Private company pensions have become rare. The long-term viability of the Social Security program is likely going to require Congress to make some hard choices, which may result in lesser than currently anticipated benefits for some future retirees.
A successful retirement, therefore, may fall more on retirees making wise decisions with their contributions to their own personal retirement accounts, like 401(k) plans and individual retirement accounts (IRAs).
Because balancing current expenditures against saving for retirement can be challenging, determining the most appropriate retirement vehicle to use to channel one’s retirement savings is critical to optimize both goals.
On the surface, saving for retirement may seem like a relatively easy thing to do. You set money aside, let it grow, and when it’s time to retire, those funds should be available to meet your retirement goals. But in reality it’s not quite that simple.
There are several options to consider. For example, is a traditional IRA, Roth IRA, or both the most suitable for your financial situation? Here we offer some details about the types of IRAs and which may be an appropriate option for you and your family. You should consult your tax and financial advisors before making any decisions.
Traditional IRAs were established in the United States by legislation passed in 1974 to help Americans save for retirement in a tax-advantaged manner and to complement employer-sponsored retirement plans.
Beginning with tax years after 2019, individuals who have earned income regardless of age, may contribute to an IRA, even if you or your spouse participate in an employer-sponsored retirement plan. And if you’re still working and own less than 5% of your company, you may still be eligible to contribute to a 401(k) plan if offered by your employer.
Depending on the amount of your income, your traditional IRA contribution may or may not be fully deductible. Also, if you are married, filing jointly, and you do not have any earned income but your spouse does, your working spouse may be able to contribute to a spousal traditional IRA on your behalf.
Contribution Limits for Traditional IRAs
For both 2019 and 2020, the traditional IRA and Roth IRA maximum contribution limit is the lesser of earned income for the year of contribution or $6,000 for those age 49 and below; or $7,000, for those age 50 and above, due to an age-based catch-up provision that allows those individuals to contribute up to an extra $1,000. Contributions for the 2019 tax year can normally be made no later than April 15, 2020, and for the 2020 tax year, no later than April 15, 2021.
If you are covered by a retirement plan at work, the Internal Revenue Service (IRS) Publication 590-A can help determine if your (MAGI) affects the amount of your deduction. If you file separately and did not live with your spouse at any time during the year, your IRA deduction is determined under the single filing status.
If you’re not covered by a retirement plan at work, also use IRS Publication 590-A to help determine if your MAGI affects the amount of your deduction. If you file separately and did not live with your spouse at any time during the year, your IRA deduction is determined under the single filing status.
Why Contribute to a Traditional IRA?
Individuals with an MAGI under a certain threshold may potentially receive an income tax deduction for contributions made to a traditional IRA.
Even nondeductible IRA contributions will nevertheless have the opportunity to enjoy the benefit of tax-deferred growth until distributed.
These after-tax contributions become tax basis in the traditional IRA. This means when it’s time to make a distribution, the amount distributed will comprise a portion that will not be taxed. When such a pro-rata distribution is made, the method to calculate the amount subject to tax is to take the total of the after-tax money and nondeductible contributions in the IRA (or total basis) and divide that total by the total amounts held in all of your IRAs, including Simplified Employee Pension (SEP) plans and Savings Incentive Match Plan for Employees (SIMPLE) IRAs, but not Roth IRAs, as of December 31 of the year prior to the distribution year. Scenario 1 depicts a hypothetical example of a 60-year-old woman who decides to take a distribution from her traditional IRA.
Rita, 60 years old, has a traditional IRA with a balance of $200,000 as of December 31, 2018. Not all of her contributions over the years have been tax deductible, resulting in a tax-cost basis of $30,000. She decides to take a distribution of $20,000 from her traditional IRA in 2019, resulting in a taxable distribution to her of $17,000 and a tax-free distribution of $3,000, which is 15% of the distribution amount ($30,000 tax-cost basis/$200,000 IRA balance = 0.15; $20,000 x 0.15 = $3,000).
Withdrawing Funds from a Traditional IRA
You may withdraw money from a traditional IRA penalty-free upon reaching age 59½. Before age 59½, you are subject to a 10% additional tax on the distribution, unless the distribution falls under an IRS exception.
Planning tip: Be careful to know the rules surrounding RMDs. Consult with your tax and financial advisors as you approach age 72. If you miss taking a timely RMD, you may be subject to a hefty 50% penalty tax on the distribution shortfall.
All else being equal, IRA accounts can potentially accumulate more than similarly invested non-IRA accounts over time because IRA accounts enjoy tax-free and/or tax-deferred accumulation until you begin taking required minimum distributions (RMDs) once you reach age 72 (or age 70½, if you attained that age on or before December 31, 2019).  The RMD for each calendar year is the account balance of all your traditional IRAs on December 31 of the preceding year divided by the distribution factor for the owner’s age at the year of distribution obtained from the IRS Uniform Lifetime Table. The distributions are subject to ordinary income tax to the extent that tax was not paid on them previously.
Also, your charitable goals may help mitigate the tax associated with RMDs. Scenario 2 outlines a hypothetical example of such a case.
Mary is 72 years old, single, and has a traditional IRA with a balance of $1 million as of December 31, 2018. Using her life-expectancy factor of 25.6 from the IRS Uniform Lifetime Table, Mary’s RMD for 2019 is $39,062.50. She is charitably inclined but finds she will not be itemizing her deductions, instead taking the standard deduction that, due to the Tax Cuts & Jobs Act of 2017, was increased to $12,200 in 2019.
Mary authorizes her IRA custodian to send $5,000 of her RMD directly to her favorite qualified charity. While she is not entitled to a charitable income tax deduction for making this qualified charitable distribution (QCD), Mary is able to exclude this $5,000 from her 2019 income by using this strategy. By using the QCD strategy, she may also save on Medicare premiums and surtaxes and on state income taxes because the distribution made directly to the charity is not included in her federal AGI.
The Roth IRA was named after Delaware Senator William Roth under the Taxpayer Relief Act of 1997, put in place to help individuals put money away for retirement with earnings on which they had already paid income tax. The Roth IRA was created to also provide the potential for owners to make tax-free withdrawals from the contributions to and earnings from those accounts in retirement.
To make contributions directly to a Roth IRA, you need to have earned income for that year, and your MAGI must be below certain limits as outlined at www.irs.gov.
As with traditional IRAs, contribution limits for Roth IRAs in 2019 and 2020 are up to $6,000 for individuals under the age of 50. For individuals 50 years and older, there is a catchup provision that allows those individuals to contribute an extra $1,000, for a potential total of $7,000 per year.
Why Contribute to a Roth IRA?
Roth IRAs potentially lower the tax on RMDs compared to owning only traditional IRAs with tax-deferred contributions and earnings. Individuals with funds in traditional IRAs are required to start taking distributions from those accounts by April 1 of the year after reaching age 72 (or age 70½, if you attained that age on or before December 31, 2019), even if they don’t need or want to withdraw the funds.
Since Roth IRAs don’t have the same minimum distribution requirement for the original owner of the account (or their spouse), the account holder may potentially have lower taxable income while enjoying future appreciation on both the income and principal in the Roth account on a tax-free basis.
In addition, Roth IRA accounts pass to heirs upon the death of the owner in a more tax-efficient manner. With some limited exceptions for “eligible designated beneficiaries” provided under the SECURE Act, when a non-spouse inherits a traditional IRA from an owner who dies after December 31, 2019, he or she is required to withdraw the entire balance of the IRA by December 31 of the tenth year following the death of the owner. The IRA distribution(s) is/are taxable at ordinary income tax rates. If that inherited IRA was instead an inherited Roth IRA, the heir would still be required to withdraw the entire balance of the Roth IRA by December 31 of the tenth year following the death of the owner, but those distributions would not be taxable to that individual. This strategy may allow individuals to pass more wealth on to their heirs on an after-tax basis.
Withdrawing Funds from a Roth IRA
A Roth IRA shares many of the same characteristics as a traditional IRA but has some significant differences. Notably, distributions from a Roth IRA have the potential to be tax-free. Roth IRA distributions will not be included in income if the distribution:
- occurs on or after age 59½; or
- is made to a beneficiary on or after the death of an individual; or
- is attributable to the owner being disabled; or
- is a qualified special purpose distribution; and
- is of contributions made at least five years prior.
Scenario 3 presents a hypothetical example of the potential tax consequences of an early Roth IRA withdrawal.
Brian is 55 years old. He first contributed $5,000 into a Roth IRA on the last day of 2019; the earliest he can withdraw his $5,000 contribution tax-free would be in 2020. But any earnings on that $5,000 original contribution would be subject to ordinary income tax if withdrawn before 2024 and could be subject to an additional 10% “penalty” tax if withdrawn before age 59½ if the withdrawal is not covered by any of the statutory exceptions.
Eligibility to Contribute to a Roth IRA
The tax-favored aspects of the Roth IRA may make it an attractive retirement vehicle, but what if you’re not eligible to contribute to one because of the income limitations? There are still contribution income limitations on Roth IRAs, but since 2010 — when prior limitations and restrictions on conversion were repealed — you can convert a traditional IRA to a Roth IRA regardless of your tax return filing status and/or how much you earn.
Whether deductible or nondeductible at the time they were made, contributions to your traditional IRA and/or earnings from them are transferred by the custodian from your traditional IRA account and are deposited directly with the custodian of your Roth IRA account. This strategy requires some or all of the converted funds be subject to ordinary income tax in the year of the conversion because they are generally treated as if they were distributions from your traditional IRA.
If your traditional IRA account contains only nondeductible contributions, then only the earnings, and not your own contributions, will be subject to tax at the time you convert the traditional IRA to a Roth IRA.
But if you’ve made both nondeductible and deductible IRA contributions to your traditional IRA, whether you plan on converting the entire amount or only a portion of it, you must calculate the proportion that is subject to tax. Under IRS rules, the amount you convert is deemed to comprise a pro-rata portion of the taxable and nontaxable dollars in the traditional IRA at year-end — in fact, in all of your IRAs (except Roth IRAs). Consider the hypothetical Scenario 4 of calculating the tax on a partial conversion.
Bill wants to convert $25,000 of his traditional IRA this year and wants to only convert from the nondeductible portion so he can pay no income tax. Unfortunately, he can’t convert $25,000 of the nondeductible contributions to a Roth IRA and have an absolutely tax-free conversion when there also are deductible contributions in the account. Instead, he’ll need to prorate the taxable and nontaxable portions of the account.
Assume Bill’s traditional IRA contains $400,000 of investments, of which $250,000 is derived from deductible contributions (taxable on distribution), $100,000 of nondeductible contributions (not taxable on distribution), and $50,000 of taxdeferred earnings (taxable on a withdrawal or conversion). So for the whole account, $300,000 ($250,000 of deductible contributions and $50,000 of tax-deferred earnings) of the $400,000, or 75% (300,000/$400,000 = 0.75), is subject to income tax. Therefore, on the proposed $25,000 conversion this year, $18,750 (75%) is taxable and $6,250 (25%) is not taxable.
Considering a Roth Conversion?
There are several ideas to explore if you’re considering a Roth conversion:
- Rather than convert an entire account balance of a traditional IRA in one tax year, consider incremental annual conversions over a term of years. The annual amount would be calculated so that when it is added to other taxable income, it would not cause taxable income to manifest into the next highest tax bracket (or higher) for that tax year. Under current law, this tactic could potentially save income tax in an amount ranging from 2% to 10% of taxable income. Further, incremental conversions that keep the taxpayer’s modified AGI below $200,000 for single filers or $250,000 for those married filing jointly could potentially help avoid the 3.8% net investment income tax, sometimes referred to as the Medicare surtax.
- If you are charitably inclined, consider making an income tax deductible contribution to a favored charity or to a donor-advised fund for later distribution to one or more of your favored charities in the same tax year as you are making a Roth conversion. This could help reduce taxable income in that year and help mitigate, or possibly eliminate for some taxpayers, the income tax effect of the conversion.
- Frequently, it may be better to pay any income tax attributable to a Roth conversion from a taxable account rather than from the traditional IRA being converted itself to help optimize the impact of the Roth conversion.
Back-Door Roth Contribution Strategy
The so-called “back-door Roth contribution” strategy allows you to move funds into a Roth IRA even if you don’t qualify for a Roth contribution because of the income limits. You first make a nondeductible contribution to a traditional IRA, if you qualify to do so, and then immediately convert that contribution to a Roth IRA.
This conversion is potentially tax free if there are no other traditional IRAs with tax-deferred contributions and/or earnings. If you already have a traditional IRA that has pretax or deductible contributions, the Roth IRA back-door strategy may not work for you because of the IRA aggregation and pro-rata distribution rules outlined in Scenario 4 above.
Pitfalls of a Roth Conversion
There are at least four factors for taxpayers to consider before making a Roth conversion or a backdoor Roth contribution:
- “Re-characterizations” are no longer available. Prior to the Tax Cuts & Jobs Act of 2017, there was a way to have a “do-over” if you made a Roth conversion and later changed your mind. You could do a re-characterization, which in effect nullified the conversion into the Roth IRA. That ability to re-characterize a Roth conversion was last available through October 15, 2018, for conversions made in 2017. Since it is no longer an option, be certain you want to convert traditional IRA assets and pay the income tax that will be due.
- If taxes are due upon the conversion, they must be paid currently compared to potentially deferring the tax payments until after age 72 when RMDs begin. It’s true that taxes are inevitable, and some individuals prefer to wait to pay them until the last moment. However, we suggest you consider the potential benefit of taking advantage of a Roth IRA conversion “early,” with many years, perhaps decades, ahead to reap the long-term tax-deferral benefits. Income tax rates are as favorable as they have been, or may be, for some time.
- Be aware of the IRA aggregation and pro-rata distribution rules for when any of your IRAs contain pretax contributions, especially if considering the back-door Roth strategy. This rule is complicated, and you should consult your tax and financial advisor on the requirements. Additionally, discuss with your advisor the effect of plan rollovers to a traditional IRA in the same year as the Roth conversion since the IRS looks at all of your non-Roth IRAs at year-end to determine the pretax value of your IRAs.
- Access to back-door Roth contribution assets is more restrictive than for access to Roth IRA assets that were directly contributed to the account. Roth IRA contributions are accessible immediately, tax- and penalty-free. This could make a significant difference for those under age 59½, who must wait five years for penalty-free access to funds converted from a traditional IRA.
Planning tip: The back-door Roth IRA benefit can be doubled for married couples filing a joint return by having the nonworking spouse also do this. Spouses with little or no income may qualify even though they don’t meet the earned income requirement, provided they file a joint tax return and the working spouse has sufficient earned income to cover the contributions for the nonworking spouse.
A Challenging Decision
Deciding which type of IRA is appropriate for you and your family can be challenging. There are many benefits to consider and pitfalls to avoid when determining if your circumstances and financial needs are best suited to a Roth IRA or traditional IRA. You should consult your tax and financial advisors to help confirm if you are making the right decision for your, and for your family’s, retirement and financial goals.
For more information, please contact your PNC advisor.