Roth IRAs have become a popular way to prepare for retirement. One valuable piece of advice we give to our clients when they are making decisions regarding financing their retirement years is for them to consider all options carefully before moving forward.

 

This is advice holds true for those who are contemplating contributions to a ROTH 401(k) or a ROTH IRA. Both of these instruments have advantages and disadvantages.  So each person must take into account their own unique circumstances when making the right selection for them.

 

Here is a synopsis of four of the key attributes offered by Roth IRAs and Roth 401(k)s:

  1. Earnings within the account are tax-sheltered; as earnings on the contributed amounts build up tax-free, it's fairly easy to qualify for tax-free distributions for retirement.

  2. Withdrawals from a Roth IRA or ROTH 401(k) accounts aren't taxed if the rules are followed

  3. A Roth IRA owner does not have to commence lifetime required minimum distributions (RMDs) after he or she reaches age 70 ½.  As is generally the case with regular qualified employer plans or IRAs, but Roth 401(k) does require a RMD

  1. Beneficiaries of Roth IRAs also enjoy tax-sheltered earnings and tax-free withdrawals. (They do, however, have to start regular withdrawals from a Roth IRA after the account owner dies – except spouses.)

  • No deduction is available for contributions made to a Roth IRA.  However, you may be entitled to a credit (saver's credit) against tax for your contribution

 

Understanding Roth IRA

Roth IRA was named for William Victor Roth Jr., a lawyer and politician fromWilmington, Delaware who served from 1966 to 1970 as theU.S. Representative from Delaware and from 1971 to 2001 as aU.S. Senator from Delaware. His legacy carries on as the sponsor of legislation creating the individual retirement plan, called Roth IRA, in his honor.

When does a Roth IRA present an effective financial strategy for retirement?

In general, the greatest tax leverage is achieved using a Roth IRA by keeping the contributions and earnings in the account as long as possible.  

Here is a thumb nail sketch of what you need to know:

Contributions. For 2017, you can contribute up to $5,500 to a Roth IRA (as long as you have compensation for the year at least equal to the contributed amount) but that limit will be increased when the cost-of-living index warrants it. There are some specific details and limits on Roth IRA contributions for individuals age 50 or older.  As well as for single taxpayers, for married taxpayers filing jointly and for married taxpayers filing separately.  Also, taxpayers with income over certain thresholds ($133,000 for single individuals, $196,000 for married individuals) aren't permitted to contribute to a Roth IRA.  You must seek advice from your CPA before arriving at conclusions about establishing and making contributions to a Roth IRA.

It is also important to note that contributions can be made to Roth IRAs even if you are a participant in a qualified plan and even if you reach age 70 1/2 , which allows many individuals who are not permitted to make traditional IRA contributions because of age or income level or employer plan coverage to make IRA contributions.

Distributions. The essential information here is that "qualified" distributions from a Roth IRA are tax-free. This means you can avoid tax on Roth IRA earnings forever if your distribution is made once you reach age 59 ½, or upon death or disability, or (up to $10,000 per lifetime) for first-time homebuyer expenses. However, it is critical to understand the distinction between qualified and nonqualified distributions. A distribution is not qualified if made within the five-year period beginning with the first tax year you made a contribution to a Roth IRA. A nonqualified distribution is treated first as a nontaxable return of contributions. To the extent a nonqualified distribution exceeds contributions it is taxable and is also subject to a 10% penalty under the regular early withdrawal rules (i.e., the penalty will not apply if the distribution is made once you reach age 59 1/2 , or upon death or disability, or in other limited circumstances).

 

Thus, especially in the early years of a ROTH IRA, where most of the account balance will be nontaxable contributions.  You can make significant withdrawals.  A possible strategy for those who can benefit from this situation might be to make ROTH IRA contributions for a number of years.  You know you will need part or all of the contributions in the future.  Then withdraw an amount not exceeding the total contributions made to the ROTH IRA at the future date. This allows you to take advantage of tax free investment growth both before and after the withdrawal.

Qualified IRA rollover contributions. You may be able to roll funds over from a regular IRA into a Roth IRA so the post-rollover income can grow tax-free in the Roth IRA. (Converting a regular IRA into a Roth IRA is treated as such a rollover.)  Any funds rolled over to a Roth IRA are taxed under the regular IRA distribution rules.  And the 10% early withdrawal penalty will not apply to the rollover. However, if you withdraw rolled over funds within the five year period that renders them taxable.  The 10% penalty will apply to the withdrawal.

Special rules apply if a Roth IRA contains conversion amounts (possibly from different years).  As well as other contributions so again, it is important to seek guidance before making any roll over decisions.

In-plan Roth rollovers. For a 401(k) plan that maintains a qualified Roth contribution program, a distribution to an individual from the portion of the plan that is not a designated Roth account may be rolled over in a qualified rollover contribution to the designated Roth account maintained under the plan for the benefit of the individual to whom the distribution was made. However, the rollover is not tax-free. Thus, an in-plan Roth rollover is a taxable distribution from an individual's plan account.   Other than a designated Roth account, that is rolled over to the designated Roth account in the same plan. There are many specifics to take into account when discussing an in-plan roll over and the expectation of tax-free treatment. There are different scenarios that could impact an in-plan Roth rollover decision.

So - the question to ponder is if you are a good candidate for making the rollover to a Roth IRA. The answer may be "yes" if:

  • You can pay the tax on the rollover with non-retirement-plan funds.  Keeping in mind that if you use retirement plan funds to pay the tax on the rollover, you'll have less money building up tax-free within the account.

  • You anticipate paying taxes at a higher tax rate in the future than you are paying now.

  • There are a number of years ahead of you before you might tap into the Roth IRA.  Which gives you an opportunity to recoup (via tax-free earnings and tax-free payouts) the tax hit you absorb on the rollover

  • You are willing to pay a tax price today.   In order to pass on tax-free income to your beneficiaries in the future

Exceptions

Individuals ineligible to make deductible contributions to a traditional IRA, or to make any regular contributions to a Roth IRA, due to limitations based on adjusted gross income, may make nondeductible contributions to a traditional IRA and then convert the contributed amounts to a Roth IRA. So individuals who have never opened a traditional IRA because they weren't able to make deductible contributions (and who have never rolled over pre-tax dollars to a regular IRA) should consider opening such an IRA.  And also making the biggest allowable nondeductible contribution they can afford.

If they convert the traditional IRA to a Roth IRA they need to include in gross income only that part of the amount converted that is attributable to income earned after the IRA was opened.  Which is presumably a small amount. They could continue to make nondeductible contributions to a traditional IRA in later years.  Then roll the contributed amount over into a Roth IRA. However, note that if an individual previously made deductible IRA contributions, or rolled over qualified plan funds to an IRA, complex rules determine the taxable amount.

401(k) plans and 403(b) annuity plans. These can include a "qualified Roth contribution program," a feature that allows participants at all income levels to make after-tax, Roth-type contributions of some or all of the elective deferrals that they otherwise can make under these plans.

  • A 401(k) plan or 403(b) annuity plan that adopts a "designated Roth contribution program" must establish a separate "designated Roth account" for each employee's "designated Roth contributions".   And maintain separate recordkeeping for each account.

  • "Qualified distributions" from a "designated Roth account" are tax-free. Also, distributions from a designated Roth account are not aggregated with other distributions from the plan or annuity.  With the purposes of determining the taxable portion of each payment. Thus, "qualified distributions" from designated Roth accounts avoid tax on Roth IRA earnings forever, because distibution of earnings may be tax-free.

  • A qualified distribution may be made when a participant: (a) reaches age 59 1/2 , (b) is disabled, or (c) dies. However, a distribution will not qualify if made within the five-year period.  Beginning with the first year in which the participant makes a designated Roth contribution.

  • Designated Roth contributions get treated like any other 401(k) plan elective deferral or 403(b) annuity plan salary reduction contribution.   Except, of course, that Roth contributions are includible in income.

  • Similarly, because designated Roth contributions are treated as elective deferrals, they are subject to the annual limit. Which is $18,000 for 2017; $24,000 for individuals who will have reached age 50 before the end of the year.

 

To use a Roth 401(k) or a Roth IRA – or not? That is the question! While Shakespeare never faced the many retirement possibilities we have available today, the most significant step is to speak with an expert who can boil down all the details, distill the information that is relevant for each situation and then work together on a plan that will deliver the most benefits in the most efficient manner.