Roth IRAs Part 1: Is Now the Time?

Periodically we like to remind readers of the benefits of a Roth IRA and extoll its virtues as a means for building and transferring tax-free wealth.  Indeed, Unified Trust views the Roth IRA as a savings vehicle with universal appeal – nearly everyone is a potential Roth IRA owner or could fund a Roth IRA for someone else.  Opening a Roth IRA furthers your account and tax diversification goals.  And should federal or state income tax rates rise in the coming years, there is urgency to consider adding a Roth IRA to your portfolio now.

First, let’s revisit some of the Roth IRA basics.  Contributions to a Roth IRA are made on an after-tax basis, meaning there is no tax deduction when contributions are made, which differs from Traditional IRA contributions.  To contribute directly you must have earned income but if you are a non-working spouse, you may contribute without having earnings.  The maximum contribution is $6,000 for those under 50 and $7,000 for those 50 and over.  Contributions are phased out if your income is above a certain level, so high income households may be shut out of making direct Roth IRA contributions.  But even if you cannot contribute directly there is a way to fund your Roth IRA. 

You may convert other tax-qualified funds (from a Traditional IRA or an employer sponsored plan like a 401(k) plan) into the Roth IRA.  When you make Roth IRA conversions, the funds you take out of the tax-qualified account are subject to ordinary income tax rates, so it is best not to undertake conversions without having first reviewed the consequences with your advisor or CPA.  Roth IRA conversions are not subject to earnings limits and can be done anytime.  Something to note, contributions and any amounts you convert can be withdrawn without tax or penalty at any time.  Once the Roth IRA has been in place 5 years, the growth on the contributions and conversion amounts can be withdrawn free of tax and penalty (provided you are 59 ½ or older).  The owner of a Roth IRA does not have to take Required Minimum Distributions from the Roth IRA but heirs must take all funds out within 10 years of the original owner’s death. 

The most compelling benefit of the Roth IRA is that it provides a means for building income tax-free wealth.  Imagine the impact of this for a young saver!  Let’s say I’m 25 years old and fully fund a Roth IRA until I retire at age 65.  Over that 40-year working span I will amass well over $1 million in tax-free savings at even a modest 6% annual rate of return.  If in retirement, I choose not to withdraw funds from the Roth IRA to meet my spending needs, my Roth IRA nest egg continues to grow and I can leave millions to my family free of income taxes.  Older savers take heart – you may not achieve these spectacular results but with regular contributions and/or conversions you too can create a significant pool of tax-sheltered money for your own retirement spending or for your heirs.

Because the Roth IRA has a 5-year clock it is important to get started!  The easiest way to get a Roth IRA in place is to make a direct contribution.  And if you are ineligible to contribute directly due to income limitations, then the next best way is to fund your Roth IRA with a conversion.  While converted funds are subject to income taxes you do not have to hurt yourself financially with a large dollar amount conversion.  A small dollar Roth IRA conversion, for example, of $1,000 is enough to get the Roth IRA opened and funded without resulting in severe income tax consequences.  If you expect calendar year 2021 to be a down year for your income due to COVID-19 (or some other circumstance) then this may be an even more opportune time to consider a Roth IRA conversion.  Before moving forward on a Roth IRA conversion, it’s important to make sure you speak with your advisor or CPA to fully understand the tax impact.

As for wealth-building solutions with widespread appeal, it is hard to beat the Roth IRA!  Even if you no longer have earned income the Roth IRA can play a role in your portfolio.  You may still benefit by shifting qualified assets to the Roth IRA via conversions.  Don’t forget to look beyond your own situation.  If you make annual exclusion gifts to children or grandchildren, for example, you may wish to allocate a portion of that gift to fund a Roth IRA (assuming all other eligibility requirements are met). 

Journalists are starting to report on potential changes to the tax code under the Biden administration, but it may be too soon to know when or if Congress will shift its focus to such reforms.  Regardless, one must be prepared for changes ahead.  If you’re nervous about potential federal or state income tax rates changes in the coming years, talk to your Fiduciary Investment Advisor or CPA.  As planners and fiduciaries, we see merit in the use of Roth IRAs as a long-term tax savings solution.  We have tools to help you understand the trade-offs between current taxation and future tax savings.

Stay tuned – we will have another blog post soon with more tips and techniques on Roth IRAs.

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