By FPA member Amy Jo Lauber, CFP®
Last Updated: October 18, 2010
The Roth Individual Retirement Account (Roth IRA) was introduced with a bang in the late 1990s, but lost some momentum due to Adjusted Gross Income (AGI) limitations on contributions and conversions. It gained strength in 2010 when the AGI limitation was lifted for conversions, and an option became available to pay the resulting tax over the tax years 2011 and 2012. Hopefully people are talking with their professional advisers about ways they may take advantage of a Roth IRA, but in the event they are not, here are some points to keep in mind.
Roth IRAs offer no tax deduction or reduction; their benefit is the potential for tax-free withdrawals. While it is highly likely that tax rates will increase in the future (at least for some taxpayers), most retirement planning models adopt the assumption that many people will be in a lower income tax bracket in retirement because they will no longer be receiving a salary. This may be true for many, but there is a segment of the population that may remain in the same tax bracket or even climb to a higher tax bracket in later years. It makes sense, then, to have assets diversified among different tax structures; tax-deferred retirement assets that are taxed upon withdrawal as ordinary income, assets in non-qualified accounts that may receive special income tax rates on dividends or capital gains, and Roth assets from which qualified withdrawals are received income-tax free.
Due to recent health care reform legislation, beginning in 2013, taxpayers who have a Modified Adjusted Gross Income (MAGI) of $200,000 ($250,000 Married Filing Jointly) or more may face an additional 3.8 percent Medicare tax on the lesser of 1) the net investment income (unearned income, such as interest, dividends and capital gains) or 2) the excess of the taxpayer’s MAGI over the applicable threshold. That means that taxpayers in this situation (even those who are retired and who may be receiving pension, Social Security, minimum distributions from IRAs, and annuity income exceeding the AGI limits) may be assessed their ordinary income tax, plus 3.8 percent on any investment earnings. For those who are facing those MAGI thresholds because of required minimum distributions, there is little than can be done. Reducing the accounts from which Required Minimum Distributions or RMDs must be received (or face a stiff penalty — 50 percent of the amount that should have been distributed but was not) is one way to manage these potential tax consequences. Arguments for converting traditional IRAs to Roth IRAs, prior to 2013, abound for this very reason; Roth IRAs have no RMD rules for the owner (there are RMDs for beneficiaries), so, the owner may make withdrawals if and when they desire or need without taxation (provided the withdrawals are considered “qualified”). This helps the taxpayer have a measure of control over their future taxation.
Retirees may be affected by the type of retirement plans they possess because of the income limits at which Social Security becomes taxable (currently $25,000 single, $32,000 Married Filing Jointly). Withdrawals from a traditional IRA or other tax-deferred plans (either by choice or by law) increase the taxpayer’s income, thereby increasing the possibility that 50 percent to 85 percent of Social Security benefits will be taxed. Qualified withdrawals from a Roth IRA, on the other hand, will not affect the taxpayer’s AGI or Social Security taxation under current legislation.
The Roth IRA may not be for everyone but it’s worth investigating whether and how you may benefit by either contributing or converting to one.
FPA member Amy Jo Lauber, CFP®, is the President of Lauber Financial Planning in Buffalo, NY