As families begin to prepare for retirement, one of the tensions they may wrestle with is having the ability to control their taxable income level while still being able to maintain the lifestyle they desire. It is critical to control income levels in the early part of retirement as higher income may negatively impact Medicare premiums and the taxation of Social Security benefits. One of the best tools available to provide tax-free income is the Roth IRA; however, it is one of the most difficult to use for families that could benefit the most from it.
Roth IRAs allow individuals to contribute $7,000 annually ($8,000 for individuals over the age of 50). The contributions are made with after-tax dollars. The Roth IRA provides tax-deferred growth like traditional IRAs and other retirement accounts. The three biggest advantages are:
- No Required Minimum Distribution (RMD)
- Distributions are tax free (provided five-year rule is met and over age 59.5)
- Inherited Roths are also tax free to beneficiaries
These are all major benefits to families who have spent most of their career in a higher income tax bracket. So, what’s the catch? Why doesn’t everyone utilize a Roth IRA? The big reason is income limitations. Individuals earning more than $161,000 or married couples earning more than $240,000 (tax year 2024) are prohibited from making qualified contributions to the Roth.
All is not lost for families who are ineligible for contributions: there are two different ways to fund a Roth IRA if they are over the income threshold.
- Roth Conversions – If an individual has a traditional IRA or a rollover IRA from a previous company retirement plan, they can convert their IRA to a Roth IRA. To accomplish this, they would establish a Roth IRA account and transfer a portion or all of their IRA account funds over to the Roth. In doing so, the amount transferred over will be taxed at the individual’s income tax rate for that year.
- Two-Step Roth Contribution – A lesser-used approach that may allow an individual to grow a Roth IRA balance while limiting their tax exposure is a Two-Step Roth Contribution. The first step is to set up a traditional IRA and make a non-deductible contribution. This simply means the individual does not get to deduct the contribution on their income tax. After the contribution is made, the individual should convert the traditional IRA to a Roth IRA. Because the contribution is made with after-tax dollars, there may be no tax due on the conversion1. While the dollar amount of the contribution is limited to the annual contribution limit, the Roth balance could grow to a sizable amount during retirement if done over a number of years.
The Roth IRA is a powerful tool for controlling income—and ultimately taxes—in retirement. It is possible that tax rates will be rising in the future. Thus, it could help to consider using the Roth conversion to take advantage of current, relatively low tax rates.
If you have any questions or need assistance with these planning techniques, please reach out to a professional with FORVIS Private Client™.
- 1 The IRA Aggregation Rule stipulates that when determining the tax consequences of an IRA distribution, the value of all IRA accounts will be aggregated together for the purpose of any tax calculations. This consideration of all IRA dollars could turn a simple two-step Roth conversion into a messy, partial Roth conversion. To avoid this situation, consult with your tax and financial planning professionals to discuss your eligibility.