Metz Lewis Brodman Must O'Keefe

Metz Lewis Brodman Must O'Keefe

Posted on May 5, 2015

By way of background, a Roth IRA is a retirement plan where the funds contributed to the plan do not qualify for an income tax deduction, but are also not taxed upon withdrawal.  On the other hand, contributions to a traditional IRA are deductible, but then taxed when the assets of the account are withdrawn.

A traditional IRA requires that the account owner begin taking distributions (called Required Minimum Distributions or RMDs) no later than April 1 of the year following the calendar year when the taxpayer attains age 70½. By doing so, deferred tax revenues within the traditional IRA are not postponed indefinitely.  A Roth account does not have required minimum distributions until after the account owner’s death, and then only if the beneficiary of the account is a non-spouse.  The prospect of tax-free growth and lack of RMDs during the account owner and spouse’s life entices many savers to use the Roth account, even though there is no income tax deduction.

Roth contributions of up to $5,500 per year are permitted for most taxpayers, with an additional $1,000 “catch-up” contribution for taxpayers over age 50.

However, many taxpayers who would like to make contributions to a Roth IRA cannot.  The ability to contribute directly to a Roth IRA is phased out for high income taxpayers.  For example, in 2015, a taxpayer who is married and filing jointly begins to have available Roth contributions limited at $183,000 of Adjusted Gross Income.  The ability to contribute to a Roth is completely phased out at $193,000.  A list of phase-out limits for other filing statuses and years can be found here or in IRS Publication 590, available here.

These income limits are not insurmountable for taxpayers with higher incomes.  In addition to contributions of earnings to a Roth IRA, there is an alternative, indirect way to fund a Roth IRA: a Roth conversion.  A Roth conversion is the process of converting a traditional IRA or other retirement account to a Roth.  Interestingly, A Roth conversion does not have the income limits that a Roth contribution does.  Therefore, a high income taxpayer with a traditional IRA can fund a Roth IRA via converting the existing IRA regardless of income.

The conversion can be either the entire account or a portion of the account.  Converting an account in portions over a few years helps spread the resulting tax bill over the same time period.  It’s important to plan for the resulting tax bill without withdrawing pre-maturely from a retirement account, resulting in an early distribution penalty. By way of background, a Roth IRA is a retirement plan where the funds contributed to the plan do not qualify for an income tax deduction, but are also not taxed upon withdrawal.  On the other hand, contributions to a traditional IRA are deductible, but then taxed when the assets of the account are withdrawn.  A traditional IRA requires that the account owner begin taking distributions (called Required Minimum Distributions or RMDs) no later than April 1 of the year following the calendar year when the taxpayer attains age 70½. By doing so, deferred tax revenues within the traditional IRA are not postponed indefinitely.  A Roth account does not have required minimum distributions until after the account owner’s death, and then only if the beneficiary of the account is a non-spouse.  The prospect of tax-free growth and lack of RMDs during the account owner and spouse’s life entices many savers to use the Roth account, even though there is no income tax deduction.

If a high income taxpayer does not have a traditional IRA, or if the taxpayer cannot deduct contributions to a traditional IRA, a second alternative is funding a Roth 401(k), 403(b), or 457(b).  These employer-sponsored plans are also not subject to the income limits on contribution, thereby granting high income taxpayers access to Roth benefits.  A comparison chart of the Roth IRA to these plans can be found here.

For more information on conversion strategies and analysis, contact any member of our tax group.