Individual Retirement Accounts: Traditional, Roth and Conversions

Individual retirement accounts (IRAs) are a blessing, but which way should you lean when it comes to choosing a tradition IRA or Roth IRA?

Either/Or?

Oxford Dictionaries defines a Roth IRA as an individual retirement account allowing a person to set aside after-tax income up to a specified amount each year. Contributions and earnings on those contributions withdrawn from a Roth IRA after age 59½ are tax-free (provided certain conditions are met). On the other hand, contributions to traditional IRAs are tax deductible, but you pay income tax on both contributions and earnings when withdrawals from the account are made during retirement.

Testing the Limits

First, there is no income limit affecting contributions to a traditional IRA and you can deduct your contributions in full if you and your spouse don't have a 401(k) or some other retirement plan at work. If either of you is covered by a plan at work, however, the IRA deduction may be reduced or eliminated. Not so with Roth IRA contributions, which are definitely income limited. In 2020, for married couples, the limit beyond which Roth contributions are completely phased out is $206,000 and for singles $139,000. For married couples, contributions are gradually reduced for income levels between $196,000 and $206,000 with no restrictions for incomes below $196,000. For singles, the unrestricted lower limit is $124,000 with phase outs occurring up to $139,000.

The 2020 combined annual contribution limit for both Roth and traditional IRAs is $6,000 ($7,000 if you're age 50 or older). And only earned income can be contributed (primarily wages, salaries, tips, bonuses, commissions, and self-employment income). Income not considered “earned” includes investment dividends and interest, child support, alimony, rental income, social security, retirement income and unemployment benefits. Traditional IRA contributions are tax deductible. Contributions to a Roth are not.

By the way, if a spouse doesn’t have earned income and the partner does, he or she can open a spousal IRA. This important feature allows an individual with earned income to contribute on behalf of a nonworking spouse. It goes without saying that to be eligible, the couple must be married and file a joint tax return. This is a rare exception to the provision that an individual must have earned income to contribute to an IRA. The working spouse's [earned] income, however, must equal or exceed the total IRA contributions made on behalf of both spouses. The use of this strategy allows married couples to contribute $12,000 to IRAs per year – or $14,000 if they are age 50 or older.

The Roth Advantage

Because an individual has paid taxes on Roth contributions, he or she can withdraw those contributions at any time and for any reason, tax free – but not earnings on those contributions. However, withdrawals are not recommended (after all, these ARE tax-advantaged retirement vehicles). In addition, individuals won’t have to take Required Minimum Distributions (RMDs) from their Roth account beginning at age 72. Annual RMDs from traditional IRAs – whether needed or not – are a must.

Why Convert?

Food for thought: A conversion from a traditional IRA to a Roth IRA necessarily involves predicting the future. If you think your personal tax rate will be higher in retirement than right now, making after-tax contributions to a Roth account or a conversion of traditional IRA assets to a Roth are in order.

A “Back Door” Roth

Some folks are eligible for direct Roth contributions and others are not (due to income restrictions mentioned earlier). In the first instance, if folks had previously contributed to a traditional IRA and later desire to convert those assets to a Roth, they simply pay federal taxes due on those assets and transfer them to a Roth account.

In the second instance, individuals whose income exceeds the Roth IRA limit can first make pre-tax contributions to a traditional IRA, and then after paying the tax due those contributions, move the money to a Roth account, thereby, sneaking through the back door. In short, this backdoor strategy opens the door to high income folks who normally would be ineligible to make contributions to a Roth IRA.

By the way, even though there are both dollar and income limits to making contributions directly to Roth IRAs, there are no income limits regarding conversions.

5-Year Rules

There are actually three 5-year rules affecting Roth IRAs. They apply if account earnings are withdrawn; if a traditional IRA is converted to a Roth; and if a beneficiary inherits a Roth IRA. Simplified explanations ignoring certain “exceptions” follow:

An individual can always withdraw contributions from a Roth IRA with no penalty at any age. At age 59½, withdrawals of both contributions and earnings can be made with no penalty, provided the Roth IRA has been open for at least 5 tax years.
The second 5-year rule come into play regarding the conversion of a traditional IRA to a Roth. It determines whether the distribution of principal after the conversion is penalty-free (an individual is supposed to pay taxes when converting from the traditional account to the Roth).
A beneficiary who inherits a Roth IRA can take a principal and/or an earnings distribution without incurring a penalty. However, if a beneficiary takes a distribution from a Roth that wasn't held for 5 tax years, the earnings will be subject to tax.

Caveat Emptor

Always the caveats. I’d be derelict if I didn’t mention a few. An individual triggers a Roth conversion simply by paying taxes on the value of the assets transferred, which can be substantial. And if tax rates prove to be lower in the future than now, there’s no resultant benefit. After opening the Roth account, an individual must wait 5 years to take tax-free withdrawals on account earnings… even if they are already 59½. Always a catch when dealing with Uncle Grabby. And figuring taxes can be complex if the individual has other traditional, SEP or SIMPLE IRAs that aren’t converted.

Speaking of Uncle Grabby, individuals making conversions can’t wait until they file their taxes to pay the conversion tax bill. It must be included as part of estimated quarterly taxes due. A “nagging” word of caution in this regard… avoid paying conversion taxes with money from the retirement investment being converted. Paying taxes with IRA funds instead of from a separate account will erode future earning power. It’s never wise to mess around with the Amazing Power of Compounding.