Considering a Roth IRA?

If you are generating income or you own anything of value, you are at the mercy of the Internal Revenue Service (IRS). Every time tax legislation is approved in Washington DC, the federal government is essentially recalibrating their ownership percentage of your wealth. Most types of earned income, dividends, interest income, and capital gains are all taxed, and those taxes just keep going up. One of the few ways to shelter income from taxation is by diverting dollars directly into certain kinds of retirement plans such as 401(k)’s and deferred comp plans. Every dollar contributed avoids taxation. Unfortunately, we are only delaying the tax hit.

With most retirement plans, all withdrawals are reported as ordinary income. There is no differentiating between principal, interest, or other earnings. If you pull $1,000 from a retirement plan, you report $1,000 as ordinary income on your tax return, and the plan administrator will withhold a certain percentage for income taxes. Sooner or later, every dollar in your retirement account will be taxed. By participating in a typical retirement plan (401k, 403b, deferred comp and others), we are choosing to delay payment of income taxes on the contributions and earnings until some future date. That’s great for me, I love putting things off. But do you ever have the nagging feeling that tax rates will almost certainly be higher in the future than they are now?

We Americans have been passionate about tax avoidance since the “Boston Tea Party” incident on December 16, 1773. The colonists were hot under the collar about paying import duties, which of course is a form of taxation. Not long after the tealeaves stained Boston Harbor, the Revolutionary War was under way. Apparently, taxation makes some people fighting mad.

One alternative to the typical retirement plan is the Roth IRA. With a Roth IRA every dollar contributed has already been subjected to income taxes (you are contributing after tax dollars). What makes the Roth interesting is the fact that your contributed amount and all future earnings and gains can be withdrawn tax-free. No matter how large the account becomes, you (and later your heirs) will have access to tax free dollars. It won’t matter if tax rates are sky high at that time.

Let’s compare the Roth IRA to the typical employer sponsored retirement savings plan.

Automatic Withholding
Having your employer automatically divert pre-tax dollars into a retirement savings plan really is a nice convenience. But automatic contributions can easily be made to a Roth as well. Your bank can process an electronic funds transfer for you on a regular schedule, and it can be just as convenient and worry free.

Contribution Limits
One weakness the Roth has is its fairly limited contribution amount. If you meet certain income requirements you can contribute a maximum of $5,000 per year ($6,000 if you are 50 or older). By contrast, most pre-tax plans (such as your deferred comp plan) allow annual contributions of three times as much. Just as a practical matter, I suspect many people (myself included) have disregarded the Roth because of the puny contribution limit, and just committed to using a deferred comp plan instead. But at this point I’m considering the possibility of using both a Roth IRA and the deferred comp plan. The idea of having access to at least some money that’s sheltered from future taxation is becoming increasingly attractive to me.

The $5,000 annual limit may not sound like much, but it actually equates to a monthly contribution amount of $416.66. That’s not a bad start at all, particularly for someone in the early stages of his or her career. Let’s say you commit to saving $400 per month for the next 15 years. Assuming a 6% rate of return, your balance will be around $116,327, and it will be free from taxation. Do a younger officer a favor, and explain how the younger you are the more advantageous a Roth IRA can be.

Particularly for younger people, Roth IRAs can be a practical way to save money. All dollars contributed can be withdrawn at any time, for any purpose, at any age, tax-free and penalty free. If you are intrigued by the Roth idea, there is no reason why you couldn’t contribute to both a Roth IRA and to an employer sponsored plan at the same time (assuming your adjusted gross income (AGI) is below the stated maximums).

One way to get larger amounts of money into a Roth is by converting balances from pre-tax accounts such as traditional IRA’s or from employer sponsored plans. An entire pre-tax account can be converted into a Roth regardless of the account’s size. Every dollar converted is reported as ordinary income. A different set of income limitations apply to conversions (more on that later).

Your Money Grows “Tax Free”
One of the biggest selling points for employer sponsored plans is tax deferral. The account is able to grow tax deferred, so the compounding process isn’t hampered by the continual loss of dollars to taxation.

Roth IRA’s also provide this same protection from ongoing taxation. But with a Roth IRA, the entire balance can eventually be withdrawn tax-free. With the typical pre-tax retirement plan, every dollar in your account will eventually be reported and taxed as income. If you aren’t careful, penalty taxes can apply as well.

“You Will Be In a Lower Tax Bracket in Retirement”
Over the years financial experts have endorsed the assumption that retirees tend to drop to a lower tax bracket once in retirement. Therefore, it is better to avoid income taxes today, and pay them later when you will be in that lower bracket.

I’m not convinced the math will always work in your favor. Let’s assume an officer was contributing to a 401k plan in the year 1980. His reportable income that year was $30,000. Now fast forward to 2008. This same officer retires and begins receiving a monthly pension benefit of $3,000. He also draws supplemental income of $1,000 per month from his deferred comp plan. His reportable income his first year of retirement is $48,000. If the retiree is drawing supplemental income of $2,000 per month reportable income will be $60,000. It is very possible that a retiree will not experience a significant reduction in income, which means no tax relief will be achieved from dropping to a lower tax bracket. Partly due to the affects of inflation between 1980 and 2008, this retiree’s reportable income could be significantly higher (in retirement) than it was during much of his career.

What if you knew ahead of time that you would be subjected to the highest income tax rates of your life during your retirement years? Would that make you mad enough to throw a fist full of tea bags into Buffalo Bayou?

With the typical pre-tax retirement plan we might be avoiding up-front income taxes of 15-20%. What if we later get slammed with a 25-30% tax rate as we take distributionst? As mentioned earlier, pre-tax accounts will forever be at the mercy of the IRS. Just how out of control will taxes be when you retire? After our federal officials bail out Wall Street (again), they will eventually be forced to rescue the Social Security, Medicare, and Medicaid programs. How is that likely to affect our tax rates?

In summary, a Roth IRA allows you pay your income taxes now at today’s rates, then enjoy tax-free growth, and later receive tax-free withdrawals. The sum of all annual contributions can be withdrawn from the Roth IRA at any time, for any purpose, tax free and penalty free. The earnings in a Roth can also be withdrawn tax free if they are left in the account until age 59 ½ (see below for more details).

The following is a brief discussion of the rules that apply to Roth IRAs. Let me know if you would like to talk about these things one-on-one.

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Maximum annual contributions: $5,000 (people age 50 or better can contribute $6,000 per year). Contributions can continue past 70 ½.
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To make annual contributions to a Roth IRA your income (AGI) should be below $101,000 if single and $159,000 if married filing jointly.
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No tax deduction is available when dollars are contributed to the Roth, but all contributed dollars can later be withdrawn tax-free at any time, regardless of your age. Compare that to pre-tax plans such as the traditional IRA and 401(k) where the entire balance is off limits until age 59 ½ (with a few exceptions). Your deferred comp plans have no age restrictions.
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Earnings must remain in the account for five years or until age 59 ½ (whichever is longer). After that the earnings can also be withdrawn tax-free. However, the earnings can be withdrawn penalty free at any age if the dollars are used for college expenses. In this case the earnings will be reported as income, but no penalty tax will be due.
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Roths are not subject to required minimum distributions at age 70 ½.
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Your beneficiaries will be pleasantly surprised. They too will have tax free access to the money regardless of how large the account becomes. In contrast, most retirement plan accounts can be subject to income taxes when passed along to beneficiaries. Roths are an excellent estate-planning tool.
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You can contribute to a Roth IRA even if you are participating in an employer sponsored plan.
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Where to open a Roth IRA: some banks, brokers, fund companies.
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A Roth balance can be invested as you see fit: CD’s, money market funds, mutual funds, stocks, bonds…
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Balances can be converted from a pre-tax retirement plan to a Roth IRA. The amount converted is reported as income and taxed accordingly. After the conversion the entire converted balance must remain untouched for either five years, or until age 59 ½, which ever comes first (notice: this is different from the treatment of earnings discussed above).
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If you are age 59 ½ or better at the time the balance is converted to a Roth IRA you can withdraw the funds tax-free at any time without concern for the 5-year wait. However your future earnings will need to be off limits for five years (it can get a little convoluted).
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Important to realize that a different set of income limitations apply to Roth conversions. You can only convert pre-tax retirement plan assets to a Roth IRA if your AGI is $100,000 or less that year. Beginning in 2010 there will no longer be an income limitation affecting your ability to convert.
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It is preferable to pay the income tax on a conversion from an outside after tax account (not from the retirement account itself).

Be sure to contact me if you would like to talk about your financial matters.

Richard Gable, CFP
© HPOPS
rgable@hpops.org
ph. 713-869-8734