Roth IRAs usually do not make it into a higher-income client's retirement planning playbook. The income limits set in place even prevent many upper-middle-class clients from contributing to a Roth. These limits do, in fact, block clients with earnings above the annual threshold level from contributing to a Roth directly, but there is an alternative route to Roths for high-income clients looking to minimize their tax burden in retirement. Like any other detour, the path to a Roth IRA takes more time and planning, but for wealthy clients who will likely remain in the highest tax brackets even during retirement, the potential for tax-free earnings can make it worth the extra effort.
In 2014, the ability to make contributions to a Roth IRA begins to phase out for married clients with income over $181,000 ($114,000 for single clients). Roth contributions are completely blocked for married clients who earn over $191,000 and single clients who earn over $129,000.
Fortunately, these higher income clients are still allowed to contribute to a traditional IRA, although those contributions might not be tax-deductible because of the income limits that apply to deductible IRA contributions. The starting point in the strategy is to open a traditional IRA; in 2014, each client can contribute up to $5,500 to an IRA ($6,500 if the client is 50 or older).
Because the income limits that previously applied to Roth conversions have been eliminated, the client then simply converts the traditional IRA into a Roth IRA, a process that can be repeated each year in order to grow the Roth.
Of course, the client will be taxed on the Roth conversion at his ordinary income rates, but the benefit of tax-free distributions—of both contributions and earnings—during retirement outweighs this burden for many.
The Benefits (and Bumps)
High-income clients will likely remain in a higher tax bracket even during retirement—they have built up retirement savings and assets that can keep them living in the style to which they have become accustomed during working years. This makes the Roth strategy even more important because, since contributions to a Roth are made with after-tax dollars, all distributions—including earnings—are taken tax-free.
These distributions, however, are not mandatory. Unlike a traditional IRA, the requirement that a client begin taking required minimum distributions (RMDs) at age 70½ does not apply to a Roth. Because of this, wealthy clients who do not need the Roth funds during retirement can use the accounts as estate planning vehicles, leaving the entire balance—and the associated tax benefits—to children and grandchildren.
Clients who have been diligently growing their traditional IRA accounts may find themselves facing a heavier tax burden when it comes time to convert to a Roth. This is because the tax imposed on conversion is based on the total amount of assets—both earnings and pre-tax contribution amounts—that the client holds in his traditional IRAs. Therefore, the strategy may be most beneficial to younger clients who have yet to accumulate substantial IRA balances.
For clients who do have substantial IRA balances, there is a potential workaround that can help minimize the tax bite: These clients can roll their IRA funds into 401(k) accounts (which are not counted in calculating the tax burden in a Roth conversion). However, though many 401(k) plans allow IRA funds to be “rolled in,” clients should be advised that not all plans allow the option.
If the 401(k) roll-in option is on the table, clients also need to examine the performance—including fees and investment options—of any workplace 401(k) to determine whether the move is worth it. It is also important to note that 401(k) funds can be more difficult to access if the client needs the funds prior to retirement.