By now, just about everyone has heard of a Roth IRA. Perhaps you are even familiar with a Roth IRA conversion. Others may have even taken part in a somewhat more involved process called a “back-door” Roth IRA contribution. For anyone who has no idea about what any of this means, fret not. All will be explained in this article, and maybe you will even pick up on a strategy that makes sense for your personal situation.
The attraction of the Roth IRA becomes clear when you hear phrases like “tax free money”! But there are plenty of additional considerations when it comes to ROTH contributions and Roth conversions that should be examined before you make a final decision. Let’s start with some of the basics:
Contributions to a Roth IRA are made with income that has already been taxed, so there is no initial tax benefit, but the money inside of the Roth grows tax-free over time.**
REQUIRED MINIMUM DISTRIBUTIONS
Additionally, Roth IRAs do not have a Required Minimum Distribution at age 72 like their traditional IRA counterparts. You can elect to let your Roth IRA money grow (tax-free) until you decide to take a distribution.
“BACKDOOR” ROTH CONTRIBUTIONS
Just like a Traditional IRA contribution, Roth IRA contributions have income limits imposed that could find some folks earning too much to make a contribution to a Roth IRA. However, there is a strategy that allows anyone, regardless of income, to contribute to a Roth IRA. It is called the “Backdoor” Roth IRA contribution.
What is a Backdoor Roth IRA and how does it work?
If your income is too high to contribute to a Roth IRA outright, the Backdoor Roth IRA offers a workaround. This strategy enables the high-income earning individual to contribute to a non-deductible IRA (this IRA does not have any income limitations in terms of who can contribute). Then, an immediate Roth conversion takes place, allowing the high-income individual to take advantage of the tax-free growth and future distributions without having to pay taxes later. Of course, they could also decide to use the Roth IRA as a legacy planning account to be passed on to their beneficiaries.
What criteria determines a good fit for a Roth IRA?
No Required Minimum Distribution and tax-free growth are two of the main benefits a Roth IRA offers, so it is no wonder this is a subject that gets so much attention. However, you must consider several factors before deciding to contribute or convert money into a Roth IRA account. One of the most important factors to consider is when converting another retirement account (like an IRA) to a Roth IRA, you will be required to pay income taxes on the converted amounts. It can make sense to pay these taxes now and avoid more taxes later, but that depends on your current tax situation and what your tax situation may be later in life. While it is impossible to predict where tax brackets could be years from now, making an educated decision based on historical trends can be helpful. Here are a few general scenarios where converting to a Roth IRA can make sense:
- YOU WILL LIKELY BE IN A HIGHER TAX BRACKET DOWN THE ROAD THAN YOU ARE NOW.
If you find yourself in an especially low tax bracket one year (perhaps because of a temporary break from employment), you could use that as an opportunity to convert funds from an existing IRA account into a Roth IRA. By converting funds in that year, you will still pay taxes, but it will be at a lower tax rate. Work with an accountant to help determine how much you can convert while keeping yourself in a lower tax bracket.
- YOU DO NOT WANT TO BEGIN TAKING DISTRIBUTIONS AT AGE 72.
If you don’t want to be forced to take Required Minimum Distributions (RMDs) from your IRA account at age 72 (yes, the law has changed the beginning age from 70 ½ to 72), converting to a Roth can make sense. Remember, the Roth IRA does not require RMDs at any age.
- YOU WANT TO LEAVE A TAX-FREE INHERITANCE TO YOUR HEIRS.
If you have extra retirement funds and worry about your heirs facing tax liability on an inheritance, converting funds to a Roth IRA can make a lot of sense. While your beneficiaries will be required to take annual RMDs from the inherited Roth account, they will not have to pay any tax on the withdrawals (if the account has been open for at least 5 years). Now, you might say “wait a minute, I though the Roth IRA didn’t have RMDs?” Just to clarify, the Roth IRA does not have RMDs for the original account owner. However, once the original account owner passes away, the beneficiaries will be required to take RMDs. Otherwise, this type of account could go on, tax free, forever, and that is not what the original intent was when the Roth came into existence.
While the previous examples might sound good, it may also be helpful to look at some scenarios where a conversion to a Roth IRA may not make sense. Consider the following scenarios:
- YOU ARE GOING TO FIND YOURSELF IN A LOWER TAX BRACKET DURING RETIREMENT.
If you have reason to believe you will be in a lower income tax bracket during retirement, a Roth IRA conversion may not make sense for you. By not converting a retirement account to a Roth IRA, you can avoid paying taxes now (at a higher rate for the conversion) and instead pay the applicable income tax on your distributions at the lower rate in retirement.
- YOU DO NOT HAVE OTHER MONEY TO PAY THE TAX FOR THE CONVERSION.
Converting a retirement account to a Roth IRA requires you to pay income tax on the converted amount now. If you do not have outside money available (from a personal account) to pay the required tax, this move may be a poor choice as you will need to take more money from the IRA account to cover the taxes. Taking more money from the IRA results in more taxes due, and this can turn into a vicious cycle that causes you to eat into a tax-deferred IRA account just to pay the tax bill.
- YOU ARE GOING TO NEED THE MONEY SOONER RATHER THAN LATER.
Any withdrawals on money that was part of a Roth IRA conversion are subject to a five-year holding period. This means you would pay a penalty on that money if you take distributions during the five-year period after the conversion.
These are just a few examples to consider. Whether or not a Roth IRA is right for you will depend on your unique situation, including your time frame, tax situation and long-term planning goals. You should consult with your financial advisor and a tax professional before making any decisions. As always, we are here to facilitate any discussion you may wish to have on this topic.
A distribution from a Roth IRA is tax-free and penalty-free provided that the 5-year aging requirement has been satisfied and at least one of the following conditions is met: you reach age 59½, suffer a disability, make a qualified first-time home purchase, or die.