Roth IRA

Roth IRA – Retirement Plan Holey Grail?

In order to understand the Roth IRA club entry fee, let’s take a step back and examine the eight features of an ideal retirement plan.

With all of the buzz in the investment/retirement planning community about Roth IRA’s as a result of the January 1st elimination of the $100,000 modified adjusted gross income threshold for converting a traditional IRA to a Roth IRA, you would think that they’re the only game in town. Although the two main attractions of a Roth IRA that were introduced in last week’s blog post, Year of the Conversion, i.e., nontaxable distributions and no required minimum distributions (“RMD’s”), are two desirable benefits of any retirement plan, there is a price you must pay to obtain them.

The Ideal Retirement Plan

In order to understand the Roth IRA club entry fee, let’s take a step back and examine the eight features of an ideal retirement plan to see which ones are present or lacking in a Roth IRA:

  1. Contribution ability not subject to income test
  2. Fully deductible contributions
  3. Unlimited contribution amounts
  4. Nontaxable income
  5. Nontaxable distributions
  6. Distributions at any age without penalties
  7. No required minimum distributions
  8. No income tax liability upon conversion to the plan

Contribution Ability Not Subject to Income Test

Unlike other types of retirement plans, potential IRA owners must clear an income hurdle in order to be eligible to make contributions. If your adjusted gross income exceeds specified limits, which are different depending upon your filing status, then you won’t be allowed to make a contribution to either a traditional or Roth IRA.

Fully Deductible Contributions

Contributions to plans that are used directly and indirectly for conversion to Roth IRA’s are often, but not always, fully deductible. These include traditional IRA’s, SEP-IRA’s, 401(k) plans, profit sharing plans, and defined benefit plans. This is an extremely important benefit not to be overlooked, particularly if you’re in a high marginal income tax bracket when making contributions to these types of plans. Roth IRA contributions, on the other hand, are never deductible.

Unlimited Contribution Amounts

In addition to being fully deductible, allowable contribution amounts for certain retirement plans, such as defined benefit plans, while they aren’t unlimited, can be quite generous, particularly for highly-compensated older employees. In addition to being nondeductible, Roth IRA contributions are currently limited to $5,000 per year, or $6,000 if 50 and above.

Nontaxable Income

All retirement plan participants enjoy the benefit of nontaxable income while funds remain in the plan. This includes interest, dividends, and realized gains from securities sales that would otherwise be taxable if the same investments were held in a nonretirement plan.

Nontaxable Distributions

As pointed out in Year of the Conversion, whenever a deduction is allowed for contributions to a retirement plan, whether it be an IRA, 401(k), or some other type of pension plan, withdrawals from the plan are taxable as ordinary income just like salary. As also mentioned in last week’s post, since contributions to a Roth IRA aren’t deductible, withdrawals generally aren’t taxable provided that they remain in the plan for five years after the Roth IRA owner established and funded his or her first Roth IRA account, or, in the case of a Roth IRA conversion, five years from the date of conversion, and the owner is at least 59-1/2.

Distributions At Any Age Without Penalties

To promote the fact that retirement plans are intended to be used for retirement, distributions from retirement plans before age 59-1/2 are generally subject to a 10% federal premature distribution penalty plus potential state penalties. This includes distributions from Roth IRA conversions.

No Required Minimum Distributions

In exchange for tax-deductible contributions and nontaxable income while funds remain in a plan, IRS requires you to begin withdrawing funds, otherwise known as required minimum distributions, or “RMD’s,” from plans at a specified age, generally age 70-1/2, or be subject to a 50% penalty on RMD’s not distributed. While Roth IRA’s escape this requirement during the owner’s lifetime, Roth IRA beneficiaries are required to take minimum distributions from their inherited plans.

No Income Tax Liability Upon Conversion to the Plan

When you convert, or roll over, company pension plans, such as 401(k) plans, profit sharing plans, and defined benefit plans to a traditional IRA, there’s generally no income tax liability assessed upon conversion. Roth IRA conversions, however, are fully taxable as ordinary income with the exception of funds originating from nondeductible IRA contributions.

Depending upon facts and circumstances, assuming you have the funds available outside of your retirement plans to pay it, in many cases, the income tax liability associated with a Roth IRA conversion won’t outweigh the potential benefits one might potentially receive from a Roth. Even though Roth IRA’s share many of the eight desirable features of an ideal retirement plan, as you can see, they aren’t the holy grail of retirement plans, and, depending on your situation, may in fact, end up being the “holey” grail for you.

By Robert Klein

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.