Roth IRAs- Some Tricks to Keep in Mind

Take-Away: We know in the 2017 Tax Act that Backdoor Roth Conversions were legitimized by Congress. There was also a great sigh of relief when the Act failed to change required minimum distributions rules for inherited Roth IRAs. There are a couple of more ‘tricks’ regarding Roth IRAs that you need to keep in mind when you advise clients on the benefits of a Roth IRA or converting a regular IRA to a Roth IRA.

Background: We all know that a Roth IRA is a great builder of wealth. It provides a tax-free source of income for the Roth IRA owner, and there are no required minimum distributions (RMD’s) with a Roth IRA forcing its depletion by its owner. Similarly, there are tax-free distributions to the Roth IRA beneficiaries after the Roth IRA owner’s death, but the beneficiary must take required minimum distributions from the Roth IRA over his or her life expectancy. It is the tax-free income that primarily drives the wealth accumulation benefit of a Roth IRA.

Limitations: But there are limitations on funding a Roth IRA, not the least of which (and its major drawback) is that only after-tax dollars can be contributed to the Roth IRA. While a regular IRA can be converted to a Roth IRA at any time, the primary drawback is the obligation to pay an income tax on the regular IRA amount that is converted to the Roth IRA. Probably the other major drawback to funding a Roth IRA is the distrust we all have in Congress. Will Congress really permit tax-free income for the lifetime of the Roth IRA owner and the lives of the owner’s grandchildren if they are named as beneficiaries of their grandparent’s Roth IRA?

Sigh of Relief: Leading up to the 2017 Tax Act there was a concern that Roth IRAs were in Congress’ cross-hairs, and in particular the elimination of the stretch distribution rules for inherited Roth IRAs. There were proposals that required a 5 year distribution rule for all inherited IRAs (both regular and Roth IRAs) but those proposals never made it into the final Act. [Nor did the handful of proposals to ‘Rothify’ all regular retirement accounts (IRAs and 401k accounts), forcing them to convert to Roth IRAs, as a source of immediate income tax revenue to off-set the projected revenue deficit caused by the reduction in tax rates.]

Basic Roth IRA Rules:

Roth Contribution Limitations: A taxpayer can contribute up to $5,500 a year to a Roth IRA; if over the age 50 years, the contribution amount by the taxpayer can be $6,500 a year. These maximum amounts can be spread between contributions to a Roth IRA and a regular IRA, but the contributions cannot be ‘doubled.’ It is the maximum amount, either to one, or to the other, or between both IRAs- only $5, 500 or $6,500 that can be contributed.
Adjusted Gross Income Limitations: In order to make the annual contribution to a Roth IRA the taxpayer’s gross income must be below $199,000 if married and filing jointly (or $135,000 if a single taxpayer.)
Roth Conversions: A taxpayer at any time can convert a regular IRA to a Roth IRA, so long as the taxpayer is willing to pay the income tax liability on that conversion amount. Restated, there is no adjusted gross income prohibition on converting a regular IRA to a Roth IRA.
Roth Re-characterizations: The big change caused by the 2017 Tax Act is that the conversion of a regular IRA to a Roth IRA is now permanent. In the past a conversion could be ‘undone’ by October 15 of the year after the conversion, which was important if the converted amount dropped in value, as no one likes to pay an income tax on phantom assets that no longer exist. However, a re-characterization is now a thing of the past. Only Roth conversions made in 2017 will be eligible to be re-characterized back to a regular IRA before October 15, 2018. Any Roth IRA conversions this year are
Re-characterization Fixes: A re-characterization is still permitted to fix some types of mistakes associated with IRAs. Example: Mother dies and her IRA is mistakenly rolled over to her son’s IRA by the IRA sponsor, which amount should have gone instead into an inherited IRA established for the son’s benefit. This mistake can be fixed by moving (re-characterizing) the rollover IRA amount into the inherited IRA to fix the mistake. [see IRC 408(d)(6).]

Roth Considerations, Strategies, and a Couple of Tricks: What follows are some considerations and tricks when working with a Roth IRA and some limited planning opportunities with regular IRAs.

Hold Back Some on a Roth Conversion: If the opportunity presents itself to convert a regular IRA to a Roth IRA, consider not converting the entire regular IRA amount to the Roth IRA. The amount retained in the regular IRA can then be used to fund charitable gifts once the owner attains age 70 ½ using the Qualified Charitable IRA Contribution; this will reduce the income tax bill on the conversion, as fewer regular IRA assets will be subject to taxation.
Name Spouse as Beneficiary to Delay RMDs: Often the temptation is made to name the Roth IRA owner’s grandchildren as the beneficiaries of the Roth IRA. There is nothing wrong with that strategy, other than that the grandchildren must begin to take their required minimum distributions from the Roth IRA, unlike a surviving spouse; in a sense, the grandchildren must begin to start to empty the Roth IRA through their annual required minimum distributions. By naming a surviving spouse as the beneficiary of the owner’s Roth IRA, the surviving spouse is not required to take required minimum distributions, which means that the funds can continue to grow inside the tax-free Roth IRA without any depletion during the surviving spouse’s lifetime.
Name a Trustee as the Roth IRA Beneficiary: Often a trustee is named as the beneficiary of the Roth IRA in order to prevent the individual beneficiary from taking a lump sum distribution from the Roth IRA, which would destroy the wealth accumulation feature of the Roth IRA. Or, a trustee is named as beneficiary of the Roth IRA because the intended individual beneficiary has creditor problems, and not all states (including Michigan) have statutes that provide creditor protection for an inherited Roth IRA. The required Roth minimum distributions must be paid by the trustee each year, i.e. passed out to the child/grandchild beneficiary of the trust. While the distributions will be tax free, the trustee has a fiduciary duty to enhance and preserve the Roth IRA assets. If trust administration expenses and fees are charged to the Roth IRA assets, while that is legitimate practice, if the fee is taken the trustee must still pay-out the required minimum distribution. It is better for the trustee to take the required minimum distribution from the Roth IRA first, put that amount in the trust’s bank account, and then pay any fees out of the trust bank account, before distributing the balance from the checking account to the trust beneficiary . These discrete steps will help to maximize the growth of the assets held inside the Roth IRA that is made payable to the trustee. In short, RMD first, then apply the trustee and other administrative fees second.
Back-Door Roth Conversions Now Authorized: As noted above, the 2017 Tax Act legitimizes this technique. The technique can be used even when a taxpayer’s reported adjusted gross income would otherwise prohibit funding a Roth IRA for the year. The ‘back-door’ steps are simple. The taxpayer first funds a ‘new’ regular IRA with $6,500 (or $5,500) using after-tax dollars. The next day the taxpayer converts their regular IRA to a Roth IRA. Normally there is an income tax imposed on the conversion of a regular IRA to a Roth IRA, but the $6,500 (or $5,500) moved in less than 24 hours from the regular IRA to the Roth IRA, so no income tax liability is incurred.
Use Net Carryover Losses to Cover the Tax on Conversion: A net carryover loss (NOL) vanishes on the death of the person who holds the NOL. If the holder of the NOL is terminally ill, knowing that the NOL will disappear on his or her death, the taxpayer might convert their regular IRA to a Roth IRA, and use the NOL to off-set the income tax liability that otherwise arises due on the conversion from the regular IRA to the Roth IRA.
Cream-in-the-Coffee Rule: Okay, this one is a bit more technical. Assume that the IRA owner has combined both pre-tax and after-tax contributions in the same regular IRA. Assume further that the regular IRA has $100,000 of which $5,000 reflects after-tax contributions by the IRA owner. The IRA owner would like to convert the $5,000 portion, reflecting his/her after-tax contributions, to a Roth IRA and avoid paying any income tax on the conversion of the after-tax dollars that were contributed to the regular IRA. The problem is what is called the ‘cream-in-the-coffee’ rule. (When you pour out the coffee cup, you get mixed/pro rata portions of both the coffee and cream.) When you take distributions from the regular IRA you get prorate portions of pre-tax dollars and post-tax dollars. Moreover, the pro-ration is not just calculated just from this ‘mixed’ regular IRA account that is the target of the desired roll-out to the Roth IRA. Rather, the calculation is made using all of the owner’s regular IRA accounts taken in the aggregate, so even if a segregated non-deductible (after-tax) regular IRA is the subject of the Roth conversion, it is not exempt from the ‘cream-in-the-coffee’ rule if there are other regular IRAs also owned. In short, even if the $5,000 of after-tax contributions was held in a stand-alone regular IRA, 5% of the rollover to the Roth IRA would still be treated as being partially with pre-tax dollars; the balance (95% following the example) would be subject to taxation on the rollover to the Roth IRA due to the presence of other regular IRAs then owned by the same IRA owner which hold pre-tax dollars. ( I told you this was technical!)
Rolling Regular IRAs Up-Stream: So now you know the problem posed by the cream-in-the-coffee rule. One way to work around this rule is what is called an ‘up-stream rollover.’ Some qualified plans, like a 401(k) plan, permit rollovers of a participant’s regular IRA to the qualified plan. But only pre-tax IRA dollars can be rolled up-stream into a qualified plan. With our prior example where the $100,000 regular IRA holds $5,000 of after-tax contributions, only $95,000 is eligible to be rolled ‘up-stream’ to the IRA owner’s qualified plan account, leaving the $5,000 of after-tax dollars behind in the owner’s regular IRA. This ‘stub’ regular IRA that holds only $5,000 can then be rolled over by the owner to a Roth IRA income tax-free (assuming that there are no other regular IRA accounts.) Obviously there will have to be accurate records to support the after-tax contributions made to the regular IRA in order for the plan participant to certify to the qualified plan administrator how much after-tax money is held in the regular IRA, and thus how many pre-tax dollars that are held in the regular IRA that can be rolled up-stream into the qualified plan. The burden is on the IRA owner to keep accurate records of after-tax contributions to their regular IRA for this technique to work to fund a Roth IRA using after-tax regular IRA contributions.
Retirement Roll-Outs: Example: Assume a taxpayer-participant holds a 401(k) account with $300,000. $100,000 of the $300,000 represents after-tax contributions by the participant. The participant, on retirement, directs the plan administrator to make a check out for $200,000 directly to a rollover regular IRA, and note on that transfer the rollover is with ‘pre-tax dollars.’ A second rollover distribution of the remaining $100,000 can then be made by the plan administrator directly to a Roth IRA in the name of the participant with the transfer note indicating that it is a rollover with ‘post-tax dollars.’ Using the two rollover distributions instead of one, the plan participant has effectively separated the cream-from-the-coffee. The IRS has approved this duel distribution approach from a qualified plan in several rulings and has even provided helpful examples to illustrate how it is accomplished.

Conclusion: Roth IRAs are excellent wealth accumulation devices to pass onto the next generation. Roth IRAs ‘survived’ the 2017 Tax Act intact, but for the loss of the ability to re-characterize a converted Roth IRA back to a regular IRA. As such, probably more thought will need to go into the initial decision to convert a regular IRA to a Roth IRA if that conversion is now permanent and can no longer be unwound. Some ‘tricks’ exist to move more after-tax IRA contributions into Roth IRAs including the now sanctioned back-door Roth, and possible upstream rollovers to isolate prior after-tax contributions to regular IRAs. Now, if only we could trust Congress to not change its mind on the tax-free income generated by a Roth IRA….