Long-term investors could benefit from the stock market pullback and changes to the tax code to build significant tax-free wealth. Adding to a Roth IRA in a down market could amplify tax-free accumulation when the market recovers.
With lower tax rates for most Americans under tax reform, the tax savings on Roth conversions could minimize the tax barrier to growth. Investors need to be aware of the most recent changes and opportunities.
The Tax Cuts and Jobs Act of 2017 (TCJA) revamped the tax code. Among other items, TCJA lowered personal income tax brackets and broadened the amount of income taxed in those lower brackets.
As a tradeoff for a high standard deduction, the law limits some itemized deductions, which could result in higher tax bills for some. The current rates are scheduled to sunset in 2025. Therefore, Americans could be paying higher taxes in future years. Investors should take advantage of this tax window.
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There are three ways to fund a Roth IRA.
▪ The first is a direct contribution.
Individuals may contribute 100 percent of earned income up to a maximum of $6,000 per year. Taxpayers over age 50 can contribute an additional $1,000 catchup contribution.
For 2019, the Adjusted Gross Income (AGI) phase-out ranges for single filers are $122,000-$137,000. The phase-out ranges for married filing jointly taxpayers are $193,000-$203,000. Income in excess of the upper limits makes the taxpayer ineligible for direct contributions.
▪ The second way to fund a Roth IRA is by converting all or part of a Traditional IRA to a Roth.
Although income tax is due on the Roth conversion, investors may benefit from intentionally triggering tax at these lower post-tax reform rates. The IRS limits contributions to Roth IRAs but there are no limits on conversions.
For individuals who pay little-to-no income tax, Roth conversions merit consideration.
▪ The third way to fund a Roth IRA is with a “backdoor Roth contribution.”
This strategy is an important planning tool for higher income taxpayers because taxpayers with income in excess of Roth AGI thresholds can make a non-deductible contribution to a traditional IRA and then convert the funds to a Roth.
Because no tax deduction is received for the contribution, no taxes will be due on the conversion — provided certain rules are followed. After-tax contributions should be tracked on IRS Form 8606.
Although an investor must have earned income and be younger than 70 1/2, there are no AGI limitations for contributing to a traditional IRA. If the taxpayer is considered an active participant in an employer retirement plan, varying AGI thresholds determine deductibility. Important rules must be followed.
The “step doctrine” collapses multiple transactions into a single transaction to determine if the end result was lawfully obtained. For example, a contribution to a non-deductible IRA followed by an immediate Roth conversion would be viewed as a direct Roth contribution.
The workaround has been to allow time to pass between the traditional IRA contribution and conversion.
The IRS does not provide guidance on the time lag. However, footnotes 268 and 269 of the TCJA Conference Report may have nullified the step doctrine as it pertains to the backdoor Roth strategy.
Footnote 269 states, “Although an individual with AGI exceeding certain limits is not permitted to make a contribution directly to a Roth IRA, the individual can make a contribution to a traditional IRA and convert the traditional IRA to a Roth IRA.”
Consult with your tax professional for his/her interpretation.
Beware of the aggregation and pro-rata rules when traditional IRAs hold both deductible and non-deductible contributions.
Assume a high wage earner active in a 401(k) plan has $95,000 in a traditional IRA. This investor decides to make a $5,000 non-deductible backdoor Roth contribution, which increases the IRA aggregate balance to $100,000 (95 percent pre-tax and 5 percent after-tax.) Because distributions are subject to the “pro-rata rule,” only 5 percent of the $5,000 conversion would be tax free: $250. The investor would owe tax on $4,750.
The TCJA repealed the do-over strategy referred to as “recharacterization.” This would have allowed the investor to reverse the transaction.
However, the investor could transfer the $95,000 pre-tax balance to his/her 401(k) if the plan allowed. Since there would then be no other pre-tax IRA money, the $5,000 non-deductible contribution would not be taxed upon conversion.
Roth IRAs are distributed in this order: regular contributions, conversions and rollover contributions, then earnings. Investors can access Roth IRA earnings without penalty after five years or attaining age 59 1/2, whichever is longer.
If an investor has a Roth 401(k) and/or after-tax contributions to roll over to a Roth IRA, the five-year holding period must be met before distributions are considered tax-free. To prepare for retirement, investors should establish a small Roth IRA to start the five-year clock ahead of rolling over the Roth 401(k).
Andy Drennen is a Certified Financial Planning professional and member of the Financial Planning Association of Greater Kansas City. He is a vice president and portfolio manager at Central Trust Co.