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The Beauty in Roth Accounts

Written by GRANT MADDOX.

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The most common type of retirement accounts are traditional Individual Retirement Accounts (IRAs) and company sponsored traditional 401(k) plans, both of which are funded using pre-taxed dollars. The goal of these accounts is to accumulate retirement assets by deferring current year taxes and reducing your taxable income. Later, when funds are withdrawn, either voluntary or as part of a required minimum distribution upon reaching age 70.5, the accumulated earnings and contributions are subject to ordinary income tax. In addition to this, if you are below age 59.5 and you withdraw funds you could be subject to an additional 10% tax penalty.

“Cue the Roth IRA.” One alternative to popular IRAs and traditional 401(k) plans is the Roth IRA and Roth 401(k) (“Roths”). Contributions to both consist of after-tax funds. The accumulated earnings and contributions are not subject to income tax upon withdrawal. In addition to this, there are no required minimum distributions for Roths until the account has reached a non-spouse beneficiary. Although no current tax break is received, there are several arguments as to why Roth accounts can be a significant attribute to your portfolio and to your estate planning. As we will discuss below, the Roth has the ability to grow income tax-free for future generations.

 Contributions:

Funding a Roth account can occur in one of two ways; either through yearly contributions, currently limited to $6,000 per year if below age 50 and $7,000 if above age 50 for 2019 Roth IRA accounts. In addition to this, contributions may be limited for Roth IRAs if your income is between $193,000 and $203,000, for married filing jointly, and you are ineligible to contribute if your income is higher than the latter figure. Roth 401(k) contributions limitations are currently set at $19,000 per year per employee, with an available catch-up contribution of up to an additional $6,000 if age 50 or older. Contributions to Roths are typically more beneficial for young people because these funds will likely grow tax-free for a longer period of time and they generally have a lower current income tax bracket.

Conversions:

The IRS allows you to convert traditional IRAs to Roth IRAs without limitation. You simply have to include the converted amount as ordinary income and pay the tax. Converting traditional IRA funds to Roth is certainly not for everyone. Generally speaking, conversions may only be considered beneficial if you are currently in a lower tax bracket now, than when the funds will be distributed in the future. If you are in the highest tax bracket, it may not make sense to execute a Roth conversion. If you do not have available taxable funds, non-IRA funds, to pay applicable taxes, then a conversion may not be the best strategy for you. Lastly, conversion strategies are not usually recommended if you will have a need for your traditional IRA or Roth funds during the course of your lifetime(s).

Example:

In the right circumstances, a Roth conversion strategy may hold great potential to transfer large sums of after-tax wealth to future generations of your family. For example, let's assume a conversion of an $800,000 traditional IRA. Of course, this would typically be done over the course of several years to limit the amount of taxes paid on the conversion. However, following the completion of the conversion, these funds will continue to grow tax-free over the course of the converters’ lifetime (and spouse's lifetime). Assuming a 30 year lifespan, at an average rate of 5% per year, this would amount to close to $3,500,000 at the end of 30 years; a $2.7 million tax-free gain. For the purpose of this example, let's also assume these Roth funds skip over the converters’ children to a future generation of four potential grandchildren. Split evenly, each grandchild would hypothetically receive $875,000. At this point, the grandchildren generally would be required to take a small required distribution, however, the bulk of these Roth funds would grow-tax free until the grandchild reaches 85 years of age.  Assuming they receive these Roth funds at age 30, it's possible each grandchild could receive $5,600,000 of tax-free growth, assuming a 6% average yearly returns. For this example, the estimated federal tax cost of converting $800,000 in IRA funds may be close to $180,000, assuming conversions remain within the 24% tax bracket year-over-year. An estimated state tax cost may vary by state, however, some states such as IL, TN and FL do not tax IRA conversions. Now, if we multiply the $5.6 million times 4 (for each hypothetical grandchild) and add the $2.7 million of appreciation during the first 30 years, this is a total of $25.1 million of potential tax-free growth over 85 years. This obviously has the potential to be a truly amazing strategy. Note that because of the rules that enable people to stretch out distributions of an inherited Roth, the people who benefit the most are young.

To review if Roth strategies may be a good addition to your overall planning, please contact DWM and allow us to assist you in this process.

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