Roth IRA accounts are one of the best retirement vehicles available to most people. These accounts are excellent avenues to lower your income taxes in retirement. We will discuss the advantages, disadvantages, and several examples/strategies of these accounts. Please keep in mind that these are generalities, and the nuances of everyone’s situation can change the strategies discussed below so it is important that you consult with your Financial Advisor to discuss your particular situation.
ADVANTAGES of ROTH IRAs
The advantages of Roth IRAs are significant and each one has some subtleties included in it. Some advantages are similar to other IRA accounts; however, the unique advantages of Roth IRAs bring substantial value over time.
- Tax-Free Growth – As with all other IRA accounts, the earnings while in the account are tax-free. However, unlike some other IRA accounts, the contributions to a Roth IRA have already been taxed, meaning you will not receive tax deductions at the time of funding the account like you do in a 401(k) account.
- Withdrawals are tax-free and include more flexibility – Since the contributions have already been taxed you can withdraw those at any time, penalty-free and tax-free. The earnings cannot be withdrawn until you reach 59 ½ years old and the account has been open for 5 years. But once you meet those criteria, all withdrawals are tax-free. The only exceptions to the age and time requirements are due to disability, a first-time home purchase, or death. This allows for much more flexibility than all other IRA accounts. For example, let’s say you contributed $20,000 over a 7-year period to a Roth IRA. After 7 years it is now worth $30,000. You could withdraw the initial $20,000 at any time and not pay taxes or penalties on it. If you attempted to withdraw $25,000 before you are 59 ½ years old and the account is not 5 years old, then you would have to pay your marginal tax rate plus a 10% penalty on the additional $5,000. The other advantage to not paying taxes on the withdrawals in retirement is that you can manage withdrawals between a Roth IRA and other accounts to help you minimize your taxable income in any given year.
- No Required Minimum Distributions (RMDs)– There are no Requirement Minimum Distributions (RMDs) on Roth IRA accounts. Most other IRA accounts force you to start taking withdrawals at the age of 72, at an increasingly higher rate each year. Those withdrawals are taxable, and you can get hit with severe penalties if you do not meet the RMDs. With a Roth IRA, you are never forced to withdrawal money from the account. This also means Roth accounts can be left to heirs tax-free. They may be required to take distributions, but at least they will not be taxed.
- No age limits – There is no age limit for contributing to a Roth IRA. As long as you have earned income from a job or receive 1099 income, then you can contribute to a Roth IRA. For 2023, the maximum contribution is $6500 per person, or if you are over 50 years old you can contribute $7500. But you cannot contribute more than your earned income.
- No effect on Social Security benefit taxes– One of the most overlooked advantages of a Roth IRA is the positive effect on the taxes of Social Security distributions, potential Medicare Surtax, and Medicare premiums. When you take social security distributions in retirement, you may get taxed on those distributions. For 2023, if your combined income is between $25,000 and $34,000 (if filing as an individual) or between $32,000 and $44,000 (if filing as married filing jointly), then up to 50% of your social security distributions could be taxed. If you are above those thresholds, then up to 85% of your social security distributions could be taxed. The key here is the term “combined income”, which includes your adjusted gross income plus nontaxable interest. That means if you invested in Municipal Bonds because your interest from those bonds is not taxable, it may still cause you higher taxes due to the inclusion of that interest in the “combined income” calculation. More on this later.
Also, Medicare Part B (medical insurance) and Part D (prescription drug coverage) can be more expensive if your income is over certain thresholds. This is called Income-Related Monthly Adjustment Amount (IRMAA). However, Roth IRA distributions, because they are tax-free, are not included in your income and will not affect the IRMAA calculation. Other taxable distributions from 401(k) or Traditional IRA accounts will be included in your income and can affect your IRMAA calculation.
For high income earners there can be a Medicare surtax and potentially a Net Investment Income tax. We will not get into these more detailed aspects, but Roth IRA distributions are not included in either of these income threshold calculations and will not trigger Medicare surtax or Net Investment Income tax liabilities.
DISADVANTAGES of ROTH IRAs
As you can see, the advantages to Roth IRAs are enormous. There are really only two disadvantages. First, you are funding the account with after tax dollars versus other IRA savings where contributions can reduce your current income (such as 401k contributions), and thereby your current tax liability. The second is the income limitation. For 2023, if you are a single filer and your Modified Adjustment Gross Income is more than $138,000, your contributions are reduced. Contributions are completely eliminated at $153,000. For married couples filing jointly, those figures are $218,000 and $228,000 respectively. However, for higher income earners, there is the potential to take advantage of a Roth conversion. We will not go into much detail in this article, but for simplicity’s sake, a Roth conversion allows you to convert other IRA funds into a Roth IRA by paying taxes on the amount converted now (assuming all the funds were contributed with pre-tax dollars). In the future, we may write an article specifically on Roth Conversion strategies and examples.
EXAMPLES
Now that we know the basics of Roth IRAs, let’s take a look at a few basic examples of how a Roth IRA can be beneficial and how to maximize contributions in certain situations.
Example #1 – An individual that is early in his/her career.
Age: 28 Filing Status: Single Income: $60,000 401(k) Employer Match: 100% up to 3%
This person would likely be better off saving in the following priority:
- Contribute 3% to the 401(k) or $1800 in order to get the employer match of $1800, which is essentially free money.
- After that, he/she should contribute up to the maximum amount of $6500 (based on 2023 thresholds) to a Roth IRA. The assumption here is that due to being early in his/her career, you would expect to be in a higher tax bracket in the future. Based on that assumption the savings on a 401(k) contribution at your current lower tax rate would be less than the tax savings you will receive from Roth distributions at higher a tax bracket in the future. The benefits of the Roth IRA far outweigh the minimal tax savings of a 401(k) contribution at this tax bracket. As their salary increases over the Roth contribution threshold in the future, then it would be beneficial to start saving up to the maximum amount in the 401(k) to reduce their current salary, and thereby their current taxes.
- If he/she can save more than $8300 (the 401(k) and Roth contributions so far), then they should work with their financial advisor to determine if additional savings to a 401(k) or a taxable brokerage account are best. This is based on the overall financial plan. For example, maybe this person would like to save for a down payment on a house in the future. If that is the case, a taxable brokerage account allows more liquidity for purchases such as this. A Roth IRA can also be used for a qualified first-time home purchase, but again, a Financial Advisor should assist you in determining the best method of saving based on your individual goals and desires.
Example #2 – A retired couple with income from Social Security, investments, a part-time job, and an annuity.
Ages: 72 & 74 Filing Status: Married Filing Jointly
Income: $15,000 – part-time job
$42,000 – social security benefits
$ 9,000 – annuity distributions
$14,000 – income from $250,000 taxable account
Because their Combined Income (for determining the taxes on Social Security benefits) is $45,000, excluding any investment earnings, they will get taxed on up to 85% of their social security benefits. Combined income equals $15,000 + $9,000 + $21,000 (half of social security benefits). Even if all the investment income is long-term capital gains and Municipal Bond interest, which is federally tax-free for this couple, it will be included in their Combined Income calculation. This will increase the amount of their social security that is taxed. Based on their tax bracket, for every additional $1 of income from a tax-free source, it will still cost them approximately 9%, or $0.09 in taxes on their Social Security benefits. For every additional dollar of taxable income, it will cost them approximately 18%, or $0.18 in taxes on their Social Security benefits. So even though this couple is in the 10% tax bracket, taxable investment income will cost them 18% in taxes. In order to prove this, you must work through the example of the IRS Social Security Benefits tax worksheet.
So, the strategy for this couple is to start contributing to Roth IRAs for each person. If one person has a job and the spouse does not, the law allows for the working person to also contribute to a Roth IRA for the spouse. The only caveat is the working spouse must have earned income at or greater than the combined contributions. They can do this by just transferring the amounts from their brokerage account to the Roth accounts.
Let’s assume they are earning non-taxable income from the brokerage account in the amount of $14,000. That would mean their Adjusted Gross Income is $42,750 ($15,000 from job + $9,000 from annuity + $18,750 taxable social security). After the standard deduction of $28,700, their taxable income would be $14,050 and their federal income tax would be $1405. However, since they are within the income threshold for the Retirement Savings Contributions Credit, they can claim a tax credit for up to $2000 (or 50% of their contribution, whichever is less) for each of them. That means by simply transferring funds from the brokerage account to the Roth IRA accounts, they will reduce their tax bill to zero, saving them $1405. Each year the one spouse is working part-time, they can continue this process of moving funds into Roth IRA accounts. Upon quitting the part-time job or transferring all the funds to the Roth IRA, they will now have non-taxable income from the Roth IRA that will also not affect the taxes on their social security benefits.
There are only two caveats to this. The first is they are assumed to have not had any distributions from retirement accounts in the last 2 years, which could affect their Retirement Savings Contributions Credit. The second is, they do not need to access the earnings from the Roth IRA accounts within 5 years of first opening the account. They can access the contributions at any time, but not any of the earnings for 5 years from the time the account was initially funded. Contributions are always withdrawn first for tax purposes.
This is a very simple strategy that can save a lower income couple several thousand dollars per year in taxes. Plus, if they never access the Roth IRA funds or they have funds leftover at the time of their deaths, the Roth IRA accounts can be transferred to their heirs with no taxes.
Example #3 – Single professional with a $250,000 cash inheritance (after any taxes).
Age: 45 Filing Status: Single Income: $90,000
The goal for this person is to use most of the inheritance for retirement. Let’s assume she only contributes up to her employer match in her 401(k) account. One strategy would be to max out her 401(k) contributions. If she does not have the cash flow to do this, then she can use the inheritance to make up the difference in her monthly cash flow. This will also lower her tax liability now. Plus, she could also contribute the maximum amount to a Roth IRA by transferring from the inheritance to her Roth. It could take her 9-13 years to transfer all of the $250,000 to retirement funds, depending on annual increases on the maximum contributions and earnings on the assets. She could further work with her Financial Advisor to identify the right time to potentially perform Roth conversions of her 401(k) account after she either quits her job or retires, if it makes sense in the future. Based on all we have discussed earlier, the goal should be to end up with as much of her retirement in a Roth account as possible. Timing the taxes paid at the time of the conversion is the key to maximizing the value of this strategy. Here is an example of what this strategy could look like, assuming no changes in the maximum contribution limits. Also, let’s assume for simplicity’s sake that earnings on the accounts are 7% per year, her employer 401(k) match is 100% up to 3%, and her marginal tax rate is 20%. We will not make assumptions about any future Roth conversions because we would need to develop her entire financial plan to identify the timing and amounts of any potential conversions.
Wrap-Up
The first example assumes that the individual has the capability to save more of their income. We realize this may not be possible for all people and others may just not want to, instead desiring to live now rather than plan for their retirement that may or may not come. Many people experience lifestyle creep throughout their careers, increasing their spending with increasing salaries. This is why it is important to establish spending discipline early in your career so you can purposefully decide how you want to spend your discretionary funds rather than slowly increasing spending throughout your life on “stuff” that does not necessarily bring you happiness.
The last two examples have nothing to do with changing spending habits at all. They are simply taking advantage of situations to minimize their taxes over a long period of time. It is very possible that the couple in Example #2 could never pay federal income taxes again, saving that money for a more comfortable retirement. Many people think their tax accountant should be doing this, but that is not the case. Most tax accountants will not model your lifetime of earnings and accounts to develop long-term strategies. They will help you minimize your taxes in any given year, but as you can see just in these simplified examples, reviewing one or two years at a time will not help you develop a lifetime of tax savings. The things you do today can significantly impact your taxes and earnings in the future. This is why working with a Financial Advisor as early in your career as possible is extremely important. A good Advisor can build successful strategies saving you thousands in taxes and setting you up to achieve all your financial goals, including a comfortable retirement.
About the Author
Kevin Caldwell provides fee-only financial planning, investment management, and retirement plan advisory services through Islands East Advisors (IEA) and fractional CFO / business consulting services through Islands East Financial Solutions (IEFS). IEA and IEFS are both based on Kent Island, MD and serve clients throughout the United States. IEA serves clients as a fiduciary and never earns a commission of any kind.