The title of my most recent MarketWatch RetireMentors article that was published on June 6th is 5 Reasons to Include Sustainable Income in Your Retirement Plan. Reason #1 is hedge against longevity.
Although sustainable, or predictable, income from Social Security, pensions, and fixed income annuities provide lifetime income that can build a solid floor for any retirement income plan, there’s another way to prepare financially for living a long life. Not traditionally touted as a longevity tool, a Roth IRA, when used strategically, can potentially extend the life of your portfolio.
It’s All about Optimizing After-Tax Income
Roth IRAs are the golden goose or Cadillac if you prefer, of the investment world. With their two distinct advantages, i.e., tax-free growth and tax-free withdrawals beginning after age 59-1/2, there’s no competition.
When you’re retired, unless (a) your taxable income is less than approximately $10,000 if single or $20,000 if married or (b) you have taxable income less than approximately $38,000 if single or $75,000 if married that’s comprised mostly of long-term capital gains, your income will be reduced by income tax.
Sustainable income isn’t immune. Depending on the amount of total income, up to 50% or 85% of Social Security benefits is potentially taxable. If you’re lucky enough to receive a pension, 100% is subject to tax. Fixed income annuity distributions are also taxable if they’re held in retirement accounts, e.g., 401(k) plans and IRAs, or if the source is fixed index annuities. A portion of distributions from single premium immediate annuities, or SPIAs, and deferred income annuities, or DIAs, held in nonretirement accounts is nontaxable as a return of principal.
Disadvantages of Roth IRAs
If optimizing after-tax income was all about tax-free growth and tax-free withdrawals, everyone would do everything possible to maximize Roth IRA account investments. There are four disadvantages, however, of Roth IRAs that need to be considered when using them as a tool to optimize after-tax retirement income. They are:
1. Non-401(k) Roth IRA contributions limited by income
Your ability to make a non-401(k) Roth IRA contribution is limited by the amount of your income. If your income exceeds certain thresholds ($132,000 if single and $194,000 if married), contributions are prohibited.
2. Low contribution limit for non-401(k) Roth IRA contributions
If you’re a participant in a 401(k) plan and your plan allows for Roth IRA contributions, you can contribute up to $18,000 to your Roth 401(k) up to age 49 and up to $24,000 beginning at age 50. With a non-401(k) Roth IRA, however, the contribution limit is $5,500 up to age 49 and $6,500 if 50 or over.
3. No income tax deduction for contributions
Whether you make a non-401(k) or 401(k) Roth IRA contribution, a notable disadvantage is that you will receive no income tax deduction for your contribution. This can work to your advantage to the extent that you’re in a lower income tax bracket when you make contributions compared to when you take distributions from your retirement plans.
4. Taxable income when using Roth IRA conversions
The fourth disadvantage of Roth IRAs comes into play when you transfer funds from a traditional IRA into a Roth IRA, otherwise known as a Roth IRA conversion. Unless the source of funds is nondeductible IRA contributions, 100% of the transfer is taxable.
Don’t be Afraid to Pay Income Tax on Roth IRA Conversions
Many people get hung up on paying income tax at the time of a Roth IRA conversion, saying that they’re prepaying tax they wouldn’t otherwise pay until they’re required to take distributions from their traditional IRAs beginning at age 70-1/2. While this may be justified in certain situations, particularly if there’s a high probability that one’s tax rate will be lower in retirement, many times it’s a knee-jerk, short-sighted reaction.
There are three things that are often overlooked or underestimated when doing a Roth IRA conversion analysis:
1. Tax-free growth of converted funds
Once you convert a traditional IRA to a Roth IRA, all future growth is nontaxable. To the extent that your conversion coincides with a downturn in the stock market, you can increase the amount of tax-free growth that you will experience. Generally speaking, the more time that you have between a Roth IRA conversion and retirement plan distributions, the more beneficial the conversion will be for optimizing after-tax retirement income.
2. Reduction or elimination of required minimum distributions
Required minimum distributions, or RMDs, beginning at age 70-1/2 from traditional IRAs will be reduced or eliminated to the extent that funds are converted from traditional to Roth IRAs. Annual reductions in taxable income can exceed the reduced amount of RMDs due to the interplay and intricacies of tax law. This includes, but isn’t limited to, potential reductions in taxable Social Security benefits and increased allowable itemized deductions from lower levels of adjusted gross income, or AGI. Medicare Part B premiums can be reduced since they’re also determined by AGI.
3. Partial conversions are allowed
Roth IRA conversions aren’t an all-or-nothing proposition. Partial conversions are allowed, encouraging the use of a multi-year strategy for doing conversions in years when income tax liability is lower and/or there’s a stock market downturn.
Roth IRA Strategy Can Extend the Life of Your Portfolio
Roth IRA contributions and conversions can potentially optimize after-tax retirement income, extend the life of a portfolio, and provide a hedge against longevity. The key is to use them strategically, looking for ongoing opportunities to maximize the leverage that they can provide for increasing after-tax retirement income compared to non-Roth IRA investments.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.