You can accumulate a nice nest egg if you persistently save and even small amounts add up over time, especially when the account can grow tax deferred. You can accumulate more wealth when the IRS and your state aren’t taking a cut of your investment earnings. An IRA allows for that tax-deferred growth. It can be a good retirement savings vehicle on its own, or to supplement contributions to an employer retirement plan. Here are some things to consider regarding IRAs and Roth IRAs.
Income Tax and Retirement Planning Implications
First, you have to qualify before you can even consider it. To contribute to a traditional IRA, you must have earned your own income or have a spouse with enough earned income to attribute to you so you can make a contribution to a spousal IRA. Note there is no longer an age restriction for being able to contribute to a traditional IRA thanks to the SECURE Act signed into law in December 2019.
Next, you need to be in a position to contribute. If you don’t have an emergency fund or have high-interest debt to pay down, perhaps you should focus on those priorities first to build wealth. Otherwise, it’s a good idea to consider adding to your retirement savings. For 2020 and 2021, you can contribute the lesser of your earned income for each year or $6,000 ($7,000 if you’re at least age 50). That limit is a combined total for all contributions to traditional and Roth IRAs. Though 2020 has ended, you have until April 15 to make a 2020 IRA contribution. For that matter, you can make your 2021 contribution while you’re at it so it can start growing tax deferred.
An IRA may be your only option if your employer doesn’t offer a retirement plan. Even if you do participate in an employer retirement plan, you can still contribute to an IRA whether you get an income tax deduction or not. If you are an active participant in a retirement plan, a married person’s traditional IRA deduction begins to phase out at an AGI of $104,000. If you don’t participate in a retirement plan but your spouse does, your IRA deduction begins to phase out at an AGI of $196,000 if you file jointly.
Beyond that, your contribution would be a nondeductible, after-tax contribution. That’s okay. This creates a basis in your IRA for later distributions to come out partially tax-free. In the meantime, the account can grow and compound tax deferred.
Contributions to a Roth IRA are not deductible. They are made with after-tax dollars. But the advantage is that even the earnings can come out tax-free when taking qualified withdrawals. Additionally, there is more flexibility with Roth IRAs. Should there be some emergency, you can always take out your contributions anytime tax-free and penalty-free. Also, there’s no required minimum distributions come age 72 (the new age under the SECURE Act for mandatory distributions). Therefore, you can leave that balance intact to grow and compound tax-free until you need it.
When given the choice of contributing $6,000 to a traditional IRA or to a Roth IRA, the Roth IRA contribution will be more valuable in retirement since it’d be tax-free. It becomes a bit of a forced savings strategy by foregoing a tax deduction now when you can better afford it in order to build something of greater after-tax value in retirement when you need it most. That being said, not everyone can contribute to a Roth IRA. There are AGI limitations. Eligibility to contribute to a Roth IRA begins to phase out at an AGI of $124,000 for a single filer and $196,000 for a married-filing-joint filer.
If you’re over those AGI limits and still wish to contribute to a Roth IRA, there is currently another strategy to get the money into a Roth IRA. If you have no other pre-tax IRA balances from prior deductible contributions or roll overs from employer retirement plans or a SEP IRA or SIMPLE IRA account, you could make a nondeductible 2020 and/or 2021 contribution to a traditional IRA. Immediately thereafter, you could convert that balance to a Roth IRA. There are no AGI limits for a conversion. There would be no taxable effect if you hold the traditional IRA contribution in a money market fund so it doesn’t appreciate before conversion. Then you can invest it however you wish once it has been converted to a Roth IRA. If you have pre-tax IRA balances but participate in an employer retirement plan, there’s a way to “clear the deck” to allow for this backdoor Roth IRA strategy to work.
IRAs can be very attractive to those who don’t have an employer plan to contribute to and for those who have excess funds they’d like to grow tax deferred. Don’t miss the April 15th deadline to make a 2020 traditional or Roth IRA contribution.
Note that much of this could change based on Biden’s tax proposals. He has proposed eliminating the pre-tax treatment of retirement contributions and replacing it with a tax credit instead. If that passes, all traditional planning would need to be revamped. So, the above guidance applies as we know it now. Stay tuned.
Estate Planning Considerations
IRA and Roth IRAs are included in your estate when you die, but they aren’t controlled by your will. They pass to whomever you’ve named as beneficiary – outside your will. No matter how up to date your will is or how well-drafted it is, your estate plan still might not work as you intend. That’s an important consideration that many people miss. Your will might have trusts being formed at death for estate tax or asset protection purposes but might not have the assets going into those trusts you think they would. You also might have trust provisions for minors but have named a minor as beneficiary on your IRA. Doing so circumvents the trust provisions. Minors can’t inherit IRAs, so there would be inadvertent complications. Understanding how your overall estate plan comes together allows you to make informed decisions on any changes that might be needed. Perhaps the beneficiary designations need to be changed.
Roth IRA conversions may make sense from an income tax and estate planning perspective. By converting a traditional IRA to a Roth IRA, you pay income tax on the converted balance since it’s never been subject to income tax. From that point forward, the account can grow tax-deferred and qualified distributions can come out tax-free. That can be beneficial if income tax rates rise as most anticipate. It can also be beneficial to your heirs that inherit the IRA. Roth IRA distributions continue their tax-free status to the beneficiaries. Paying the income tax for their benefit is like a gift that isn’t subject to gift tax.
Under the SECURE Act, inherited retirement accounts must be fully distributed within 10 years for most beneficiaries. Such a short distribution period could cause higher income taxes for those inheriting a traditional IRA. A Roth IRA has the same short distribution period, but the tax-free distributions wouldn’t complicate the beneficiary’s tax situation.
The SECURE Act’s 10-year payout period might cause your beneficiary to get the cash sooner than you would like. Now’s the time to revisit those beneficiary designations to see if any changes need to be made as a result. Possibly certain types of trusts might need to be named as beneficiaries instead.
There’s always so much to think about when it comes to personal finances. We find there is usually another perspective or consequence to factor into most things. Considering all aspects allows you to make more fully informed decisions. Contact our wealth management experts today to further discuss your specific situation.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.