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Introduction

Formulate a Financial Plan

Know Your Net Worth

Manage & Minimize Debt

Accumulate Assets

Budget to Live Within Your Means

Understand Investing Basics

Plan for Retirement

Insure People & Property

Deal with Financial Advisors

Review Your Employment Contract

Make Plans for Your Estate

Make Good Decisions

Conclusion

Investment accounts are distinguished by their tax-related characteristics. Eligibility, contribution limits, required withdrawals, and tax implications for these accounts can get confusing. Consult a licensed accountant to ensure the best decisions are made.

Some plans are technically non-qualified but do provide tax advantages. They may be sponsored by an employer or by you as an individual. These plans include the Traditional Individual Retirement account (Traditional IRA) and the Roth IRA.

IRA limits for 2019 and 2020 are $6,000. If you are over the age of 50, you’re allowed a catch-up contribution of $1,000. Your annual compensation must be at least as high as the amount of direct contributions made in a given tax year to IRA accounts.

Any funds you withdraw from a Traditional IRA prior to age 59.5 are subject to a 10% penalty, on top of the taxes payable on the amount withdrawn. Once you reach age 72 you must begin to take distributions out of your account.

While annual contribution limits for IRAs are lower than for 401(k)s, there’s usually far greater investment flexibility in IRAs. You may be able to buy any of thousands of stocks, bonds, mutual funds or exchange traded funds. This makes it easier to diversify your investments, and also gives you the flexibility to select investment funds that have very low management fees.

In a Traditional IRA, contributions you make in a given year are made pretax, allowing you to reduce your income tax bill in the year the contribution is made. Your investments in an IRA grow tax-deferred—no taxes until you begin to take money out.

In a Roth IRA, your contributions are made after tax. That is, you don’t get to lower your taxes in the contribution year. Any gains are tax-deferred, but most importantly, you pay no taxes when you take the money out. Needless to say, not having to pay any taxes on gains is very appealing. It’s so appealing that everyone wants to do it. But the government limits eligibility for Roth IRA contributions by income.  In 2019, if you are single and have an adjusted gross income (AGI) of less than $122,000 ($124,000 in 2020), you can contribute the maximum to a Roth IRA. The permitted contribution gradually phases out, so that once your AGI reaches $137,000 ($139,000 in 2020), you are likely no longer eligible to contribute to a Roth IRA at all. If you are married filing jointly, for 2019 your permitted contribution begins to phase out at a combined AGI of $193,000 ($196,000 in 2020), and eligibility ends at $203,000 ($206,000 in 2020).

Check the IRS website for the latest updates.

Your contributions to a Roth can be withdrawn at any time without tax implications, because they were made post-tax, but any gains are taxed if withdrawn before age 59.5. There is a caveat that withdrawn funds have to have been in the account for at least five years. Otherwise, you could owe taxes and the 10% penalty.

It is possible to convert a Traditional IRA to a Roth, but that generally triggers taxes since the contributions to the Traditional account benefited from tax deductibility in the years they were made and the government wants its share of your income.

If you participate in a qualified retirement account offered by your employer (e.g., 401(k) or 403(b)) you may also be able to contribute to a Traditional or Roth IRA. I recommend confirming with your accountant whether you are eligible. If you’re not eligible to contribute and still have some money you’d like to put away tax-deferred you can contribute to a Non-deductible IRA. As the name implies, you are unable to deduct contributions from your income but the funds grow within the account on a tax-deferred basis. When withdrawn in later years you pay taxes on the gains but not on your original, non-deductible contributions.

It’s important to discuss non-deductible IRA contributions with your accountant as she may need to document the precise dates and amounts of your contributions in order to properly calculate taxable gains in future, in particular if you decide to convert some of the non-deductible Traditional IRA funds into Roth IRA.

 

The SECURE Act

The 2019 Setting Every Community Up for Retirement Enhancement (SECURE) Act made some significant changes to intergenerational IRA transfers. It is still possible for a spouse to inherit an IRA account and roll it over into her own name.  Subsequently, it’s as though she has been the owner of the account all along, and she can elect how she would like to receive the proceeds, subject to rules specifying required minimum distributions. By very gradually taking required distributions over her remaining lifetime she can minimize the taxes payable on those account withdrawals.

It used to be the case that an IRA owner could also pass an account to a child, who could then stretch out required distributions over their expected lifetimes. The younger the children, the smaller their required annual distributions. This approach was commonly referred to as a “Stretch IRA.” Note that this was a strategy—not a formal IRA type.

The Stretch IRA allowed the child to extend RMDs over many more years than the parent, allowing more of the balance to remain invested where it could grow further on a tax-deferred basis. Furthermore, the child’s tax bill could be much more favorable than the parent’s, due to a lower likelihood that the (smaller) additional income would push the earnings to a higher tax bracket. The strategy could also be used with grandchildren. The original IRA owner could name a grandchild as beneficiary, and that youngster could stretch required distributions out over many decades.

The SECURE Act took away the Stretch allowance for most non-spouse beneficiaries. There are some exceptions, for example, in the case of siblings who are close in age to the original owner or children with disabilities, but most inter-generational inheritors must now empty the inherited account within ten years. This rule has been dubbed the “drain in ten” rule.

Acceleration of distributions is much more likely to force recipients into higher marginal tax brackets and deprives them of the tax-deferred growth they could have realized over many more years. Any funds remaining in the account are subject to heavy penalties, which could reach 50% of the amount not distributed as required.

Another negative consequence of this rule change is that distributions received by the beneficiary are no longer in a tax-deferred account, so any subsequent interest, dividends, or capital gains on those distributions are subject to tax. 

For decades, estate planners drafted Trust documents using wording consistent with the now expired Stretch IRA regime. Many of those documents must now be updated. If you or a parent has any such documents, have them reviewed to ensure the language still holds unambiguously.

There are other ways to approach intergenerational tax planning challenges, including naming a Trust as the beneficiary of a retirement account. Due to potential complexities of Trust law, it’s highly advisable to review all these decisions and structures with a competent and specialized attorney and or tax accountant.

 

Related Links:

IRS IRA Contribution Limits

IRS Cost of Living Adjustment for Limitations on Benefits and Contributions

FINRA Inherited and Stretch IRAs

Merrill Edge IRA Selector Tool

TD Ameritrade IRA Selection Tool

 

Backdoor Roth IRA

You may have heard of the Backdoor Roth IRA tactic. It’s often touted as a way for high earners to bypass income limits and still be able to contribute to a Roth. The Backdoor Roth is a tactic, not an official type of IRA. The procedure requires you to contribute to a non-deductible IRA and then convert it to a Roth account. Your non-deductible IRA contributions were made post-tax so they are compatible in that sense with Roth contributions which are also made post-tax. Some people suggest that you convert immediately to avoid the account accruing any gains as those would be subject to taxation following conversion. Others argue that immediate conversion risks running afoul of the Step Transaction Doctrine, which could be used by a tax court to argue that your hasty steps are nefarious.

Setting aside the step transaction doctrine, which requires legal opinions from a licensed tax expert, there is another catch. If you already have other Traditional IRA (pre-tax) assets, then the amount of your backdoor Roth IRA that gets the favorable Roth taxation treatment is pro-rated based on the relative amounts of your post-tax and Traditional pre-tax accounts at year-end. For example, if you have $95,000 of pre-tax (Traditional) IRA holdings and $5,000 in post-tax (Non-deductible) IRAs you wish to convert, the percentage of any conversion to Roth that gets true Roth treatment is only $5,000/$100,000 = 5%. This means you will owe income taxes on 95% of the conversion. This pro-rata rule was put in place to ensure the Roth benefit does not go to people who are well-positioned for retirement by already having significant Traditional IRA assets. The rule significantly dilutes the benefit of the conversion.

There is a way to sidestep this pro-rata rule, by getting rid of your Traditional IRA assets. This is possible if your employer-provided 401(k) or 403(b) allows you to roll-in external assets into the account. The idea is that after rolling-in all your Traditional IRA assets into the qualified account, you will have zero pre-tax IRA assets, and the pro-rata rule will not affect you. Keep in mind that 401(k) and 403(b) accounts generally offer fewer investing options, and fees may not be as low as you could find in an IRA. So, you could convert to Roth, but your now larger holdings in qualified employer accounts may be subject to higher annual fees. That represents a drag on your value gains and somewhat undermines the conversion strategy.

An alternative if you own a company is to set up a Solo 401(k) through a provider that allows roll-ins. Then transfer your Traditional IRA assets into that new account, thereby side-stepping the pro-rata rule.

Final thoughts on such conversions: the process is fairly straightforward, but your tax filing must be precise. Any mistakes on your part or on the part of your accountant could lead to headaches, penalty payments, and additional filing costs in future. You or your accountant must properly track the timing of conversions and file IRS Form 8606, titled, “Nondeductible IRAs,” along with any other required paperwork. You should also be aware of the previously mentioned step transaction rule which could be invoked to undermine your contribution-and-immediate-conversion strategy.

I’ve encountered several accountants who were not aware of all the required steps and limitations. You may wish to direct them to some of the relevant links posted below.

 

Related Links:

How to do a Backdoor Roth IRA contribution while avoiding the IRA aggregation rule and the step transaction doctrine

Morningstar Backdoor Roth IRA? Avoid These 6 Mistakes

Nerdwallet Backdoor Roth IRA high-income how-to guide

Bogleheads IRA recharacterization

Schwab Roth IRA Conversion Calculator

Fidelity Roth Conversion Calculator

 

Traditional vs. Roth Accounts

It’s commonly assumed that Roth accounts are more advantageous than Traditional IRA accounts. For the most part this is correct. Most people assume this is correct because it’s great to receive money in future without having to pay taxes. But if that was the only consideration, the decision between the two would hinge only on whether you believe taxes will be higher or lower when you retire. If you believe you’ll pay higher taxes in your retirement years, then the Roth strategy makes more sense because you pay low taxes now and avoid higher ones in future. If you believe taxes will be lower in retirement, you’d be better off with a Traditional IRA because you’ll avoid higher taxes now and pay lower taxes later.

The superiority of the Roth IRA comes from its flexibility. In particular, Roth IRAs don’t force us to take required minimum distributions, while Traditional IRAs are subject to RMDs, which trigger taxes. Having control over the timing of withdrawals without penalty is very useful.  It is also easier to initiate early withdrawals from Roth IRAs by taking your own contributions out since they were made post-tax. Early withdrawal from Traditional IRAs may trigger 10% penalties on top of taxes. It is generally inadvisable to withdraw early from Roth accounts, but the flexibility to do so as needed is useful.

Roth IRAs used to have the additional advantage that you could continue to make contributions at any age, while Traditional IRAs did not allow contributions after age 70.5. But that difference was removed by the SECURE Act which now allows Traditional IRA contributions beyond age 70.5.   

We don’t know whether our taxes will be higher or lower in retirement. Forecasting taxes decades into the future is an impossible task and not worth the effort. A further complication is that in addition to uncertainty about future tax rates, we don’t know whether future legislation will tax Roth IRAs or undermine any of the other existing retirement account types. If that happens, existing account holders may be grandfathered under the old rules but there are no guarantees. The only response to these unknowns is a tax diversification strategy of purposely holding both pre-and post-tax accounts in case tax laws change.

 

Related Links:

Roth versus Traditional IRA account?


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