Understand pros and cons of a Roth IRA

By Elliot Raphaelson
Posted on December 13, 2019

Based on the mail I receive, many readers misunderstand Roth IRAs, including the benefits for the initial owner and for beneficiaries. I’ll explain some of the basics associated with Roth IRAs below.

However, I should preface this by saying that Congress is contemplating modifications in the regulations that will affect the length of time beneficiaries will be able to stretch out benefits from both traditional and Roth IRAs. If Congress does pass new legislation that becomes law, I will discuss the impact in a subsequent column.

Benefits for original owners

A significant benefit of a Roth IRA is that all income earned in the account — whether from interest, dividends or capital gains — is tax free.

When you invest in a Roth IRA, you are investing after-tax income. Any withdrawals you make from your Roth, after retirement, will be tax free, regardless of whether the withdrawals exceed the amount of your initial purchases.

Tax-free distributions from Roth IRAs will not expose investment income to the 3.8% surtax either.

Another benefit to original Roth IRA owners is that there are no required distributions. This is very important in comparison to the regulations applicable to traditional IRAs.

Under current regulations, at age 70½ owners of traditional IRAs are required to start taking required mandatory distributions (RMDs) from their IRAs. The RMD amount changes each year based on the value of the IRA at year-end and the life expectancy of the IRA owner. All withdrawals from traditional IRAs are taxed at ordinary income tax rates.

An individual with earned income can make contributions to the Roth IRA of a spouse who is not working or has limited income, as long as the working spouse has sufficient income to cover the contributions for the non-working spouse plus any contributions made for the working spouse.

If you have earned income after age 70½, you can still make contributions to a Roth IRA (not true of traditional IRAs).

Even if you are under 59½, you can withdraw any contributions you made to a Roth (not including earnings thereon) without penalty. If you make any withdrawals from a traditional IRA, you would be subject to a 10% early withdrawal penalty and income taxes.

Benefits for Roth beneficiaries

These are some of the advantages of a Roth IRA to beneficiaries:

Withdrawals of Roth IRA contributions are income tax free. Earnings can be withdrawn tax free as long as the five-year rule has been met (i.e., the account was at least five years old when the owner died; see “Penalties” below).

Beneficiaries can, under present regulations, stretch tax-free distributions over their lifetimes. (Proposed congressional proposals may change that limit to 10 years.)

Spouse beneficiaries are not required to take RMD distributions. Non-spouse beneficiaries (such as children) are required to take RMDs based on their age from the IRS Single Life Expectancy Table, starting the year after the owner’s death. Each year the life expectancy for non-spouses is reduced by one year. (See IRS 590-B for instructions and the appropriate table.)

Back-door contribution loophole

If you earn more than the maximum (for 2019 the limit is between $193,000 and $203,000 for married filers and between $122,000 and $137,000 for single filers) and if you are younger than 70½, you can make a contribution to a traditional IRA and then convert that account to a Roth. This can be done in the same year.

[However, note that this requires paying tax up front on any pre-tax IRA contributions and any earnings using “pro-rata” rules that take into account the value of all IRAs you own. This can be somewhat complex, so consult an adviser before doing this.’

Also note: You are no longer allowed to undo (called a recharacterization) a conversion done in 2018 or onward.

Penalties

Although Roth contributions can be withdrawn without penalty, some withdrawals would be subject to penalties and taxes.

If you make a withdrawal that exceeds your original contribution and are under age 59½, or you have not waited five years after your contribution, you would be subject to a 10% penalty and income tax liability for the amount of the withdrawal that exceeds your contributions.

Beneficiaries are not subject to the 10% early withdrawal penalty, but they are liable to income tax on earnings related to funds that were not held in the account for five years.

Elliot Raphaelson welcomes your questions and comments at raphelliot@gmail.com.