by: Josh Stelzer, CFP®
As Roth accounts and Roth conversions continue to grow in popularity, there are several misconceptions in regard to the rules surrounding these qualified accounts. Today we will take a look at 3 of the most common statements we hear, and provide and explanation as to why these are not necessarily true.
I can’t access my Roth IRA funds without a penalty until age 59 ½
This may be the most misunderstood characteristic of Roth IRA’s. Most clients are aware of the rule associated with deductible Traditional IRA contributions, which says you cannot touch your funds until 59 ½ without incurring a 10% penalty, in addition to income taxes on the distribution amount. This restriction causes many younger clients to hesitate “locking up” their funds in an IRA, due to the long time horizon to retirement ahead of them.
While the rules on early distributions outlined above are very true with the Traditional IRA, Roth IRA’s are treated a bit differently. The Roth IRA allows you to withdraw any amount up to your total contributions, tax and penalty free at anytime. How is this possible?
Publication 590 of the Internal Revenue Code clearly states that all distributions are accounted for on a first-in-first-out basis (FIFO). Since the funds contributed to the Roth IRA have already been taxed, there is no additional tax or penalty owed on distributions up to your total contribution amount.
It is very important to realize that this withdrawal is up to your total contribution only. Any non-qualified distribution of earnings or interest will cause those earnings to be taxed as ordinary income, in addition to a 10% penalty.
If the rules are followed properly, this Roth IRA “loophole” can provide flexibility for younger investors who would like to take advantage of tax-deferred earnings, while still maintaining access to their principal amount in the case of an emergency.
PLEASE NOTE: Any distributions of funds that were previously converted from a Traditional IRA or 401(k) have additional rules that must be followed. Please consult with a Certified Financial Planner™ when considering this type of withdrawal prior to age 59 ½.
My income level is too high to contribute to a Roth IRA
While this may be true if your taxable income level for the year exceeds the Roth limits ($188k for married filing jointly, or $127k for single filers), there are still ways around this rule.
If you fall within this income level restriction, and you or your spouse participates in a company sponsored qualified plan such as a 401(k), you are likely ineligible to deduct your Traditional IRA contributions due to the phase-out rules.
For example, if you file as “single” for tax purposes, are an active participant in your company’s 401(k), and make any amount over $69,000 per year, you will not receive a deduction for your Traditional IRA contributions. The inability to receive a deduction makes the Roth IRA a much better choice in this scenario.
What happens if we raise that income to $127,000? You now are ineligible to contribute to a Roth IRA, and you will not receive a deduction for your Traditional IRA contributions. So what should you do?
This is the perfect scenario for an innovative Roth IRA conversion strategy. The concept is to make a non-deductible Traditional IRA contribution (must file IRS Form 8606), and then immediately convert the contribution amount to a Roth IRA account. Yes, you are ineligible to make a Roth contribution, but with the added step of a conversion you are essentially doing the same thing.
As you may have guessed, it’s often not this simple. If you have an existing Traditional IRA account prior to implementing this strategy, it is extremely important to consult with a Certified Financial Planner™ prior to making the conversion. Any existing funds which you’ve received prior deductions for can result in a hefty tax liability if not planned for appropriately.
My Roth IRA is not subject to Required Minimum Distributions
In a Traditional IRA you are forced to begin withdrawing the funds in the year that you turn 70 ½. These “forced withdrawals” are known as Required Minimum Distributions (RMD’s) and are calculated based on your life expectancy. These RMD amounts increase each year and are taxed as ordinary income to the account holder, often times pushing them into a higher tax bracket.
This has been one of the major selling points for contributing to a Roth IRA. Roth IRA original account holders are not required to take RMD’s, thus allowing for continued tax-deferred growth. Over time this compounding growth can add up to a major tax savings. So why is the above statement incorrect?
While original account holders are not subject to RMD’s, any non-spouse beneficiaries of these accounts will be. In most cases, the beneficiary must begin taking RMD’s in the year following the original account holder’s death, or they will be forced to withdraw the entire amount by the end of the fifth year following the death. If the account contains any converted funds, the beneficiary should consult with a Certified Financial Planner™ to see if a separate 5 year rule regarding distributions also applies.