Roth IRAs are powerful retirement savings tools — if used correctly. Unfortunately, many advisors and their clients hold beliefs about Roth IRAs that are downright wrong. These misguided beliefs can lead to negative consequences, including passing up planning strategies that could save valuable tax dollars for clients during retirement. With that in mind, here are 5 Roth IRA myths you simply can’t afford to believe.
1. Your client is too old to convert to a Roth IRA.
Please, can we once and for all get rid of the notion that age has anything to do with whether or not your client should convert to a Roth IRA?! It doesn’t!
That’s not to say that, on average, a Roth IRA conversion will make sense for the same number of 80 year-old clients as it does for 40 year-old clients. It doesn’t. But that’s not due to a client’s age so much as it is other factors, including current vs. future expected tax rates.
That said, there are plenty of reasons why clients in their 70s, 80s or older should consider making a Roth conversion. For instance, making a Roth conversion might increase income in the year of conversion to the point where a client is forced to pay higher Medicare Part B premiums (generally two years later). But that added conversion income is a one-time occurrence.
Without the conversion, higher Medicare Part B premiums might be an every-year issue once required minimum distributions (RMDs) begin if no conversion is made. Advisors must consider Part B premiums and other issues, including the taxability of an increased portion a client’s Social Security benefits, in any Roth conversion analysis.
Picture another scenario: clients who are 70 or 80 years old, are in a low income tax bracket, but have still-working beneficiaries who are in higher tax brackets. Converting now, using clients’ lower bracket, can help minimize the cumulative tax bill that will be owed on their retirement savings.
As you can imagine, there are any number of possibilities, but the point is simple: Just because a client is 75 or 80 doesn’t automatically make him or her “too old” to benefit from a Roth IRA conversion.
2. There is a five-year waiting period to take distributions.
No, there’s not. If I had a nickel — or more realistically, a five dollar bill — for every time I’ve heard an advisor say this, oftentimes to a client, I could probably make my entire 2015 IRA contribution! When it comes to IRAs, including Roth IRAs, clients are always 100 percent vested in their funds. And, from the tax code’s perspective, there is absolutely no waiting period required before distributions may be taken. Of course, a client’s investment option could impose its own liquidity rules, but that has nothing to do with the tax code or tax rules.
So why the confusion? There are two Roth IRA 5-year rules that you may have to deal with. But here’s the thing: Neither of them has anything to do with preventing a client from taking money out of a Roth IRA! Instead, those rules just deal with the tax consequences of the Roth IRA distributions they take. Myth busted.
3. Clients must be age 59 ½ to access Roth IRA money tax- and penalty-free.
In general, clients must be age 59 ½ and have established a Roth IRA at least five years ago in order for Roth IRA funds to be tax- and penalty-free for life. But just because not everything in your client’s Roth IRA is tax free yet, it doesn’t mean that none of their Roth IRA money is.
Not that it’s a good idea, but in many situations your clients can put money into a Roth IRA today, then use it tomorrow without tax or penalty — regardless of their age or the reason for their withdrawal.
Simply put, Roth IRA contributions can be distributed at any time without incurring a tax or penalty. And here’s the even better part: Your client’s Roth IRA contributions are always considered to be the first money out of their Roth IRA (for distribution purposes all of your client’s Roth IRAs are treated as one account).
Every dollar of contributed money comes out tax- and penalty-free before a single dollar of earnings —which may be taxable and/or subject to a 10 penalty — is distributed. Funds that have been converted to a Roth IRA often receive the same tax treatment.
They are always tax-free. After all, your client paid the tax on those funds when they made their Roth conversion, right? In addition, they will also be penalty free if your client’s conversion took place more than five years ago or if they are already over 59 ½.
4. Roth IRA calculators provide consistently realistic projections.
Have you ever questioned whether a Roth IRA contribution or conversion was right for your clientd or if they’d be better off making a traditional IRA contribution and getting a deduction? If so, then chances are you’ve wondered if there was a simple calculator that could take all your client’s pertinent data, analyze it, and then, like a “Magic 8 Ball” of Roth planning, spit out a definitive “yes” or “no,” telling you the correct course of action.
Unfortunately, that’s generally not going to be the case. Don’t get me wrong, calculators of all types, including Roth IRA calculators, can be wonderful tools and have their place in helping you evaluate the merits of a particular transaction for a client. But they are also often highly unrealistic when modeling what actually happens in the real world, with real clients. Here’s a prime example of what I mean:
In order to make a fair, apples-to-apples comparison, most should-a-client- go with-a-Roth-IRA-or-traditional-IRA software compares the projected future value of a client’s Roth IRA account to the projected future value of a client’s traditional IRA account, plus the projected future value of a taxable account that represents the funds that would have otherwise been used to pay the tax on the Roth money at the time of contribution/conversion.
For example, suppose your client is trying to decide between making a $5,500 traditional IRA contribution for 2015 or a $5,500 Roth IRA contribution. Furthermore, suppose that if they chose the traditional IRA option, they would save $1,000 in taxes. Most software will compare the projected future value of your client’s $5,500 Roth IRA contribution to the projected future value of their $5,500 traditional IRA contribution, plus the projected future value of their $1,000 tax savings invested in a similar manner, but in a taxable account.
Roth IRA-conversion calculators typically incorporate a similar analysis. Then, the software simply calculates which of these options is worth more on an after-tax basis when your client retires or otherwise plans to use the money. The calculator’s assumptions on one large financial website read, in part, as follows.
“For Roth IRAs, the analysis assumes that the amount of the contribution grows tax-deferred at your hypothetical rate of return for the number of years you selected until taking your first withdrawal. For traditional IRAs, the analysis assumes that the tax savings from deducting the contribution are invested in a separate, taxable account at your hypothetical rate of return and then added to the value of your IRA at withdrawal.”
These calculations are nice for academic purposes, but in most cases, that’s about all they’re good for. How many clients, after running such a calculation and determining it was advisable to opt for the traditional IRA, do you think would actually put aside an amount equal to the taxes saved by making that contribution and invest it in a similar manner? Would your clients? Each and every year?
That’s what I thought. It simply doesn’t happen. It sounds great, and it’s the only fair way to compare the two options mathematically, but practically speaking, it simply doesn’t add up. Let’s be real. The $1,000 of tax savings is more likely to go toward the purchase of a new car or a family vacation than it is to a non-retirement investment account that’s put aside for your client’s retirement. Once that happens, your traditional vs. Roth IRA contribution calculation goes right out the window.
If, on the other hand, your client opted for the Roth IRA contribution option, they will have essentially saved twice for retirement. Once for the contribution itself, then again for an amount equal to the future tax bill they would otherwise have needed to pay on the funds when they were eventually distributed from their traditional IRA.
So in many ways, a Roth IRA is really like a forced savings account for a client’s future tax bills. In many “real world” scenarios, that might help your clients receive more money for retirement than if they opt for the traditional IRA and deduction — even if your Roth IRA calculator says otherwise.
There are two final points to note. First, there are really wonderful Roth contribution and/or Roth conversion calculators that do perform useful analyses. Second, and perhaps more importantly, I am not saying a Roth contribution and/or conversion is better for everyone. That is definitely not the case.
That is still a very personal decision that hinges on each client’s specific set of facts, circumstances and projections about the future. My point, rather, is that you and your clients consider what assumptions are built into the analyses you’re basing key decisions on, and that you realize that sometimes numbers don’t tell the whole story.
5. Roth IRAs have no impact on a child’s financial aid.
If a client is hoping to receive student aid for their child’s college education, the Free Application for Federal Student Aid (FAFSA) is a likely starting point. There are well over 100 questions on the FAFSA form, which is designed to help calculate what’s known as the expected family contribution. The EFC is essentially the amount the federal government thinks a person should pay for their own education; and it’s calculated, in part, based on the assets of a student and their parents.
When reporting assets on the FAFSA form, most assets, including 529 plans, are included in the calculation. Roth IRAs and other retirement accounts are, however, not considered assets when determining a family’s EFC. There’s no cap to that amount either, so your client may actually be able to accumulate significant sums in Roth IRA and still qualify for student aid for a child. That’s the good news…
… But here’s the potential trouble spot: Roth IRA distributions are included in the income calculation. That’s true of both taxable Roth IRA distributions and tax-free distributions. So, if a client takes a distribution from a Roth IRA to pay for a child’s college education this year, it could impact the aid they are eligible to receive in future years. And as any parent with a child in or approaching college age can tell you, that financial aid can be extraordinarily valuable.
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