Tax-Free Income for Everyone! by Nate Eads

As most investors are aware, diversification is a key component in developing a good investment strategy.  While traditional diversification focuses on an investor’s allocation among different asset classes such as US stocks, international stocks, bonds, and cash, the tax diversification of your portfolio is an important component as well.  By having a portion of a portfolio held in a Roth IRA, tax-free income can be generated to help supplement other income sources as well as manage future tax liabilities.  Fortunately, opportunities to utilize Roth IRAs are available to almost everyone with proper planning.

The Basics

Roth IRAs differ from traditional retirement plans (employer provided plans such as 401(k)s or 403(b)s) as well as traditional IRAs in that qualified distributions are not subject to income taxes.  As long as the initial contribution to a Roth IRA was held in the account for at least five years and the account holder is over age 59 ½, distributions will be tax-free.  In addition, Roth IRAs are not subject to Required Minimum Distributions (RMDs) like traditional retirement plans and IRAs.  Account holders of these types of retirement accounts must start withdrawing their money at age 70 ½ (RMD), even if they don’t need the income.  The tradeoff for the tax-free income provided by Roth IRAs is that when contributions are made to Roth IRAs, the taxpayer’s income is not reduced by the contribution amount as is the case with a traditional retirement plan and deductible IRA contributions.  Another lesser known benefit of Roth IRAs is that contributions can be withdrawn from the account at any age without tax or penalty.  Only growth of the investments is subject to the age 59 ½ distribution limitation. 

Direct Roth Contributions

Taxpayers who make contributions to a Roth IRA are subject to certain limitations.  First, the maximum that can be contributed to a Roth IRA in a given tax year is $5,500 (2016 and 2017) or their total earned income, whichever is less.  Taxpayers over age 50 can contribute an additional $1,000 due to the “catch-up” provision.  Unfortunately, the bigger hindrance for making contributions for many is the AGI limitation.  A married couple must have a modified AGI under $184,000 to make a full Roth IRA contribution and are phased out of making contributions if their modified AGI is over $193,999.  A single taxpayer’s modified AGI is limited to $117,000 to make full contributions and is phased out if their modified AGI is above $131,999.  These limitations make Roth IRAs inaccessible to higher wage earners, or so it would seem. 

An alternative to making contributions to a Roth IRA may be a Roth 401(k).  Roth 401(k)s have been added to many retirement plans.  For higher income earners it may make sense to allocate a portion of their 401(k) savings to the Roth 401(k) as most of the characteristics of the Roth IRA are the same in the Roth 401(k).  If the employer offers matching or profit sharing contributions, those dollars can only be deposited into the traditional 401(k), even if the employee is allocating 100% of their contribution to the Roth. 

Backdoor Roth IRA Contributions       

So what if a taxpayer’s income is above AGI limitations and their employer doesn’t offer a Roth option in the retirement plan?  Another option to creating tax diversification among investments may be a “backdoor” Roth.  A backdoor Roth IRA is completed by first making a non-deductible contribution to a traditional IRA.  The same maximum annual contribution limits apply to traditional IRAs as noted above, however, there is not an eligibility limit on AGI for non-deductible contributions.  Assuming the taxpayer has no other IRA accounts and the contribution has not increased in value, the non-deductible IRA is then converted to a Roth IRA with no tax ramifications (more on Roth conversions below).  This strategy is often overlooked by those who are not eligible to make direct contributions, but can be an effective way to still have a portion of their portfolio positioned for tax-free growth and distributions.

Roth Conversion Opportunities

There may also be opportunities to convert deductible retirement plans to Roth IRAs as well.  Simply put, a Roth conversion is completed when a taxpayer takes money that is in a deductible retirement account (traditional IRA, 401(k), etc.) and “converts” those funds to a Roth IRA.  This money is moved from a position where future distributions are taxed as income, to one where future distributions will be tax-free.  Of course, there is a cost to make this conversion.   The taxpayer must report any of the money that was converted, both principal and growth, as income in that year.  Does it really make sense to pay tax on IRAs now rather than deferring the taxes to a future date?  In several scenarios, the answer may be “yes”.

Scenario 1

Let’s assume a couple retires at age 62.  They have about $800,000 in savings and taxable (non-retirement) investment accounts and about $2,400,000 that has been rolled into IRAs from company retirement plans.  They also have a pension they can begin taking at any time between now and age 70 as well as social security. They estimate they need about $175,000 per year to maintain their lifestyle.  One option is to start taking the pension and social security benefit now while supplementing them with withdrawals from their investment accounts and IRAs to achieve their income need of $175,000.  A quick calculation shows that this will put them in the 28% tax bracket.  A closer look reveals that there may be an opportunity to reduce their tax bill both now and in the future.

If the taxpayers elect to defer both the pension and social security until age 66, they have virtually no income up until that time.  They can cover their living expenses of $175,000 by taking withdrawals from their non-retirement accounts which have limited tax consequences due to being primarily taxed at the long-term capital gains rate of 15%.  They can then convert a portion of their IRA each year up to the income limit that keeps them in the 25% tax bracket, which is around $150,000 per year.  Over four years they are able to move about $600,000 of their retirement assets into a tax-free position!  While there is some tax liability due to the conversion, the converted money is being taxed at lower rates (up to the 25% rate) than it would be if they were also taking the pension and social security.  Also, the money converted to the Roth is no longer subject to income tax when withdrawn and will not be included in the RMD calculation at age 70.  This may even allow them to stay in a lower tax bracket in the future as well.

Scenario 2

In this scenario, we have an investor who is still working and allocates almost her entire IRA investment to a diversified equity portfolio.  During a bear market, she notices that her IRA has lost over 35% of its value.  While not concerned about the investments themselves as she is confident this is a normal swing for her portfolio, she wonders if the temporary loss of value has created an opportunity.  In fact, it has.  Based on her financial plan she assumes that she will be in the same tax bracket in retirement that she is in currently.   A consideration is to take a portion of her IRA, now 65% of what it was, and convert it to a Roth IRA.  There is now a lower tax liability upon conversion, as opposed to if she did the conversion when the IRA was at its full value.  Assuming the investments will come back in value and continue to grow, she has just moved a portion of her retirement assets to grow tax-free for decades at a significant discount.

Good financial planning not only involves having a sound investment strategy, but also knowing how all the pieces of the financial picture (taxes, insurance, estate planning, etc.) are intertwined.  Utilizing opportunities outside of portfolio management, such as Roth IRAs or Roth conversions, can have a significant impact on whether or not a financial plan is successful.