Published December 13, 2017
There are three common investment terms all involving Roth IRAs that we have found to be frequently misunderstood by the corporate professionals we work with.
The terms may sound similar, but they can have a drastically different impact on your long-term financial position, depending on how and when they are implemented.
A Roth contribution occurs when you put money directly into a Roth IRA from an after-tax source. For example, writing a check from your checking account and depositing the funds into your Roth IRA would be considered a Roth contribution.
Age and Roth Contribution Limits:
· If you are under age 50, you can contribute $5,500 to a Roth IRA.
· If you are age 50 or older, you can contribute $6,500 to a Roth IRA.
Income and Roth Contribution Limits:
· For single tax filers: phase out of the allowable contribution amount begins at $120,000 of AGI and contributions are not allowed at all above $135,000 of AGI (For the 2018 year).
· For married couples with joint filing, the phase out begins at $189,000 of AGI and contributions are not allowed at all above $199,000 of AGI (For the 2018 year).
*Note: You have until the tax filing deadline (April 17th for 2017) to make a contribution.*
A Roth conversion transfers funds from a pre-tax retirement account (like an IRA or 401k) to a post-tax Roth IRA. The converted funds originate from a pre-tax retirement account, meaning there were no taxes paid on the IRA (or 401k) contribution, thus when the pre-tax funds are moved to a post-tax Roth IRA there are taxes due on the conversion. If you were to withdraw funds from a pre-tax account, you would pay taxes on the amount you take out. Similarly, individuals are required to pay ordinary income taxes when converting the pre-tax funds to a Roth IRA. Unlike a Roth contribution, there are no earnings limits that may prevent you from doing a Roth conversion.
Consider that you decide to convert $50,000 from your pre-tax IRA to a Roth IRA. You would process a conversion to move the entire $50,000 of pre-tax funds to the Roth IRA. Thus, when you file your taxes (for the tax-year the conversion was made), the $50,000 will be added to your ordinary income. In other words, your taxable ordinary income for the tax-year of the conversion will increase by $50,000.
Therefore, it may be more tax-efficient for an individual to complete a Roth conversion during a lower-income year.
While you can withhold taxes from a Roth conversion, it’s not always the best option to optimize tax-savings. Generally, it’s more advantageous to pay taxes from a non-retirement account because if you maximize the amount of funds that are moved into the Roth IRA, then you keep a larger amount of money growing tax-free in a retirement account, which received tax preferential growth. For most people that decide to convert, the value is in moving money from a pre-tax retirement account to a post-tax retirement account in a low tax year, thus it often makes sense to convert the largest amount possibly. However, each person’s situation is unique and you need to assess all facets of your long-term financial plan before you can make a sound decision.
A Roth re-characterization is essentially a reversal of a Roth conversion. When you process a Re-characterization, you are sending funds that you converted to Roth back to a pre-tax IRA and the amount of re-characterized funds will not be added to your ordinary income for that year.
Consider that you completed the Roth conversion of $50,000 in the aforementioned example. As the year comes to a close, your annual income is higher than you predicted it would be at the time the conversion was made. Thus when you file your tax return for that year, you’ll be placed in higher income tax bracket, and the converted funds will be subject to a higher tax rate than you originally intended.
In such a situation, you would likely process a Roth re-characterization, which will prompt the transfer of the converted $50,000 (along with any applicable earnings or loss) from your Roth IRA back to your pre-tax IRA as if it never happened. It’s important to remember that Re-characterizations must be completed by the tax filing deadline or by the specified deadline for any applicable extensions you receive. In addition, current tax reform proposals may do away with the Roth re-characterization option in the near future, which may affect how such financial decisions will impact your long-term financial plan.
While Roth contributions, conversions and Re-characterizations are all great planning tools, they’re accompanied by their own specific rules and tax forms. It is important for you to consult with your CPA or Financial Advisor before deciding on a strategy. If you want to learn more about how each of these strategies compare, our team is available to answer any questions you may have via phone or in person. Click here to request more information or schedule a phone call with a WJA representative.
Willis Johnson & Associates is a registered investment advisor. This material is intended for informational purposes only and should only be relied upon when coordinated with individual professional advice. Please speak to an investment professional before implementing any advice here. Willis Johnson & Associates does not provide tax or legal advice.
Nick Johnson, CFA®, CFP®
Nick Johnson believes that financial planning is more than numbers on a balance sheet and a standardized process. People are unique and should be treated as such.
As Vice President and Wealth Manager at Willis Johnson & Associates, his goal is to really get to know his clients, all the while providing a proactive approach to comprehensive wealth management.