By Andy Ives, CFP®, AIF®
Roth IRAs are a wonderful way to save for retirement. A person can sock away $6,000 a year (plus another $1,000 if they are age 50 or older) and the earnings will grow tax free. Plus, most custodians allow Roth IRA dollars to be invested in an incredibly wide array of options – mutual funds, stocks, ETFs – a veritable smorgasbords of choices. Can’t beat that with a stick!
Did I mention that Roth IRAs have no required minimum distributions at age 70 ½? (Put that in the “pro-Roth” column.) What about age restrictions on who can contribute? You’re telling me that anyone can contribute to a Roth IRA as long as they have earned income and do not exceed certain income limits? Grandma Jones who is 84 and works part-time at the local bookstore can contribute to a Roth IRA? Darn tootin’ she can. And when Grandma Jones passes her Roth IRA to her grandchildren, those kids will inherit tax-free dollars. What a magical account!
But tread lightly, my friends.
Maybe you started your Roth IRA with a contribution. You walked into the local bank and proudly handed over $6,000. But then later in the year you hit a big sales target at your company and earned a sizable bonus. Now you make too much money. Once you exceed the income limits you are ineligible for a Roth. You can recharacterize your Roth contribution to a traditional IRA, but you better get it done before October 15 of next year. Otherwise, it will be an excess contribution and a 6% penalty will apply.
Another way to establish a Roth IRA is to convert all or a portion of an existing traditional IRA. This conversion is final. There is no going back, no way to recharacterize a conversion like you can with a contribution. You lose your job and suddenly can’t afford the taxes on that big Roth conversion? Too bad. The IRS does not want to hear your sob story.
Also, be sure to consider ALL of your IRAs before you dive into the Roth conversion pool. Don’t play games and attempt to convert only the basis in one of your traditional IRAs. Can’t do that. The pesky pro rata rule dictates that all IRA, SEP and SIMPLE dollars must be accounted for. If you leap before you look, an unexpected tax bill resulting from your Roth conversion could be sneering at you in the spring.
As for the taxes due on a Roth conversion, it would be a good idea to pay those from assets other than IRA dollars. Why? Well, once IRA dollars float away to the IRS, they are forever gone and have no ability to grow tax free in your Roth IRA. As for anyone under age 59 ½ who wants to convert to a Roth and pay the taxes with IRA dollars – bad move. The taxes you send to the IRS for the conversion never actually get converted. They are considered a withdrawal and face a 10% early distribution penalty. Double whammy.
One final item to consider – is a charity your beneficiary? It is suggested you not leave the charity your Roth IRA. Find something else to give them – like maybe a traditional IRA. Charities don’t pay taxes, so a traditional IRA donation will be just as appreciated. If you convert a traditional IRA to a Roth and pay taxes on the conversion yourself, give someone who would otherwise have to pay taxes on an inheritance your tax-free money. Eating the conversion taxes yourself and then giving the Roth IRA to a charity makes little sense.
Are Roth IRAs the best thing since sliced bread? They are pretty darn tasty, but not always a perfect fit for every financial diet. Monitor your carbohydrates.