Sunday, July 31, 2016

Is it time to revisit Roth IRAs?


Once again, tax planning emphasis appears to have shifted from focusing on minimizing the estate subject to tax and focusing on the reduction of current taxable income. The main reason for this shift is that only a few estates may actually be taxed because, to incur the tax, the taxable estate must exceed $5,450,000. There is an investment strategy that permits a buildup of value without income tax and then when that untaxed increment is withdrawn, it is not subject to income tax.

The strategy referred to is Roth Individual Retirement Account (Roth IRA). The traditional IRA may provide up to a $5,500 income tax deduction and the fund that is invested compounds free of income taxes until it is withdrawn.

There are a number of rules restricting when a taxpayer can make a deductible IRA, such as income levels and participation in employer plans. Then, like retirement plans generally, the taxpayer must start taking distributions at age 70½, but if a distribution is taken before age 59½ there is a severe penalty.
Whatever has accumulated up to the taxpayer’s death is then subject to estate tax if the estate overall is large enough, but when withdrawn it is still taxable income to the heir but hopefully at a lower rate than when it was deducted by the deceased.

Remember, with the large estate tax exclusion, a taxpayer can accumulate a significant IRA balance with good investment advice and planning. However, it still generates taxable income to whomever withdraws the money.

Can we improve on this? Possibly, provided a number of factors fall into line, some of which can be controlled and a few which cannot be controlled. Like all investment options, there are tax consequences, and ultimately the decision revolves around the risks with which a taxpayer is comfortable.
The Roth IRA presents an investment vehicle that may satisfy some but not all the risks. Roth contribution limits are similar to those of regular IRAs, as are the income level restrictions, but participation in an employer’s plan is not a problem. However, the contribution is not deductible. Why then discuss it?
When a withdrawal is made after the end of the fifth year from the beginning of the first tax year in which the Roth contribution was made, then that withdrawal is completely free of income tax. Whatever earnings have accrued in that five-year period and are part of the distribution escape income tax entirely.

Certainly, age is a factor to consider since the compounding factor is a crucial benefit. Investment options are critical. Income tax rates are a must consideration, both in the year of contribution when there is no tax deduction benefit and in the year of projected withdrawal.

In addition to the possible non-taxable distributions, Roth IRAs are not subject to a required minimum distribution. Unlike regular IRAs, Roth contributions can be made at any age, even after 70½, which is another benefit as people live longer.

The tax free compounding offers such an enticing possibility that under proper investment projections, the decision to convert or “rollover” a regular IRA or other retirement plan into a Roth IRA is something to consider, even though that transaction is fully taxable now.

Certainly, the Roth IRA is not for everybody, but with the increased emphasis on reducing income taxes without the overriding worry of increasing wealth, the Roth IRA option is another possible investment alternative to discuss with your advisors. Naturally, like all tax alternatives, there are many rules to observe.