It’s common for questions to arise regarding your clients’ ability, eligibility, and desire to fund a Roth IRA during tax-filing time. But keep in mind that there are benefits beyond the obvious tax-saving opportunities that may require a more thoughtful approach. Many of the Roth rules have evolved over time. Understanding the financial planning ramifications opens the door for deeper conversations on the Roth beyond income tax management and playing with tax brackets. As many CPAs embrace financial planning as part of their practice, the impact of the Roth on cash flow, risk management, retirement options, estate planning, and investment strategy should be communicated.
Roth IRAs are available to those with earned income under certain thresholds, depending on tax-filing status. Roths do not offer a tax deduction since they are funded on an after-tax basis, but they generate tax-free income and growth if eventually taken as part of a qualified distribution. There is no required minimum distribution (RMD) to the original owner. If taken early, the tier system of distribution allows original contributions to be taken first with no tax or penalty on those amounts. This offers opportunity unavailable with other retirement monies.
With tax-deferred retirement accounts, penalties on early distributions may force smaller contributions out of fear of needing those funds. If participants have access to their original contributions without penalty, they may be more inclined to save greater amounts. Adding to its flexibility, Roth contributions may be made up until the tax-filing due date, not including extensions.
Earned income limitations may preclude some from funding Roth IRAs as a retirement savings option. If adjusted gross income is too high, a nondeductible IRA may be used. In some cases, those nondeductible IRAs could be converted to Roth IRAs, particularly if there are no other IRA accounts. This is often referred to as a “back door Roth.” The nondeductible piece is considered basis, while any earnings would be taxable upon conversion. Other options in funding Roths when limitations apply include Roth 401(k)s and Roth conversions.
More employee retirement plans are adding a Roth feature to their 401(k) options. Employees may now defer even larger amounts than traditional funding allows. This may be attractive to those in lower earning years where the tax deferral is not as impactful. Then, if changing jobs, rolling Roth 401(k) monies into a Roth IRA opens the door to tapping those original contributions, if needed. Tracking employee contributions is critical in these cases. If a Roth feature is not available, individuals can take advantage of the IRA conversion to Roth when they are in lower-income tax brackets.
Careful tax planning is necessary when considering Roth conversions. Factors include having funds available to pay the subsequent tax, circular calculations of income inclusion, and tax deductions. For example, Social Security income is taxed based on other income on the return. Converting prior to filing for these types of benefits allows for larger conversions. Certain itemized deductions may be limited by income. Tax projections are a must to mitigate the impact of these on potential conversions.
Review of the current tax brackets versus those during retirement, or even the tax brackets of heirs, requires thoughtful consideration. Retiring prior to collecting Social Security or taking RMDs may open the window for conversions at much lower tax brackets than when these are required. Other resources would have to be available to fund cash flow, such as savings or investments. Shifting retirement monies from taxable to nontaxable income for survivors is a powerful tax-saving and estate-planning strategy.
Surviving spouses who remain single might fall into a higher tax bracket than they were when married. Planning could help the survivor manage taxes, cash flow, and their own estate planning. In addition, adult children inheriting IRAs may still be working, and any RMDs will be exposed to a higher tax rate. Retirement accounts allow for a primary and contingent beneficiary designation. Using the contingent classification opens the door for disclaimers by the primary beneficiary. A surviving spouse or working child may not need the funds, and can disclaim to a child or grandchild if named as the contingent beneficiary.
Roths offer significant investment opportunities as well. Qualified distributions have no tax impact. Therefore, growth in the Roth has more advantages on distribution than growth in the ordinary, taxable IRA or 401(k). Reviewing the allocation of fixed income investments to an IRA or 401(k) versus equity-growth-type investments to tax-free accounts such as Roths may not be obvious to a tax preparer, yet it can be critical in the overall tax plan.
Taking the time with clients for a thorough review of the Roth opportunities and strategies demonstrates the value beyond just income tax savings.
Laurie A. Siebert, CPA, CFP, is an investment adviser representative of Valley National Financial Advisors, and securities are offered through Valley National Investments Inc., member FINRA, SIPC. She is a member of the
Pennsylvania CPA Journal Editorial Board, and can be reached at email@example.com.