Which Is Better a Traditional IRA or a Roth?

FedWeek’s recent article entitled “Does a Roth IRA, or Roth Conversion Make Sense for You?” explains that with a traditional IRA, if your income is below certain levels, you make pre-tax contributions to your IRA (that you may be able to deduct) and pay your taxes when you withdraw that money after retirement, when you may be in a lower tax bracket. You’re paying those taxes on both your contributions and the earnings on those contributions. In contrast, with a Roth IRA, you contribute already taxed money to the IRA and, if your withdrawals are qualified, you pay no taxes at the time of withdrawal.

If you started your retirement savings before the introduction of the Roth or if you have had incomes too high to allow you to contribute to a Roth, you may want to move more of your retirement savings from traditional IRAs (where you pay taxes at withdrawal) to Roth IRAs (where you pay taxes up front, but benefit from tax free growth).

A Roth IRA conversion allows you to move monies from your traditional IRA into a new or existing Roth IRA. There are no income limits or limits on the amount that can be converted, but you must pay tax on all untaxed monies that you convert. Therefore, if you converted money from a traditional IRA where you were able to deduct your contributions, you’d pay tax on every dollar you converted. And if you converted money from a traditional IRA where you were not able to deduct your contributions, you’d pay tax on the amount of the conversion that was attributable to earnings. These taxes would be at your rate for ordinary income. Think about these items, before you decide to convert money from a traditional IRA to a Roth IRA:

When will you need the money? If you have an immediate need for the funds or need them to support your current standard of living, then a Roth conversion is probably not a good idea. But if you have no immediate need for the funds, a Roth conversion can be a terrific way for your money to grow tax-free over your lifetime.

Where will the money come from to pay the tax? Typically, the money to pay the tax on the Roth conversion should come from outside funds and not from a retirement account, if the conversion is to make sense. When a conversion is made, it almost always triggers a taxable event. As a result, your ability to pay that tax with outside money will go a long way in determining if a Roth conversion is right for you.

What do you think future tax rates will be? If you think that your income tax rate will be the same or higher in retirement, then converting funds to a Roth is wise. That’s because you’ll be paying your taxes at a lower rate. But if you believe your income tax rate will be lower in retirement, conversion may not be right for you.

Reference: FedWeek (March 30, 2021) “Does a Roth IRA, or Roth Conversion Make Sense for You?”

Are Roth IRAs Smart for Estate Planning?

Think Advisor’s recent article entitled “Secure Act 2.0, Biden Tax Hike Plans Make Roth IRAs a Crucial Tool” says that Roth IRAs offer an great planning tool, and that the Secure Act 2.0 retirement bill (which is expected to pass) will create an even wider window for Roth IRA planning.

With President Biden’s proposed tax increases, it is wise to leverage Roth conversions and other strategies while tax rates are historically low—and the original Secure Act of 2019 made Roth IRAs particularly valuable for estate planning.

Roth Conversions and Low Tax Rates. Though tax rates for some individuals may increase under the Biden tax proposals, rates for 2021 are currently at historically low levels under the Tax Cuts and Jobs Act passed at the end of 2017. This makes Roth IRA conversions attractive. You will pay less in taxes on the conversion of the same amount than you would have prior to the 2017 tax overhaul. It can be smart to make a conversion in an amount that will let you “fill up” your current federal tax bracket.

Reduce Future RMDs. The money in a Roth IRA is not subject to RMDs. Money contributed to a Roth IRA directly and money contributed to a Roth 401(k) and later rolled over to a Roth IRA can be allowed to grow beyond age 72 (when RMDs are currently required to start). For those who do not need the money and who prefer not to pay the taxes on RMDs, Roth IRAs have this flexibility. No RMD requirement also lets the Roth account to continue to grow tax-free, so this money can be passed on to a spouse or other beneficiaries at your death.

The Securing a Strong Retirement Act, known as the Secure Act 2.0, would gradually raise the age for RMDs to start to 75 by 2032. The first step would be effective January 1, 2022, moving the starting age to 73. If passed, this provision would provide extra time for Roth conversions and Roth contributions to help retirees permanently avoid RMDs.

Tax Diversification. Roth IRAs provide tax diversification. For those with a significant amount of their retirement assets in traditional IRA and 401(k) accounts, this can be an important planning tool as you approach retirement. The ability to withdraw funds on a tax-free basis from your Roth IRA can help provide tax planning options in the face of an uncertain future regarding tax rates.

Estate Planning and the Secure Act. Roth IRAs have long been a super estate planning vehicle because there is no RMD requirement. This lets the Roth assets continue to grow tax-free for the account holder’s beneficiaries. Moreover, this tax-free status has taken on another dimension with the inherited IRA rules under the Setting Every Community Up for Retirement Enhancement (Secure) Act. The legislation eliminates the stretch IRA for inherited IRAs for most non-spousal beneficiaries. As a result, these beneficiaries have to withdraw the entire amount in an inherited IRA within 10 years of inheriting the account. Inherited Roth IRAs are also subject to the 10-year rule, but the withdrawals can be made tax-free by account beneficiaries, if the original account owner had met the 5-year rule prior to his or her death. This makes a Roth IRA an ideal estate planning tool in situations where your beneficiaries are non-spouses who do not qualify as eligible designated beneficiaries.

Reference: Think Advisor (May 11, 2021) “Secure Act 2.0, Biden Tax Hike Plans Make Roth IRAs a Crucial Tool”

Should I Name a Living Trust Beneficiary of a Roth IRA?

The simple answer is yes, a living trust can be the beneficiary of a Roth IRA. However, without knowing more about an individual’s specific circumstances, it’s hard to know if this is a wise move.

A November 2018 article from NJ Money Help entitled, “Be careful when choosing a beneficiary,” explains that there are several things you need to know when considering a living trust as the beneficiary of a Roth IRA.

By designating a living trust as your beneficiary, the distributions from the Roth at your death will become mandatory based on the life expectancy of the oldest beneficiary named in the trust.

This is an important point if you’re currently married. That’s because you’ll forfeit the ability for a spousal rollover, by naming the trust as your beneficiary.

Current law permits IRAs to be passed to a spouse as a beneficiary, and the spousal beneficiary can treat the account as if it was their own IRA.

In the case of a Roth IRA, this means the surviving spouse can continue to defer distributions tax-free for their lifetime.

By naming the living trust as beneficiary, this benefit is lost no matter if your spouse is one of the living trust beneficiaries.

Why?

Distributions are required to begin immediately, if the beneficiary is anyone other than a spouse.

Thus, you would forgo the ability to allow the funds to continue to grow tax-free for a longer period of time.

You should talk about this with an experienced estate planning attorney. He or she will be able to look at your entire financial situation before you determine if this is a wise move for you.

Reference: NJ Money Help (Nov. 2018) “Be careful when choosing a beneficiary”

Roth IRA has a 5-Year Rule

Roth IRAs are popular for their flexibility and the simplicity of putting after-tax dollars in and not paying taxes on withdrawals during retirement. However, making the most of a Roth IRA requires paying attention to the details, according to a recent article “What is the Roth IRA 5-Year Rule?” from U.S. News & World Report.

More specifically, there are certain five-year rules that can undo all the good that comes from using a Roth, if you don’t know them. Avoid paying penalties or fees, by understanding how the Roth IRA rules work.

The Roth IRA five-year rule applies to investment earnings, and not to initial contributions. If you make withdrawals of investment earnings before the five-year time period, you’ll get hit with taxes and penalties, no matter how old you are. Many people think that once they turn 65 or 70, they can tap their Roth IRA whenever they want, but that’s not true.

Once you’ve opened and funded a Roth IRA, you’ll have to wait five years until you can start taking tax-free withdrawals of your investment earnings. The clock starts ticking on the date you open the account and make your very first contribution.

After five years, there are still certain requirements that must be met to take out earnings without a penalty. Before you can take out tax-free withdrawals, you will need to be at least 59½ or older.

That’s even if your first contribution was made the year you celebrated your 58th birthday. You’ll need to wait until age 63 before you may take qualified distributions from the account. The five-year rule applies, even if you opened the Roth IRA at age 70.

How is this time frame calculated? The IRS does it based on tax years. A tax year runs from January 1 to December 31. The deadline for contributions is the same as the deadline for filing taxes. Let’s say you funded a Roth IRA in April 2021 for the calendar year of 2020. The five-year rule begins on January 1, 2020. Apply the five-year rule, and you could begin taking withdrawals from the account on or after January 1, 2025.

What happens if you need to make withdrawals before the account hits that five-year mark? In that case, withdraw contributions to the account and not investment earnings.

If you’ve contributed money to a Roth IRA account, you can take that money out with no tax or penalty, no matter how old you are. However, make sure you meet all of the requirements. Remember that to avoid any taxes or penalties, you’ll need to leave the earnings in the account.

Reference: U.S. News & World Report (March 10, 2021) “What is the Roth IRA 5-Year Rule?”

How Do I Talk to the Children about My Estate Planning?
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How Do I Talk to the Children about My Estate Planning?

Some $68 trillion will move between generations in the next two decades, reports U.S. News & World Report in the article “Discuss Your Estate Plan With Your Children.” Having this conversation with your adult children, especially if they are members of Generation X, could have a profound impact on the quality of your relationship and your legacy.

Staying on top of your estate plan and having candid discussions with your children will also have an impact on how much of your estate is consumed by estate taxes. The historically high federal exemptions are not going to last forever—even without any federal legislation, they sunset in 2025, which isn’t far away.

One of the purposes of your estate plan is to transfer money as you wish. What most people do is talk with an estate planning attorney to create an estate plan. They create trusts, naming their child as the trustee, or simple wills naming their child as the executor. Then, the parents drop the ball.

Talk with your children about the role of trustee and/or executor. Help them understand the responsibilities that these roles require and ask if they will be comfortable handling the decision making, as well as the money. Include the Power of Attorney role in your discussion.

What most parents refuse to discuss with their children is money, plain and simple. Children will be better equipped, if they know what financial institutions hold your accounts and are introduced to your estate planning attorney, CPA and financial advisor.

You might at some point forget about some investments, or the location of some accounts as you age. If your children have a working understanding of your finances, estate plan and your wishes, they will be able to get going and you will have spared them an estate scavenger hunt.

If possible, hold a family meeting with your advisors, so everyone is comfortable and up to speed.

Most adult children do not have the same experience with taxes as parents who have acquired wealth over their lifetimes. They may not understand the concepts of qualified and non-qualified accounts, step-up in cost basis, life insurance proceeds, or a probate asset versus a non-probate asset. It is critical that they understand how taxes impact estates and investments. By explaining things like tax-free distributions from a Roth IRA, for instance, you will increase the likelihood that your life savings aren’t battered by taxes.

Even if your adult children work in finance, do not assume they understand your investments, your tax-planning, or your estate. Even the smartest people make expensive mistakes, when handling family estates.

Having these discussions is another way to show your children that you care enough to set your own ego aside and are thinking about their future. It’s a way to connect not just about your money or your taxes, but about their futures. Knowing that you purchased a life insurance policy specifically to provide them with money for a home purchase, or to fund a grandchild’s college education, sends a clear message. Don’t miss the opportunity to share that with them, while you are living.

Reference: U.S. News & World Report (Feb. 17, 2021) “Discuss Your Estate Plan With Your Children”

What Do I Need to Know about Roth IRA Conversions?

People with large tax-deferred accounts they intend to leave to their children can eliminate a tax burden on their heirs, by converting the tax-deferred money over time. By doing the conversion this way, says a recent article from The Wall Street Journal entitled “Roth IRA Conversions: What You Need to Know,” the cost is manageable and the heirs won’t have to pay taxes.

For a Roth conversion, the owner pays income tax on every dollar converted, which makes sense for people who retire early and want to avoid higher taxes in the future, or when children inherit the assets.

Recent changes require account owners to start taking required minimum distributions at age 72. The withdrawals can be costly in two ways: pushing household income into a higher tax bracket and forcing Medicare premiums higher.

Withdrawals from a Roth IRA, on the other hand, are not taxed and have no required distributions. It is tax-free money, since taxes are already paid. It can be a cash fund as needed, or a tax-free legacy to heirs.

The interest in Roth conversion increased since Congress tightened rules for inheriting tax-deferred assets. In the past, heirs had a lifetime to take withdrawals from inherited IRA accounts. Now, only surviving spouses and a small group of other individuals have this option. For everyone else, there’s a ten-year window to empty the account, which means increased income tax bills, especially for heirs who are already in high tax brackets.

Those who do the conversion over an extended period of time eliminate a tax timebomb for heirs and funds can be invested more aggressively to maximize growth.

In the simplest type of conversion, the owner notifies the custodian of the account of their wish to move assets from the tax deferred account to the Roth account. They need to specify how much they want to move, what funds they want to move and what date they want the transaction to happen. When taxes are filed the next year, all of the money transferred is treated as ordinary income.

Doing this during a market decline is a smart move. One investor moved $200,000 of stock mutual funds during the market downturn, which cost him about $85,000 in federal and state taxes. The converted funds have since bounced back to around $320,000, above where they were before the market decline. Those gains in a tax-deferred account would have been taxable, but now, they are tax free.

Seniors who have low taxable income, but large tax-deferred accounts, might consider doing a conversion every year before reaching age 72, when they must begin taking required minimum distributions.

Reference: The Wall Street Journal (Nov. 19, 2020), “Roth IRA Conversions: What You Need to Know,”

Why Is a Roth IRA a Perfect Supplement to Social Security?

The average monthly Social Security is a little more than $1,500. It wasn’t designed to sustain seniors without other income.

Tucson.com’s recent article entitled “3 Reasons a Roth IRA Is a Perfect Supplement to Social Security” reminds us that it’s important to line up some additional income streams outside of those benefits. A good one to look into is a Roth IRA, and here’s why.

  1. You’re able to fund a Roth IRA at any age. Many seniors choose to work in retirement, either to make some more money or to give themselves something to do with their free time. If you go this route, you’ll have the option to put those earnings into a Roth IRA. You can contribute to a Roth IRA at any age. Therefore, if you decide to work more for the purpose of alleviating boredom and don’t need your full paychecks to live on, you can save that money and allow it to enjoy tax-free growth.
  2. Withdrawals won’t trigger taxes on your Social Security benefits. If Social Security is your only source of retirement income, you’ll probably collect your benefits in full without being subject to federal taxes. However, if your earnings exceed a certain threshold, there are taxes on Social Security income. To determine whether you’ll have taxes on your Social Security benefits, you’ll need to calculate your provisional income (your non-Social Security income plus half of your yearly benefit). You could be taxed on up to 50% of your benefits if you earn between $25,000 and $34,000 as a single tax filer, or between $32,000 and $44,000 as a married couple filing a joint return. iI your provisional income goes beyond $34,000 as a single tax filer or $44,000 as a joint filer, you could be taxed on up to 85% of your benefits. Any Roth IRA withdrawals from that account won’t count toward your provisional income. That might also leave you with more money from Social Security.
  3. Flexibility. The Roth IRA is the one tax-advantaged retirement savings account that doesn’t have required minimum distributions, or RMDs. That allows you considerable flexibility with your money. You can let your account sit there, while your money enjoys tax-free growth. You can also leave some money to your heirs, if that’s something you can afford to do.

Plan on having access to some retirement income outside of Social Security. While that income doesn’t have to come from a Roth IRA, it pays to open one and contribute steadily during your career. A Roth IRA won’t give you an immediate tax break, but your contributions will be made with after-tax dollars. Therefore, the benefits you stand to gain in retirement more than make up for that.

Reference: Tucson.com (Oct. 5, 2020) “3 Reasons a Roth IRA Is a Perfect Supplement to Social Security”

How to Benefit from a Roth IRA and Social Security

When originally created, Social Security was designed to prevent the elderly and infirm from sinking into dire poverty. When most working Americans enjoyed a pension from their employer, Social Security was an additional source of income and made for a comfortable retirement. However, with an average monthly benefit just over $1,500 and few pensions, today’s Social Security is not enough money for most Americans to maintain a middle-class standard of living, says the article “3 Reasons a Roth IRA Is a Perfect Supplement to Social Security” from Tuscon.com. It’s important to plan for additional income streams and one to consider is the Roth IRA.

Roth IRAs can be funded at any age. Many seniors today are continuing to work to generate income or to continue a fulfilling life. Their earnings can be put into a Roth IRA, regardless of age. If you are still working but don’t need the paycheck, that’s a perfect way to fund the Roth IRA.

Withdrawals from a Roth won’t trigger taxes on Social Security benefits. If your only income is Social Security, you probably won’t have to worry about federal taxes. However, if you are working while you are collecting benefits, once your earnings reach a certain level, those benefits will be taxed.

To calculate taxes on Social Security benefits, you’ll need to determine your provisional income, which is the non-Social Security income plus half of your early benefit. If you earn between $25,000 and $44,000 as a single tax filer or between $32,000 and $44,000 as a married couple, you could be taxed as much as 50% of your Social Security benefits. If your single income goes past $34,000 and married income goes past $44,000, you could be taxed on up to 85% of your benefits.

If you put money into a Roth IRA, withdrawals don’t count towards your provisional income. That could leave you with more money from Social Security.

A Roth IRA is flexible. The Roth IRA is the only tax-advantaged retirement savings plan that does not impose Required Minimum Distributions or RMDs. That’s because you’ve already paid taxes when funds went into the account. However, the flexibility is worth it. You can leave the money in the account for as long as you want, so savings continue to grow tax-free. You can also leave money to your heirs.

While you don’t have to put your savings into a Roth IRA, doing so throughout your career—or starting at any age—will give you benefits throughout retirement.

Reference: Tuscon.com (Oct. 5, 2020) “3 Reasons a Roth IRA Is a Perfect Supplement to Social Security”

Will Your Estate Plan Work Now?

The demise of the stretch IRA is causing many IRA owners and their advisors to take a look at how their estate plans will work under the new law. An article from Financial Advisor titled “Navigating The New Estate Planning Realities” offers several different planning alternatives.

Take larger IRA distributions during your lifetime. If possible, take the IRA distributions and reinvest them in a Roth IRA or other assets that will receive a stepped-up income tax basis on the death of the account owner. The idea is to take out significant additional penalty-free amounts from IRAs during your lifetime, so you will hopefully be taxed at a lower rate than you would be otherwise, with the net after-tax funds then reinvested in either a Roth IRA or other assets that will receive a stepped-up income tax basis when you die.

Paying all or part of the IRA portion of the estate to lower-income tax bracket beneficiaries. The theory here is that if we have to learn to live with the new tax law, at least we can attempt to minimize the tax pain by doing estate planning with a focus on tax planning. If a person has four children, two in high-income tax brackets and two who are in lower tax brackets, leave the IRA portion of the assets to the children in the lower tax brackets and assets with a stepped-up basis to the higher earners.

Withdrawing additional funds early and using the after-tax amount to purchase income-tax-free life or long-term care insurance. Rather than withdrawing all of the IRA funds early, freeze the current value of the IRA, by withdrawing only the account growth or the RMD portion, whichever is greater. Note that this won’t work if the withdrawals push the person’s income into the next higher tax bracket. All or a portion of the after-tax withdrawals then go into an income-tax-free life insurance policy, including second-to-die life insurance that pays only upon the death of both spouses.

Paying IRA benefits to an income tax-exempt charitable remainder trust. This involves designating an income-tax exempt charitable remainder trust as the beneficiary of the IRA proceeds. Let’s say a $100,000 IRA is made payable to a charitable remainder unitrust that pays three adult children or their survivors 7.5% of the value of the trust corpus (determined annually) each year, until the last child dies. Assume this occurs over the course of 30 years, and that the trust grows at the same 7.5% rate for the next twenty years. The children would net nearly $400,000. Note that the principal of the trust may not be accessed, until it’s paid out to the children, according to the designated schedule.

Every situation is different, so it is important to sit down with your estate planning attorney and review your entire estate, tax liabilities under the new law and how different scenarios will work to both minimize taxes during your lifetime and for your heirs. It’s possible that your situation benefits from a combination of all four strategies.

Reference: Financial Advisor (Feb. 11, 2020) “Navigating The New Estate Planning Realities,”

Alternatives for Stretch IRA Strategies

The majority of many people’s wealth is in their IRAs, that is saved from a lifetime of work. Their goal is to leave their IRAs to their children, says a recent article from Think Advisor titled “Three Replacements for Stretch IRAs.” The ability to distribute IRA wealth over years, and even decades, was eliminated with the passage of the SECURE Act.

The purpose of the law was to add an estimated $428 million to the federal budget over the next 10 years. Of the $16.2 billion in revenue provisions, some $15.7 billion is accounted for by eliminating the stretch IRA.

Existing beneficiaries of stretch IRAs will not be affected by the change in the law. But going forward, most IRA heirs—with a few exceptions, including spousal heirs—will have to take their withdrawals within a ten year period of time.

The estate planning legal and financial community is currently scrutinizing the law and looking for strategies will protect these large accounts from taxes. Here are three estate planning approaches that are emerging as front runners.

Roth conversions. Traditional IRA owners who wished to leave their retirement assets to children may be passing on big tax burdens now that the stretch is gone, especially if beneficiaries themselves are high earners. An alternative is to convert regular IRAs to Roth IRAs and take the tax hit at the time of the conversion.

There is no guarantee that the Roth IRA will never be taxed, but tax rates right now are relatively low. If tax rates go up, it might make converting the Roth IRAs too expensive.

This needs to be balanced with state inheritance taxes. Converting to a Roth could reduce the size of the estate and thereby reduce tax exposure for the state as well.

Life insurance. This is being widely touted as the answer to the loss of the stretch, but like all other methods, it needs to be viewed as part of the entire estate plan. Using distributions from an IRA to pay for a life insurance policy is not a new strategy.

Charitable Remainder Trusts (CRT). The IRA could be used to fund a charitable remainder trust. This allows the benefactor to establish an income stream for heirs with part of the IRA assets, with the remainder going to a named charity. The trust can grow assets tax free. There are two different ways to do this: a charitable remainder annuity trust, which distributes a fixed annual annuity and does not allow continued contributions, or a charitable remainder unitrust, which distributes a fixed percentage of the initial assets and does allow continued contributions.

Speak with your estate planning lawyer about what options may work best in your unique situation.

Reference: Think Advisor (Jan. 24, 2020) “Three Replacements for Stretch IRAs”