By: Stefanie Ostrich, CPA
A Roth IRA is a retirement savings account in which after-tax dollars are invested and both the earnings and the principal withdrawals become tax-free qualified distributions, when taken after reaching age 59 ½ and after the Roth account has been open for 5 years. While it’s often thought Roth IRAs primarily benefit young people, they can also be a beneficial tool for Baby Boomers—in a big way. Here’s how…
Qualified Roth IRA distributions are tax free.
- If you will be in a higher tax bracket during retirement than during your working years, you will save tax dollars by contributing after-tax dollars to your Roth IRA during your working years and taking tax-free distributions during retirement. Conversely, Traditional IRA contributions are generally pre-tax (unless you made nondeductible IRA contributions), while the portion of the distributions attributable to income is taxable as ordinary income.
- Your Roth IRA distributions will not be included in your adjusted gross income (AGI) for your tax return. This can benefit seniors, as having lower modified AGI in retirement can cause Social Security benefits to be partially or completely tax free. Social Security benefits are tax free if your AGI is <$25,000 single ($32,000 married filing joint) and is partially taxable if your modified AGI is ≥$25,000 single (≥$32,000 married filing joint). Lower AGI may also allow for higher medical deductions if you itemize.
Roth IRAs are great for estate planning
- Since Roth IRAs have no required minimum distributions (RMDs) during the account owner’s lifetime, they can grow tax free for decades. If the sole beneficiary is a spouse, the spouse can transfer the Roth IRA into one in their own name and have no RMDs during their lifetime (non-spouse account beneficiaries of a Roth IRA will have RMD requirements). Traditional IRAs have RMDs by April 1st, the required beginning date (RBD), of the year after you turn age 72 (the previous RBD age of 70 ½ applied if you reached that age before January 1, 2020.
- These accounts can also be thought of as a replacement for life insurance since taking out a life insurance policy for a Baby Boomer can be cost prohibitive.
Contributing to a Roth IRA
- You can contribute up to $6,000 ($7,000 if you’re age 50 or older) to a Roth IRA in 2021, provided you (or your spouse if you are filing jointly) have earned income of at least that amount. However, there are income limitations. Your allowable Roth contribution will be reduced if your AGI is ≥$125,000 single ($198,000 married filing joint) and will be zero if your AGI is ≥$140,000 single ($208,000 married filing joint).
- If your employer offers a Roth 401(k), you can contribute $19,500 in 2021 ($26,000 if you are age 50 or older), with the same tax benefits of a Roth IRA contribution.
- You can make a “backdoor” Roth IRA contribution by contributing to non-deductible traditional IRA account then shortly after converting to a Roth IRA. This approach is subject to the basis proration rules noted below so consult with your tax advisor before you decide to convert a non-deductible traditional IRA account.
You can convert Traditional IRAs to Roth IRAs. This will require you to pay taxes on the income portion of the Traditional IRA account in the year of conversion. Any tax basis you have in all your IRAs combined will be allocated pro rata in determining your taxable conversion. If you are in a lower tax bracket now than you will be in retirement, Roth conversions can prove beneficial to you or your beneficiaries in the long run. For wealthier Baby Boomers with taxable estates and large IRAs, the payment of income tax on a large Roth conversion will cause a reduction of the taxable estate by the tax paid on the conversion.
Roth IRAs and Roth 401(k)s can be great tools for Baby Boomers to reduce future tax liabilities while enhancing the value of inherited retirement accounts by making them tax free for their beneficiaries. Talk to your tax or financial advisor to maximize the benefits of Roth IRAs and Roth 401(k)s for both you and your beneficiaries.