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George F. Bearup, J.D. Senior Legal Trust Advisor

3-Jan-18

Roth IRAs – A New Look After Tax Reform

Take-Away: A Roth IRA is more valuable than a regular or traditional IRA to its owner and to the owner’s designated beneficiaries. This enhanced value is due primarily to the tax-free accumulation and tax-free distribution of income earned by a Roth IRA and the absence of any required minimum distributions (RMD) from the Roth IRA for its owner.  Consequently,  a Roth IRA is an investment vehicle with a totally tax-free return. With the new lower income tax rates this year an IRA Roth conversion may make more sense to some clients. In addition, if a client wants to maximize the wealth that their heirs will inherit and enjoy on the client’s death, a Roth IRA is a great asset to pass along to the next generation (as it provides to the beneficiaries a lifetime of tax-free income), especially if there exists the concern that the 40% federal estate tax will return in 2026 [or perhaps sooner.]

Fast Facts Regarding Roth IRAs:  25 million households own Roth IRAs. 35 million households own  traditional IRAs. 17 million households own more than one IRA. 8% of all retirement assets are now held in Roth IRAs [$660 billion] compared to traditional IRAs [$8 trillion.]Despite the clear tax benefits of Roth IRAs, 95% of rollovers from qualified plans nonetheless go to a traditional IRA, not a Roth IRA. We can expect the pace of rollovers to continue when you consider that 10,000 Baby Boomers turn 65 each day! Source: Investment Company Institute, statistics determined for 2016.

Roth History: Roth IRAs have been around for 20 years. Over the past two decades the Roth rules’ have change, primarily for the better. Examples of a couple of those positive changes include: (i) Roth 401(k) accounts were permitted, beginning in 2006; and (ii) the elimination of the taxpayer’s adjusted gross income limits on when a conversion from a traditional IRA to a Roth IRA could occur, starting in 2010.

Basic Roth Rules:

  • Gross Income Limitations: A taxpayer is not able to contribute to a Roth IRA due to high earnings. In 2018, married couples with a modified adjusted gross income (MAGI) of $199,000 or more, and single persons with a MAGI of $135,000 or more, cannot directly contribute to a Roth IRA. But there is a way around this MAGI limitation called the back-door Roth IRA (described below.)
  • Conversions: Note that the MAGI limitations apply to Roth IRA contributions, not to Roth IRA conversions- anyone, at any time, and with any level of earnings, can still convert their traditional IRA to a Roth IRA, just so long as they are willing to pay the income tax liability on that conversion.
  • Contributions: A taxpayer can create and fund a Roth IRA each year. $5,500 is the annual limit for a taxpayer under age 50 years. $6,500 is the annual limit for taxpayers 50 years and older. But in each instance the taxpayer must have taxable earned compensation to fund the Roth contribution. This is the total after-tax amount that an individual can contribute to both a Roth IRA and a traditional IRA combined, in a single tax year. Restated, the amounts are not doubled; it is pretty much an either-or proposition in funding a traditional IRA or a Roth IRA, but the maximum amount can be allocated between the two types of IRAs.
  • Distributions:  There are complex ‘ordering rules’ for distributions from a Roth IRA. Contributions are deemed to be the first funds that are distributed out of a Roth IRA (which is why it is important to keep accurate records of contributions and conversions to the Roth IRA.) Contributions come out of the Roth IRA both tax and penalty free, regardless of the Roth IRA owner’s age. [Think: a child owns a Roth IRA and his/her need to access those funds for their college education.] Once the contributions are used up, the next Roth IRA distribution will  be from converted (traditional IRA) amounts. The distribution of converted amounts will not be taxable to the owner,  but the distribution could be subject to the 10% early distribution penalty if the conversion amount has been held in the Roth IRA for less than 5 years. After contributions and converted amounts are distributed, then earnings are deemed distributed to the owner. The earnings of the Roth IRA will be taxable to the Roth IRA owner up until age 59 ½.  The distributed earnings will also be subject to the 10% early distribution penalty unless a narrow exception to the penalty applies. A broad generalization is that a Roth IRA ought to be funded with the thought that there will be no distributions from the Roth IRA account for at least 10 to 15 years to avoid penalties and to permit the compounding of its tax-free earnings to have a material effect on increasing wealth.
  • Required Minimum Distributions: There are no required minimum distribution rules (RMDs) applicable to Roth IRAs, which is a big deal for retirees who appropriately often get stressed out about taking their RMD for the year from their traditional IRA. And who wouldn’t get anxious knowing that there is a 50% penalty imposed on the RMD amount from a traditional IRA that was not timely taken by its owner. No RMDs, no stress.
  • Tax on Conversions: A traditional IRA, including those who own SEP IRAs and SIMPLE IRAs (after two years) can be converted to a Roth IRA, so long as the traditional IRA is included in the taxpayer’s taxable income in the year of the conversion, and the additional income tax is paid. Participants in 401(K), 403(b) and governmental 457(b) plans can also do Roth IRA conversions as long as they are eligible to take a distribution from the plan and the funds are eligible for a rollover to a traditional IRA. The primary drawback to most Roth conversions is the need for the IRA owner to possess ‘outside’ funds available to pay the additional income tax liability incurred on the Roth conversion.
  • Repeal of Re-characterization of Roth: The ability to ‘un-do’ a Roth IRA conversion by October 15 of the following calendar year was repealed by the Tax Cuts and Jobs Act. Thus, any conversion of a traditional IRA to a Roth IRA is now

Comparison of a Roth to a Traditional IRA:

  • Age Limit: There is no age limit on making a contribution to a Roth IRA. In contrast, an individual cannot make a contribution to a traditional IRA upon reaching the year in which he or she attains the age 70 ½ years.
  • Required Minimum Distributions: As noted above, unlike a traditional IRA, there are no required minimum distributions from a Roth IRA faced by its owner. The absence of any RMDs for a Roth IRA permits the Roth IRA owner invest funds for a much longer period than with a traditional IRA. Equally important,  the growing Roth IRA account can act as the centerpiece of inheritance planning for the owner’s heirs.
  • Participation in an Employer Plan: With a traditional IRA, when the IRA owner is employed and participates in a qualified plan, the income limits for deductible traditional IRA contributions are lower. With a Roth IRA, continued participation in an employer-sponsored qualified plan does not limit other Roth IRA contributions  by the plan participant.
  • Withdrawals: As noted above, contributions to a Roth IRA can be withdrawn at any time for any reason, tax-free and penalty-free. Thus, accumulated Roth IRA contributions are always available as tax-free savings account for the Roth owner. In contrast, all withdrawals from a traditional IRA are subject to income tax and the 10% early withdrawal penalty if the traditional IRA owner is then under age 59 ½ years.

Roth IRA – an Estate Planning Tool: Since Roth IRA owners never have to take a required minimum distribution, that means that the Roth IRA’s assets can continue to grow in value over the owner’s lifetime with no erosion in the payment of income taxes- kinda like a grantor trust where the assets grow (hopefully) in an income-tax free environment when the grantor pays the trust’s income tax liability. The beneficiaries of the inherited Roth IRA will then have tax-free income potentially for their lifetime, although the beneficiaries, unlike the original owner of the Roth IRA, will have to begin to take required minimum distributions from the Roth IRA using their own life expectancy. This benefit takes on even more of a significance with the Tax Cuts and Jobs Act. Due to the ‘doubling’ of the owner’s applicable exemption amount, that means that even more wealth can grow inside a Roth IRA while ultimately escaping any federal estate taxation on the owner’s death. [Remember, though, that the ‘doubled’ federal estate tax exemption amount disappears beginning in 2026.] Clearly with the changes in the estate and gift tax rules being so significant, with the resultant shift in focus to saving income taxes, what better asset is there to pass along to heirs than a Roth IRA which will provide to them income tax-free income for their lifetime? If the Roth IRA owner is worried about the spendthrift tendencies of his or her intended beneficiaries, the Roth IRA can be made payable to an accumulation trust to receive the required minimum distributions using the beneficiary’s life expectancy. All distributions to the trust from the Roth IRA will be income tax-free. Thus, while there is usually a trade-off between naming  a trustee or naming the children as direct beneficiaries of the traditional IRA, the distributions from the Roth IRA to the irrevocable trust will not be subject to the confiscatory 37% income tax bracket that trusts normally face when accumulating income inside the trust above $12,500 a year. Consequently,  we may see a more aggressive use of Roth IRAs payable to an irrevocable accumulation trust over the next few years for a variety of reasons including virtually no exposure to estate tax erosion, and the ability to generate income tax-free for the trust beneficiary’s lifetime.

Roth Flexibility: It is easier to access a Roth 401(k) account without a penalty. Suppose a younger employee participates in a Roth 401(k) plan at work. The employee wishes to leave employment to pursue an MBA. The employee could roll their 401(k) Roth account over to a Roth IRA. They could then access the Roth IRA contribution to pay for their education while avoiding the 10% early distribution penalty, even if the Roth IRA has not been in place for five full years- generally contributions and then conversions come out tax-free under the unique ordering rules (described earlier.) Similarly, a Roth IRA can be helpful for first-time homebuyers who want to avoid a premature distribution penalty on distributions after their Roth IRA conversion if the distribution is needed to pay the down payment on the new home purchase.

Roth Tricks:

  • Reduce RMDs: Many folks nearing retirement find themselves owning a  jumbo traditional IRA. When they reach the age 70 ½ they will have to start to take required minimum distributions from that IRA, which translates into reporting substantial taxable income each year during their retirement. By converting a part of their traditional IRA to a Roth IRA they will reduce the taxable required minimum distributions that they will have to take from their traditional IRA. By converting a portion of their traditional IRA to a Roth IRA over several years prior to reaching that magic age,  using partial conversions each year prior to retirement, the RMD for the traditional IRA will be dramatically reduced, while permitting the IRA owner to build an after-tax fund without pushing the IRA owner into a marginally higher income tax bracket. But this makes sense, i.e. the serial conversion to a Roth IRA several years prior to the actual retirement age, to minimize the converted amounts to marginally higher income tax brackets.  In contrast, making a Roth conversion of the entire traditional IRA balance on the eve of the owner’s retirement merely bunches that taxable income into one year, and often at the highest marginal income tax rate. So, start early if portions of the traditional IRA are to be converted over time in order to manage the taxable distributions from the traditional IRA upon reaching age 70 ½. .
  • Back-Door Conversion: This simple strategy is when a traditional IRA is created and fully funded with after-tax dollars by its owner each year.  Usually the back-door strategy is used when the owner cannot contribute to a Roth IRA due to their too high modified adjusted gross income {MAGI] for the calendar year. Once created, the traditional IRA owner then converts their traditional IRA, that holds their after-tax dollars, to a Roth IRA. Recall that a conversion can occur at and time, at any age, and at any earnings level- but it will be permanent.  Example: assume a taxpayer earns too much income to qualify to contribute directly to a Roth IRA for the year. Instead the taxpayer makes a nondeductible contribution of $5,500 to a traditional IRA (he/she could contribute $6,500 if age 50 or older.) Once the traditional IRA is funded with after-tax dollars, the funds are then promptly converted to a Roth IRA. This practice of fund and convert could occur each year for several years. This back-door conversion strategy was expressly sanctioned in the recent Tax Cut and Jobs Act. Or, consider a possible ‘jumbo-back-door’ conversion, where a taxpayer who participates in a 401(k) plan makes an in-service rollover to an IRA while employed. In 2018 it may be possible for the taxpayer to contribute as much as $55,000 to their 401(k) account for the year, through a combination of employee pre-tax contributions, employer matching contributions, and employee nondeductible contributions. Thus, up to $55,000 could be available for a back-door Roth IRA conversion by the end of 2018. Admittedly income taxes would have to be paid on the conversion, but immediately shifting $55,000 into a Roth IRA would be a great way to jump-start the accumulation of substantial wealth inside a Roth IRA.
  • Deathbed Roth Conversions: While it often makes sense to serially convert a traditional IRA to a Roth IRA over several years to avoid exposing that taxable converted income to marginally higher income tax brackets, some IRA owners do not have the luxury of time, especially when they are terminally ill. The beneficiaries of the decedent’s traditional IRA will have to pay income taxes on their inherited IRA, which could become problematic if those beneficiaries are already in the highest marginal federal income tax bracket. It might be better if the traditional IRA owner approaching death converted his/her IRA to a Roth IRA and paid the income taxes on the conversion, depleting his/her taxable estate in the process. Thus any required minimum distributions to the wealthy Roth beneficiaries will not be subject to any income tax. Moreover, the income tax burden faced on the Roth conversion may not be as expensive if there are considerable medical expenses incurred as a result of the IRA owner’s terminally ill condition (but this may require number-crunching since the recognized income from the Roth conversion will reduce the medical expense deduction, and also because the medical expense income tax deduction is only around for another year.) If the terminally ill IRA owner did not have the liquidity to pay the income tax liability on the conversion, the funds might be loaned to that owner, if overall taxes are the focus of what can be saved looking at income taxes, estate taxes, and future income taxes paid on inherited IRA distributions. The key point is that if the intended beneficiaries of the owner’s traditional IRA are already in a marginally high income tax bracket, they could end up paying 37% tax on the inherited traditional IRA distributions, while if they inherited a Roth IRA, all distributions will be income tax-free to those high-income beneficiaries. If the intended IRA beneficiaries are already in a marginally high income tax bracket, it may make sense to name beneficiaries who are in much lower income tax brackets to inherit the traditional IRA if a Roth conversion proves to be too expensive for a deathbed conversion.

Roth Traps: Despite  general knowledge about Roth IRAs, many of the direct benefits of a Roth can also be lost due to inattention or simply not thinking through the intended benefits of the Roth IRA.

  • Failure to File Form 8606: This Form tells the IRS of the conversion of a traditional IRA to a Roth IRA. It also tells the IRS of a distribution from a Roth IRA. The Form must also be used when there is a ‘back-door’ Roth conversion. Failure to timely file the Form can lead to penalties and interest, if not disqualifying the IRA as a Roth IRA.
  • Blowing the Non-Prorata Rule: A Roth conversion can be partly taxable and partly tax-free. That is true even if the conversion is made from an IRA account that holds only after-tax dollars. Close attention needs to be paid to an IRA account that holds both taxable and after-tax contributions.
  • Confusing the ‘two’ 5-Year Distribution Rules: Two different 5 year distribution rules apply to Roth IRAs, which are often confused. Rule #1: The first rule applies for tax-free distributions of earnings from a Roth IRA. For this rule, the five-year period begins with the first contribution to the Roth IRA,  or a conversion to the Roth IRA. This  five-year waiting rule does NOT RESTART with subsequent contributions or conversions  made to the Roth IRA. If this rule is passed and the Roth owner is at least age 59 ½  then withdrawn earnings will not be taxed. Rule #2: The second five year rule applies to a Roth conversion. It imposes a 5 year waiting period before the Roth IRA owner who is under age 59 ½ can access their converted funds, penalty-free. In this case the five-year waiting period DOES RESTART with each subsequent conversion to that Roth IRA.
  • Funding the Roth With IRA Dollars: It seldom pays to convert a traditional IRA to a Roth IRA and use part of the traditional IRA assets to pay the income tax liability incurred on the conversion. Fewer assets, post-income tax payment, will make their way into the Roth IRA as a result. It is better to have ‘outside’ assets ( like a windfall inheritance) available to pay the income tax liability on the Roth IRA conversion. If there are no other ‘outside’ IRA assets available to pay the income tax liability on  the Roth IRA on conversion, consider a partial Roth conversion over a period of several years, where a smaller amount of ‘outside’ assets will be required each year to pay the additional income tax liability resulting from the partial Roth conversion. There is no requirement that a Roth conversion take place in one calendar year, where the traditional IRA income must be ‘bunched’ into a single calendar year and possibly be exposed to a marginally higher federal income tax bracket. In the ‘old days’ it was sometimes suggested that the traditional IRA owner take out a home equity line-of-credit and use the loan proceeds to pay the additional income tax liability that results on the Roth IRA conversion. But since interest paid on a home equity line-of-credit is no longer deductible by the borrower under the Tax Cut and Jobs Act, this no longer may be a wise strategy to pay the income tax liability on conversion.
  • Lump Sum Distribution: The income that the Roth IRA generates is income-tax free. What if the owner’s designated beneficiary of the inherited Roth IRA takes a lump-sum distribution of the Roth IRA on the owner’s death? All that tax-free income in the future will be lost if the Roth IRA is unwittingly cashed out by its beneficiary. If the beneficiary of the inherited Roth IRA is a spendthrift,  it is better to name a trustee of an accumulation trust as the beneficiary of the inherited Roth IRA. The trustee will take the required minimum distributions from the Roth IRA, and add the distribution to the accumulation trust’s principal, held for the ultimate benefit of the trust beneficiary.
  • Trustee Fees: If an inherited Roth IRA  is made payable to an irrevocable trust on the owner’s death (more than likely an accumulation trust since the distributions from the Roth IRA are income tax-free) any fees that the trustee charges to the Roth IRA will accelerate the erosion of the Roth IRA assets that generate the tax-free income. A better approach is for the trust to be drafted to call for paying the required minimum distribution (RMD) from the inherited Roth IRA to the trust’s taxable account first, and only then pay the fiduciary’s fee from of the taxable account, and not from the inherited Roth IRA. This will prevent a ‘double hit’ to the Roth IRA.
  • Congress: Do we really trust Congress to keep in place the tax-free treatment of Roth IRAs and inherited Roth IRAs? With deficits ballooning and perceived looming threats to the Social Security and Medicare programs, it is hard for many people to believe that Congress will not change the rules in order to tax the income generated by Roth IRAs to meet these future deficit and program challenges. Even if the tax-free nature of Roth IRAs is preserved, Congress could  start to impose required minimum distributions (RMD) on Roth IRAs, flushing those distributions from the tax-free environment that the Roth IRA furnishes, and exposing all income generated by those RMD distributions to income taxation. Beyond not having enough ‘outside’ assets to pay the income tax on a Roth conversion, I suspect that this fear of Congress changing the rules causes many to place Roth IRAs in the ‘if it’s too good to be true, then it’s too good to be true, or to last’ category.

Conclusion: Roth IRAs remained relatively untouched by the Tax Cut and Jobs Act, other than the loss of the flexibility to re-characterize and ‘do-over’ a Roth conversion ‘gone bad.’ But with the lowering of the federal  income tax rates and the slight spreading of the income tax brackets, more traditional IRA owners may begin to consider engaging in a Roth conversion, if the income tax burden is lessened to some degree. Or, with lower income tax rates, more individuals may decide to aggressively pursue the back door Roth IRA, now that the Tax Cut and Jobs Act formally recognizes it as a valid retirement planning strategy. Finally, the ability to provide tax-free income to heirs through an inherited Roth IRA may prompt many individuals to explore creating, funding, and growing Roth IRAs, knowing that their now ‘doubled’ federal estate tax exemption will preclude any erosion of that Roth IRA through the imposition of federal estate taxes on that unique asset. One can only guess how clients will react to the Tax Cut and Jobs Act, but there may be new interest in funding Roth IRAs, at least until 2026 when the old, higher, income tax rates come back.