Do You Know About Roth IRAs?

Let’s start with the basic idea of a Roth IRA: With these accounts, you contribute after-tax dollars. But then everything you make is free from future income taxes as well.

Unlike regular IRAs, you can also withdraw the contributions you’ve made to your Roth IRA at any time without paying taxes or penalties. Yes, even if you’re younger than 59 ½. (Account earnings will be subject to taxes and penalties if you’re not yet retirement age, and possibly even if you are because of the so-called “five-year rule.”)

You can fund a Roth IRA all the way up until April 15 of the following year, and the maximum contribution rate is $5,500 for 2017.

You can contribute up to $5,500 to your Roth IRA in 2017; $6,500 if you’re over age 50. Data source: RothIRA.com

However, here are some cool side notes about Roth contributions:

First, you can make an extra $1,000 “catchup” contribution if you’re 50 or older.

Second, your spouse can contribute to his or her own Roth IRA even if you’re the only person with earned income. (The individual limits apply to each of you unless your total earnings are less.)

Third, you can make contributions no matter what your age. Young children with jobs all the way up to retirees with earned income can have and fund these accounts.

Meanwhile, one of the other great aspects of Roth IRAs is that, unlike regular IRAs, you never have to make minimum withdrawals (RMDs).

That fact alone makes Roth IRAs a nice way to keep and potentially grow money that you intend on leaving to an heir.

But this is especially true if your heir opts to take their distributions based on their own life expectancy.

See, whether you own a regular IRA or a Roth IRA, a non-spousal designated beneficiary might have two different choices.

If the account owner dies on or before the required RMD date, the heir can either:

A. Take the full amount out by Dec. 31 of the fifth year after the original account owner’s death.

B. Begin receiving minimum distributions based on his or her own life expectancy.

(If the account owner has already begun RMDs, then option A is off the table.)

So while choice B is a good one for a regular IRA, it’s a GREAT one for a Roth IRA.

Reason: Not only does the original account owner get to leave the maximum amount of money behind, but the tax-free protection extends to the heir for another lifetime.

Here’s an example ...

Say you leave your Roth IRA to your son who is 53 at the time of your death. If your son decides to take minimum distributions, the IRS will use its actuarial tables (available in IRS pub. 590) to figure out roughly how long your son is likely to live.

Then the IRS will divide the value of your account by that number (31.4) to arrive at a dollar amount for yearly distribution. In the case of a $100,000 portfolio, your son would have to withdraw $3,289 in the first year ($100,000/30.4). The divisor then drops by 1 every subsequent year.

And remember, while your son is taking those minimum distributions, the value of his inherited investment account can continue to rise!

I’m sure you can see the appeal of this approach, especially since you’re well-aware of the effect of compounding.

Think about what would happen if you loaded up that Roth IRA with stocks that steadily increase their dividends. And imagine what would happen if you were reinvesting those dividends back into more shares! You’d be combining complete tax efficiency with multiple layers of compounding interest.

With enough time, you could leave behind a nest egg that was rising faster than the rate of your heir’s mandatory withdrawals!

That brings me to another point: While this strategy would be great for a son or daughter, it would be even better for a grandchild or a great-grandchild. After all, those minimum distributions are calculated on the recipient’s age. The lower the number, the less money coming out every year and thus the longer the account can grow.

The lynchpin in this whole plan is absolute agreement on the part of the original account owner and the beneficiary on opting for taking the minimum distribution route. And more importantly, only if lawmakers don’t mess with things.

That said, if you’re a betting person, it might be worth the gamble. You may even consider converting your traditional IRAs into Roth IRAs. Traditional IRA account owners should consider the tax ramifications, age and income restrictions in regards to executing a conversion from a Traditional IRA to a Roth IRA.  

What exactly needs to be done?

Assuming you want to keep the account at the same place, you merely let your firm know that you’d like to start the process ... indicate how much money you are converting ... and so on. Many brokerages allow this to be done very easily through their online platforms.

When you do the conversion, you will be forced to pay taxes on pre-tax contributions and earnings made in the account. But if you are close to the point of RMDs already, that may not be a big issue.

And while there ARE income restrictions for making regular contributions to Roth IRAs, there are no longer any income restrictions on who can convert a traditional IRA to a Roth.

Just realize that you will need to have enough money set aside to pay for the taxes on the conversion. Unless you’re 59 ½ or older, the money will have to come from a source outside the account or else you’ll pay the 10% early withdrawal penalty, too.

Also, the conversion could move you into a higher tax bracket and prevent you from getting other tax benefits like dependent child and college tuition credits.

These are all things to consider before you make a final decision.

What about possible legal changes affecting Roth IRAs in the future?

I continue to worry about that, but I believe Roth IRAs remain viable vehicles, especially for older Americans.

This goes entirely against conventional wisdom, which says someone in my age bracket should be favoring the many decades of future tax-free status.

But the way I see it, older Americans are the least likely to be impacted by any future legal changes. Under current laws, Roth IRAs still have a lot of advantages. And even if some of those attributes end up changing, account owners could simply withdraw their money and take another path.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.