Roth IRAs: Are they right for your client?

By Barbara Bryniarski

Whether a traditional IRA or a Roth IRA is best for a client can depend on several factors, such as the client's age, annual income, tax bracket, and expected future earnings.

In recent years, Roth IRAs have overtaken traditional IRAs in both the number of individuals who contribute to such retirement vehicles and the total amounts contributed. In 2018, the latest year for which IRS statistics are available, approximately 7.1 million individuals invested more than $24.2 billion in Roth IRAs compared with 4.4 million individuals who invested a little more than $18.6 billion in traditional IRAs.

While both types of IRAs are instrumental in helping clients prepare for retirement, Roth IRAs are a particularly sound investment for young people just entering the workforce who can afford to make retirement plan contributions. Because younger workers' starting salaries are generally much lower than they are later in life, their tax rates are also lower. This is advantageous for contributing to a Roth IRA. In fact, in 2018, the largest number of investors in Roth IRAs were those in the 25 to 39 age group. Approximately 2.5 million individuals in that group invested almost $7.6 billion in Roth IRAs compared with 903,000 in the same age group who invested approximately $3.2 billion in traditional IRAs.

Due to the tax-free compounding growth over an extended time period, small investments in a Roth IRA early in life can generate substantial tax-free retirement funds later in life. Assume, for example, that Gwen, 25, contributes $100 each month to a Roth IRA. At age 65, assuming a 5% return each year, she'll have a tax-free nest egg of $145,000. If the annual return turns out to be closer to 10%, the S&P 500's historical average, she'll end up with $531,000. Even teenagers with summer jobs can get in on the action by opening a Roth IRA account with the help of a parent or other custodial individual. This is a terrific way to introduce them to the concept of investing and saving for the future. And with the establishment of a custodial Roth IRA, parents and relatives can gift money to that IRA.

On the other hand, Roth IRAs may not be the best choice for individuals who are in a high-income tax bracket or are nearing retirement age because they will pay higher taxes on their contribution and have less time in which to generate substantial earnings. Thus, they would need to contribute larger after-tax amounts to make up for not investing earlier in order to build a substantial nest egg.

Contribution rules

There are limits to the amount that can be contributed to a Roth IRA, and in addition, not everyone is eligible to make the maximum contribution. The maximum Roth IRA contribution amount in 2022 is $6,000 ($7,000 for those age 50 or older). However, the taxpayer's contribution generally is limited to the lesser of his or her taxable compensation or the maximum contribution amount. In addition, the amount of the maximum contribution a taxpayer can make phases out after the taxpayer's modified adjusted gross income (MAGI) exceeds an MAGI threshold.

The MAGI thresholds for 2022 are $204,000 for a married couple filing jointly or a surviving spouse; $129,000 for single, head of household (HOH), or married filing separately (and not living with a spouse at any time during the year); and $10,000 for married filing separately and still living with a spouse. Individuals who are only making a contribution to a Roth IRA and who have taxable compensation income of at least the maximum contribution amount of $6,000 ($7,000 if 50 or older) and whose income is below their MAGI threshold can make the maximum contribution.

Under the Roth IRA phaseout rules, individuals with MAGIs of up to $214,000 for married filing jointly or surviving spouse, and up to $144,000 for single, HOH, or married filing separately and not living with a spouse may be eligible for a partial contribution.

Thus, as an individual ages, if his or her salary increases enough to exceed these income thresholds, contributing to a Roth IRA may no longer be an option. This makes contributing during the earlier years all the more valuable in terms of making use of the tax break.

Distributions

In order for a distribution from the Roth IRA to be tax-free, it must be a "qualified" distribution. A qualified distribution is any payment or distribution from a Roth IRA that is made after the five-year period beginning with the first tax year for which a contribution was made to the Roth IRA where the payment or distribution is either: (1) made on or after the date the owner reaches age 59½; (2) made because the owner is disabled; (3) made to an owner's beneficiary or the owner's estate after death; or (4) made, up to $10,000, to help buy, build, or rebuild a first home (known as the "first home" exception).

Another advantage of a Roth IRA is that there is no annual required minimum distribution as there is for traditional IRA owners when they reach age 72. Thus, if the funds aren't needed, a Roth IRA owner can leave the money in the account where it continues to grow tax-free.

Additionally, receiving tax-free distributions from a Roth IRA during retirement years has several advantages over the receipt of taxable distributions from a traditional IRA. First, because the taxability of an individual's Social Security income depends on the individual's taxable income, distributions from a traditional IRA increase the chances of paying tax on Social Security income (and, similarly, can raise Medicare premiums in some cases).

Second, individuals tend to experience more health crises as they age, which results in higher medical bills. Because the deductibility of medical expenses is limited to amounts that exceed 7.5% of taxable income, the lower an individual's taxable income, the greater the medical deduction on the individual's tax return. Third, because state taxes are generally based on federal taxable income, distributions from a Roth IRA will not usually increase an individual's state tax liability if he or she lives in a state with an income tax.

Self-directed IRAs

Finally, when discussing whether a Roth IRA is a good fit for a client, practitioners should caution clients about the potential pitfalls of self-directed IRAs. These are either traditional IRAs or Roth IRAs that allow the owner to pick the specific assets in which the IRA will invest. Self-directed IRAs often allow owners to invest in assets in which brokerage firms or other entities that operate as IRA custodians will not allow.

A number of owners of self-directed IRAs have taken severe financial hits for engaging in prohibited transactions with their self-directed IRAs. Such was the case for a couple who used a self-directed IRA to acquire the initial stock of a newly formed C corporation, which acquired the assets of an existing business. The couple guaranteed the loan that the seller of the business made to the newly formed C corporation. The Tax Court determined that this was a prohibited transaction because the taxpayers were disqualified taxpayers and the loan guarantee was an indirect extension of credit to the IRA by the taxpayers. This prohibited transaction caused the IRA to lose its status as an IRA and resulted in a deemed distribution of all of the IRA's assets to the taxpayers in a taxable transaction (Thiessen, 146 T.C. 100 (2016)).

For young clients with a long investment time horizon, who can also afford to make retirement plan contributions, Roth IRAs can be a valuable addition to their retirement planning portfolio.

Barbara Bryniarski, CPA (inactive), MST, is an executive editor at Parker Tax Publishing. To comment on this article or to suggest an idea for another article, contact Dave Strausfeld at David.Strausfeld@aicpa-cima.com.

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