Traditional IRA before being converted to the Roth IRA. For my clients, I settled on a conservative position of one full year. My philosophy is that if I am going to be audited, I don’t want the auditor to have any low-hanging fruit that I have to defend when a little discipline could have avoided the issue altogether. GOOD NEWS: The recent tax reform has stated that it is okay to make your nondeductible contributions and immediately convert to a Roth IRA, thus eliminating the administrative task of tracking nondeductible contributions and related earnings and the timing of subsequent contributions to keep everything straight.

Roth IRAs are great assets to have on your balance sheet. Here’s a quick recap how to build these assets:

  1. Regular contributions, if permitted based on income
  2. Contributions via your company sponsored retirement plan, if allowed
  3. Converting other pre-tax IRA assets to your Roth IRA
  4. Making nondeductible IRA contributions with immediate conversion

Taxes and fees are silent killers for wealth building. Always keeping an eye on these will allow you to build wealth in a more efficient manner.


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