Armanino Blog

Ways High-Income Taxpayers Enjoy Tax-Free Roth

by John Karls
September 13, 2017
First, let’s start with a multiple-choice question: Whom was the Roth individual retirement account (IRA) named after?

A. David Lee Roth
B. Mark Roth
C. William V. Roth, Jr.

Though A and B dominated rock and bowling, respectively, in the late 70s and early 80s, the namesake for the Roth IRA was C. William V. Roth, Jr. A senator from Delaware, he sponsored the legislation for the Roth IRA, which has existed since 1998.

Roth IRAs offer substantial income and estate tax benefits. Although contributions aren’t deductible, qualified distributions are tax-free — the growth is never taxed. And unlike traditional IRAs, Roth IRAs have no required minimum distributions. If you are in the enviable position of not needing the money in retirement, you have the opportunity to let the entire balance grow tax-free to benefit your heirs.

However, modified adjusted gross income (MAGI) phase-out’s limit who can contribute. For 2016, the MAGI-based phase-out ranges are:
  • $184,000–$194,000 for married taxpayers filing jointly
  • $117,000–$132,000 for singles and heads of households
If your MAGI falls within the applicable range, your contribution will be limited. Even worse, if your MAGI exceeds the ceiling, you are prohibited from making any Roth IRA contributions. At least, that’s what the IRS wants you to believe…Fortunately, there are three ways higher-income taxpayers can still take advantage of Roth accounts:

1. Allocate your resources. Your employer may allow you to allocate some or all of your 401(k) plan contributions to a Roth account, and no income-based phase-out applies. In 2016, the 401(k) contribution limit is $18,000 ($24,000 if you’ll be age 50 or older on Dec. 31). It is important to note that any employer match will be made to a traditional account.

2. Knock on the back door. If you don’t have a traditional IRA, a “back-door” Roth IRA is an option. You set up a traditional IRA and make a nondeductible contribution (up to $5,500 in 2016, or $6,500 if you’ll be age 50 or older on Dec. 31). Once the transaction has cleared, you can convert to a Roth IRA. The only tax due will be on any growth from the contribution date to the conversion date, which would be minimal if the conversion occur quickly after the original contribution.

3. Become a convert. If you have a traditional IRA, converting some or all of it to a Roth IRA may be beneficial. The converted amount is taxable in the conversion year, but future qualified distributions will be tax-free. There’s no longer an income-based limit on who can convert. If you have a down year for income, use this as an opportunity for strategic tax planning with a Roth IRA conversion. You may be able to take advantage of the graduated rate tables, a net operating loss, or excess itemized deductions that would otherwise be lost.

Regardless of your current income tax situation, the Roth IRA conversion offers tremendous estate planning opportunities. If you have a taxable estate, a Roth IRA conversion is an even more powerful tool for your future generations. The income tax due to the Roth IRA conversion is paid with your dollars, which would already be subject to estate tax. Since you’re paying the tax liability now instead of when your beneficiaries take distributions, you are effectively making tax-free gifts to your heirs.

And the best thing about a Roth IRA conversion? The IRS allows you a DO OVER! So, if you convert your traditional IRA to a Roth IRA and have second thoughts, you are allowed to recharacterize the transaction up to the filing deadline of your return, including extension. This means you could perform a Roth IRA conversion on January 1, 2017, and have up until October 15, 2018, to decide whether it is the right answer for you and your heirs.

September 13, 2017

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John Karls - Partner, Tax - Dallas TX | Armanino
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