Part of Oak Street Advisors’ 10 Financial Commandments for Millennials series, we discuss the advantages a Roth IRA presents for young investors. From tax-free compound growth to backdoor Roth IRA contributions— we explain why young investors need to use Roth IRAs regardless of their income level.
The 7th Financial Commandments for Millennials is to max our Roth IRA contributions. Roth IRA accounts have been available since 1997. Unlike a Traditional IRA, Roth IRA contributions are taxed in the year of the contribution but never taxed again if certain requirements are met.
The magic of compounding means, the earlier you start, the greater the tax-free growth within the account. If you are 20 when you start making contributions, you could be looking at four doubles of your original contribution by the time you retire at age 60. That means a $6,000 contribution this year could grow to $96,000, creating $90,000 of tax-free income for your retirement years.
With today’s historically low income-tax rates, it would be prudent to put as much money as one can into a Roth IRA. Always consult your CPA before making this decision, but one could argue the tax-free growth and withdrawals outweigh the hurt of paying today’s top tax rates.
The 5 Year Rule
Another reason to open a Roth IRA is the flexibility it can provide to fund emergencies that may arise over your life.
You can always withdraw any Roth IRA contributions without taxes, after all, you paid income tax on the money prior to making the contribution. However, if you haven’t had the Roth IRA open for at least five years, your distribution could still be subject to a 10% tax penalty, similar to the early withdrawal penalty for Traditional IRAs.
The five years for withdrawals begins when you open the account, not when you make subsequent contributions. There is also a five-year rule for Roth IRA conversions that start in January of the year you make a conversion; this prevents someone from using a Roth IRA conversion to avoid early distribution penalties from early Traditional IRA withdrawals.
Who Qualifies for a Roth IRA
If you have a modified adjusted gross income of less than $122,000 if single, or less than $193,000 if married filing jointly, you can make Roth IRA contributions of 100% of your income up to $6,000 if younger than age 50 or $7,000 if age 50 or older.
Back-Door Roth IRA Contributions
Without income limitations for converting assets in a Traditional IRA to a Roth IRA, many who are disqualified for income resort to the back-door method for funding a Roth IRA. This works because anyone may open and contribute to a non-deductible Traditional IRA, even if you are covered by a qualified retirement plan.
Once the funds are deposited into the non-deductible Traditional IRA, they can then be converted to a Roth IRA. This has the same net income-tax effect as contributing directly to a Roth IRA. The IRS recently loosened the back-door conversion rules and allow for immediate conversions, where in the past investors were recommended to wait a few months before converting to satisfy the IRS.
The Younger, The Better
Tax-free growth and tax-free distributions are very enticing, especially for young investors. The more time your account grows tax-free, the better. Another point to make is that the more of your nest egg you have in a Roth IRA, the less your Required Minimum Distributions (RMDs) will be during retirement. Which inherently leads to you and your financial advisor having more ability to control/minimize income taxes during retirement years.
You’ve inherited an IRA- so what happens next?
Before we start, we need to understand some key terms:
Required Minimum Distribution (RMD):
The dollar amount the IRS requires one to distribute from IRAs and defined contribution plans like 401(k)s and 403(b)s. This amount is distributed from your IRA and taxed as normal income unless that distribution comes from your basis or from a Roth IRA.
This dollar amount is determined by the IRS’ Single Life Expectancy Table. You can always distribute more than the Required Minimum Distribution, but never any less. Failure to distribute the required amounts results in a sever 50% penalty. If your RMD was $10,000 and you took nothing, the IRS would penalize you $5,000!
IRS’ Single Life Expectancy Table
The table is created by the IRS to calculate how much of your IRA balance needs to be distributed each year. The table can be seen here. There are rules that govern which life expectancy age an owner or beneficiary must use in this calculation, which we will discuss.
Starting The Process
When it’s time to start the transfer process, you’ll first setup a Beneficiary IRA to hold the inherited assets. This Beneficiary IRA cannot be co-mingled with any other IRA, retirement plan, brokerage account, etc. Remember, understanding the IRS will require you to distribute some of your inheritance and knowing how that distribution is calculated is crucial in determining how to structure your Beneficiary IRA.
With your Beneficiary IRA established the IRS gives you a few options on how you can distribute the assets:
Cash Out Everything
You can take the money- but don’t run. The lump sum distribution will be taxable income and may bump you into a higher tax bracket. When April rolls around you can expect a higher tax bill from the large distribution.
Distribute Everything in 5 Years
You can take withdrawals as you please, so long as the entire IRA balance has been distributed by December 31st of the 5th year after the original IRA owner’s death. Each distribution will be taxed as normal income, so again- tax planning is crucial.
Take RMDs Based on Your Life Expectancy
If the IRA owner has not started taking RMDs or your life expectancy is longer than the IRA owner’s, use your age in the year following the year the original IRA owner died (i.e. owner dies in 2018, you would use your age in 2019 to determine the RMDs for 2019). This is especially useful for heirs who are much younger than the original IRA owner, keeping more tax deferred income and growth in the Beneficiary IRA for a longer time.
Take RMDs Based on IRA Owner’s Life Expectancy
This only applies when your life expectancy is less than that of the IRA owner’s. You use the life expectancy table based on the deceased’s age rather than your own. All distributions are taxed as normal income.
Take RMDs Based on the Oldest Beneficiary’s Life Expectancy
Only applicable with more than one beneficiary and only if no separate Beneficiary IRA accounts are setup for said beneficiaries by December 31st of the year following the IRA owner’s death. Using the oldest beneficiary’s RMD schedule for all other beneficiaries. This could be a major negative for a younger heir. Again, all distributions are taxed as normal income.
What’s Best for You?
The best thing any IRA beneficiary can do is talk with a fee-only financial adviser who will look at their entire financial picture to determine a customized strategy. Often there are further financial and tax-related issues that should be addressed when considering how to move forward with an Inherited IRA so attention to detail is of the upmost importance.
If you’re not sure what to do with an inherited IRA give us call (843.901.7778 / 843.946-9868) or shoot us an e-mail and we’ll reach out to help you navigate your Beneficiary IRA strategy.
If you're age 70 ½ or older you probably know you must begin taking distributions from your IRA -whether you want to or not. The IRS life expectancy tables determine your required minimum distribution (RMD) based on the previous years ending balance for your IRA and your attained age for the tax year.
The qualified charitable distribution rules provide those subject to RMDs an option that can help them reduce their income tax liability by having certain charitable contributions made directly to a qualified charity. Given the changes to itemized deductions and the standard deduction in the 2017 tax law update, the qualified charitable distribution rules for your IRA account becomes even more important.
If you make charitable contributions throughout the year, it would be wise to consider making those contributions directly from your IRA. Up to $100,000 of charitable distributions from each IRA owner's accounts can be excluded from your taxable income each year.
Say you plan to give $10,000 to your church or another qualified charity and you are receiving taxable distributions from your IRA. If you make the contribution to the charity directly from your IRA, your $10.000 gift will not be reported as income on your income tax return.
If you instead receive these funds as income from your IRA distribution and then send the same $10,000 to the charity it is included in your taxable income and could result in higher Medicare premiums and a higher percentage of your social security income being taxable. If you do not have itemized deductions that exceed the new $24,000 per couple or $12,000 per individual standard deduction, you could lose all the tax benefits of your generosity.
By having the distributions sent directly to the qualified charity from your IRA, you will exclude the amount from your taxable income, potentially lowering your Medicare premiums, the taxable portion of your social security benefits, and your overall income tax rate at both the federal and state level.
If you follow this strategy, be sure to let your income tax preparer know. There is no indicator on the 1099R you receive at the end of the year that shows that part of your distribution is non-taxable, so there is a chance many people using this strategy are over-paying their income taxes each year.
With the end of the year approaching now is the time to look for opportunities to save on income taxes. Here are some items you should look for.
Assets can transfer to your heirs in one of two ways when you die. They can transfer by will, which includes probate court and public filing of related documents, or they can transfer by contract.
The advantages of having your assets transfer by contract include:
Examples of assets that transfer by contract include accounts or assets titled Joint Tenants with Right of Survivorship, Transfer on Death and Pay on Death accounts, Life Insurance and Annuity contracts, Trusts, and your IRA and 401k accounts if you complete the beneficiary forms correctly.
When you first establish an IRA or 401k, an annuity or life insurance contract, you are provided a form to name beneficiaries. If you fail to complete these forms the assets will usually pass back into your estate and become part of the probate process. By naming a beneficiary or beneficiaries you can let these assets transfer by contract. You should also name contingent beneficiaries and choose whether you want the assets to transfer per stirpes or per capita. By filling out these beneficiary forms you are insuring that your wishes are honored after your death.
Many people name only a spouse as a beneficiary. If the couple have children or grand children they wish to provide for they should consider making them contingent beneficiaries to preserve the tax benefits of an IRA (however if the children or grandchildren are minors be sure a guardian has been named or the funds will be encumbered until the courts name a guardian).
Currently only surviving spouses can transfer assets from their deceased spouse's 401k to their own IRA, but the recently enacted Pension Protection Act of 2006 will extend that privilege to any beneficiary after 2007.
The bottom line is beneficiary forms are an integral and important part of your estate plan. Choosing the right way to transfer these assets can save time and money, but can also be confusing. If you are unsure how to proceed choose a professional to help you, but don't delay.