Roth IRA Planning

In 1997, Congress created the Roth IRA.¹ While a taxpayer cannot take an upfront deduction for contributions, qualified distributions are not taxable. In addition to Roth contributions, individuals may make qualified rollovers of traditional IRA and qualified plan assets into Roth IRAs, commonly referred to as conversions. Converted assets are included in gross income, subject to a few exceptions.² The opportunity to get more assets into Roth vehicles via various means has evolved over the last several years, most recently with the promulgation of Notice 2014-54. This was a huge taxpayer win, allowing rollovers of after-tax dollars in retirement plans directly to Roth IRAs to potentially be completely tax-free.

Benefits of Roth Assets

Roth IRA assets can have many advantages:

• Similarly to an IRA or qualified plan, the earnings within the account are tax-sheltered.
• Unlike those from a regular IRA or a qualified plan, distributions from a Roth IRA are not included in gross income if certain conditions are met.³
• Roth IRA assets are not subject to required minimum distributions (RMDs). However, assets in a designated Roth account under a qualified cash or deferred arrangement are subject to RMDs.⁴
• Once the original owner of a Roth IRA dies, if the assets transfer to nonspouse beneficiaries, lifetime distributions must begin, but these distributions are tax-free.⁵
• Owners who will be in a higher tax bracket in the future could benefit from tax rate arbitrage by paying taxes on contributed monies at their current, lower rate.
• Contributions to Roth IRAs can be made at any age, even after age 70½,⁶ assuming that the taxpayer meets the contribution requirements.⁷

Strategies to Maximize Roth Assets

Roll Over After-Tax Monies in a Qualified Retirement Plan Directly to a Roth IRA

An important recent development in Roth planning is the promulgation of Notice 2014-54 in September 2014. Previously, opinions had differed regarding the treatment of after-tax portions that a taxpayer rolled from a qualified retirement plan to a Roth IRA.

Example 1: An individual has a $1 million Sec. 401(k) plan balance, of which $100,000 is attributable to after-tax contributions (not designated Roth account contributions). If the individual moved $100,000 directly to a Roth, would it cause an inclusion of $90,000 of taxable income (based on the pro rata rule) or zero taxable income? Until it issued Notice 2014-54, the IRS had argued that the distribution should be considered a pro rata distribution of all pretax and after-tax balances in the plan.⁸

Under Notice 2009-68, the IRS stated that if an individual made a partial rollover to another plan or IRA and a distribution to himself or herself, this is treated as two separate distributions, to each of which the “cream-in-the-coffee” rule⁹ would apply. If it is deemed to be one distribution, then an exception could apply,¹⁰ which would make any after-tax amounts kept by the individual not subject to the cream-in-the-coffee rule. This exception states that in a partial rollover from a qualified retirement plan, the pretax monies are deemed to be rolled over first. Therefore, in Example 1 above, if the individual had $1 million distributed to him and, within 60 days, he deposited $900,000 to an IRA, 100% of the dollars in the IRA would be considered pretax. The dollars remaining outside would be considered 100% after-tax. This would bypass the cream-in-the-coffee rule and effectively distribute $100,000 to the individual with no income tax ramifications.

In Notice 2014-54, the IRS declared that pretax and after-tax amounts distributed to multiple destinations at the same time should be treated as a single distribution, which allows the exception to apply. Therefore, an individual can effectively move after-tax proceeds directly to a Roth IRA without causing an income tax liability if all of the pretax monies are simultaneously rolled to another plan or a traditional IRA. This was a huge win for taxpayers and presents an opportunity to accumulate more in Roth assets if coordinated correctly.

Roll Pretax Monies of an IRA Into a Qualified Retirement Plan and Convert Remaining IRA Balance

If an individual has an IRA that contains both pretax and after-tax amounts and does a conversion, the pro rata rule would apply. If the taxpayer has a $100,000 IRA with $60,000 of after-tax contributions and $40,000 of earnings (i.e., pretax), any dollar converted would result in 40 cents of taxable income.

An opportunity exists for individuals who have an IRA with after-tax contributions and who also participate in a qualified retirement plan that accepts rollovers. If the individual rolls dollars into the qualified plan, they are deemed to come from the pretax dollars first,¹¹ and a qualified plan can accept only pretax dollars. Therefore, if the individual rolls in all pretax amounts, the dollars remaining in the IRA would be 100% after-tax. The individual could then do a conversion of the IRA and nothing would be included in his or her income, given that 100% of the dollars that are converted to a Roth IRA are after-tax.¹²

Example 2: Following Example 1, if the taxpayer rolled $40,000 of his IRA into his qualified retirement plan, it would leave $60,000 in his IRA. The pretax dollars are considered to be rolled into the plan, deeming the $60,000 remaining in his IRA as 100% after-tax dollars, since he had $60,000 of after-tax contributions. When he then converts the IRA to a Roth IRA, the amount included in income is calculated as follows: $60,000 − ($60,000 × [$60,000 ÷ $60,000]) = $0 included as taxable income

This assumes that the $60,000 in the IRA was the only IRA account that the individual had. If he had others (whether SIMPLE, SEP, or traditional), they would be factored into the calculation to determine the taxability of converting the $60,000. When a taxpayer can do a Roth conversion with no tax liability, it makes deciding whether to convert much easier.

Contributions

The most direct way to build Roth assets is through contributions, either to a Roth IRA or to a designated Roth account.

Roth IRA Contributions

Taxpayers whose modified adjusted gross income (MAGI) is below certain thresholds and who have earned income of at least $5,500 (or $6,500 if age 50 or above) can contribute the maximum amount directly to a Roth IRA, and the same holds true for a spouse, if there is at least $11,000 of earned income between them ($13,000 if both are age 50 or above).¹³ A Roth IRA may be more appropriate than a traditional IRA in the following circumstances:

• Individuals who are young, with many years of compounding power in front of them.
• Individuals who are likely in a lower tax bracket today than they will be when they withdraw the assets.
• Individuals who have more assets than they will need for retirement. Roth IRAs can be excellent estate planning tools because the beneficiary can make distributions over his or her lifetime and continue the tax-free compounding, potentially over many decades.¹⁴ This applies if the ultimate beneficiaries of the individual’s estate are individuals. If the ultimate beneficiaries are charitable beneficiaries, which are not subject to income tax,it would be fruitless for the IRA owner to pay the tax upfront that could be avoided altogether.
• Individuals who are seeking tax diversification of assets. As Roth IRAs and designated Roth accounts are relatively new, many individuals who have been working and saving for retirement for many years have more in taxable and pretax retirement funds. Individuals can hedge against future tax changes by building up assets in multiple tax “buckets.”

Roth IRAs also can be useful savings vehicles for children and grandchildren, who may be unable from an income standpoint to amass cash. Family members can make Roth IRA contributions on their behalf, assuming that the children or grandchildren are eligible, based on earned income and MAGI. While this could be more income-tax beneficial than setting up a trust for the benefit of the same beneficiary, it does give beneficiaries more control over the assets—which could be a negative aspect, depending on the beneficiaries’ maturity level (and that of their spouse or significant other).

Designated Roth Account Contributions

Employees have long been permitted to make “elective deferral” contributions to workplace retirement plans. In traditional qualified retirement plans, an employee is not subject to tax on the deferred compensation and earnings thereon until they are later distributed to the employee or his or her beneficiaries.¹⁵

Beginning in 2006, if a plan allowed it, participants had an additional option to choose from. Instead of deferring the income tax that was attributable to the compensation set aside into the retirement plan, they could pay income tax on the monies set aside and contribute them to a designated Roth account within the employer’s plan.¹⁶ Distributions from the designated Roth account later would not be taxable.

The two main differences between designated Roth accounts and Roth IRAs are that designated Roth account contributions are not limited to taxpayers under certain income levels, and the contribution limits are higher (in 2015 and 2016, for those under age 50, $18,000, versus $5,500 for Roth IRAs, and $24,000 versus $6,500 for those age 50 and over). If Warren Buffett had access to a designated Roth account through his employer, he would be eligible to contribute up to $24,000 of his earned income to it.

Employees do not have to choose 100% Roth contributions or 100% pretax contributions. As long as combined deferrals do not exceed the annual contribution limit, employees can designate any portion of their earnings to their designated Roth account and the remaining portion to their traditional pretax retirement account. The only caveat is that these decisions must be made in advance, as recharacterizations are not allowed in designated Roth accounts once the deferral to the Roth portion is already made, and vice versa.¹⁷

If the employer is making any contributions to the plan, either through matching, safe-harbor, or profit sharing contributions or otherwise, those will continue to be made on a pretax basis, even if the employer’s contributions result from the employee’s contributions to the designated Roth account.¹⁸

Unlike a Roth IRA, a designated Roth account is subject to the same lifetime distribution rules as other qualified plans.¹⁹ This means that employees could be subject to RMDs beginning at age 70½ unless they are still working and own less than 5% of the company.²⁰ Participants would be wise to consider an in-service distribution if they would be subject to RMDs from their employer’s designated Roth account. If they rolled the designated Roth account assets into a Roth IRA, which, as stated earlier, is not subject to RMDs,they could keep the assets in a Roth vehicle to continue tax-free compounded investment growth. Otherwise, a distribution would have to be made, and although it would be tax-free, all future growth would forever be outside the preferential Roth environment.

Conversions

Another way to get assets into Roth vehicles is by doing a rollover from a traditional IRA or retirement pretax vehicle to a Roth IRA, commonly referred to as a conversion. Whatever amount is moved from the traditional IRA or retirement plan to the Roth vehicle will be taxed as ordinary income.²¹ The one exception is that an individual’s after-tax contributions are not taxable when distributed or converted.²²

Prior to 2010, married taxpayers filing jointly were permitted to do a conversion only if their MAGI was less than $100,000.²³ This income cap has since been removed.

Obviously, because the converted assets are subjected to tax today rather than in the future if they remain in the traditional IRA or retirement plan, the individual must weigh the costs and benefits of paying the income tax liability currently. A conversion may be appropriate in the following situations:

• The taxpayer has ample assets outside the traditional IRA or retirement plan funds to pay the resulting income tax liability due upon the conversion. Having to pay the income tax liability from the retirement funds diminishes the benefit, as fewer assets remain in the Roth to grow tax-free.
• The individual anticipates having a higher tax rate in the future than now. Many observers believe that tax rates for upper-middle-income and high-income individuals will trend higher in future years, as marginal ordinary income tax rates are currently low when considered from a historical perspective.
• Individuals who retire prior to age 70½, when RMDs must begin from traditional IRA assets,²⁴ may be in a lower tax bracket than in the future. By doing small Roth conversions during the years prior to age 70½, taxpayers can potentially maximize the after-tax value of their wealth and reduce future RMDs that will be subject to ordinary income tax.
• Individuals who will need the assets for their living expenses in a retirement that is still a number of years away could be good candidates for a conversion. This allows additional tax-free compounding of growth and diminishes the relative cost of the upfront income tax costs of conversion.
• If individuals are not planning on needing these assets for their own living expenses and have individuals as beneficiaries who could benefit from continued tax-free growth over their respective lifetimes, a Roth conversion can be appropriate if the current owner is willing to foot the income tax bill for the ultimate benefit of those future beneficiaries. If the current account owner intends to leave the retirement assets to charitable beneficiaries, a Roth conversion is not appropriate. This is because the current owner would pay income tax today that otherwise could be avoided altogether, since the charitable beneficiary will not pay income tax on the IRA or pretax retirement assets it receives upon the death of the current owner,²⁵ and the owner’s estate will get an estate tax deduction for the IRA assets that are left to charity.²⁶

Conversions Within a Qualified Retirement Plan

The Small Business Jobs Act of 2010, P.L. 111-240, added a provision that allows any Sec. 401(k), Sec. 403(b), or governmental Sec. 457(b) plan that provides for both traditional and designated Roth account contributions to offer the ability to do a conversion within the plan itself.²⁷ A plan is not required by law to offer this feature to its participants, even if it does allow its participants to participate in a designated Roth account within the plan. Initially, the ability to do an in-plan conversion required participants to be entitled to a distribution from the pretax plan, which meant that they had to meet certain age or qualifying event requirements. This limited the availability of conversions of qualified plan assets for many individuals.

However, the American Taxpayer Relief Act of 2012removed many of these restrictions and permitted individuals to convert balances in an employer-sponsored tax-deferred retirement plan into a designated Roth account beginning in tax years after Dec. 31, 2012, if the plan allows it.²⁸ The tax consequences are the same as if the money had been rolled over to an IRA and then converted to a Roth IRA, meaning that any amounts not attributed to after-tax contributions are taxed as ordinary income.

For example, a conversion by a taxpayer in the 35% marginal federal income tax bracket of $500,000 within the plan, assuming that the amount converted consisted entirely of pretax contributions and earnings attributable to them, would trigger $175,000 of additional income tax, besides any additional taxes the taxpayer might incur due to a higher total income (e.g., net investment income tax, limitation of itemized deductions, etc.).

One drawback of doing a conversion within the employer-sponsored plan, as opposed to from an IRA, is that the taxpayer cannot recharacterize the conversion later. This can be particularly costly if the assets’ value sharply declines between the time of the conversion and when the account could have been recharacterized had the conversion taken place in an IRA.

Conversion of Qualified Retirement Plan Assets Directly to a Roth IRA

Before 2008, the Code permitted rollovers into Roth IRAs only from IRAs and designated Roth accounts. This meant that anyone who wanted to roll over pretax funds within an employer-sponsored retirement plan to a Roth IRA had to roll over the funds to an IRA and then convert them to a Roth IRA. Now these two steps can be reduced to one step, and the individual can move assets directly from the pretax retirement plan to a Roth IRA.²⁹ These provisions apply to:

• Qualified retirement plans under Sec. 401(a);
• Secs. 403(a) and (b) contracts and plans; and
• Governmental Sec. 457(b) plans (rollovers from nongovernmental 457(b) plans are not allowed).³⁰

With these rollovers, individuals are not required to withhold 20% income tax that typically applies to distributions from a qualified plan. Tax withholding can be applied electively,³¹ but if the individual has other assets, they would be a preferable source from which to pay the resulting income tax liability due to the conversion. This keeps the amount within the Roth as large as possible.

Nondeductible IRA Contributions and Subsequent Conversion

Due to the income limits applicable to Roth IRA contributions and the deductibility of regular IRA contributions, taxpayers with higher incomes may think that they cannot participate in Roth IRAs. This is not necessarily the case.

Individuals, regardless of income levels, are allowed to make contributions to regular IRAs. If the individual’s income level exceeds certain thresholds, the contributions will be deemed nondeductible, meaning that the contributions are considered made with after-tax dollars. Then the individual can convert these assets within the traditional IRA to a Roth IRA. Upon the conversion, he or she will have to include in gross income only the amount that is attributable to any earnings on the contributions. If the conversion takes place relatively soon after the contribution, this amount would likely be very small, if anything.

There is a major caveat to this planning opportunity. If the individual has other IRA assets that are pretax dollars, calculating the amount included in taxable income is more complex. The cream-in-the-coffee rule³² would apply. All IRAs are aggregated to determine the amount that is considered includible in the taxpayer’s income. This is reported on Form 8606, Nondeductible IRAs, with the taxpayer’s Form 1040, U.S. Individual Income Tax Return. Essentially, the calculation multiplies all distributions from the individual’s IRAs for the year by a fraction to determine how much is taxable and how much is a recovery of basis. The numerator is the total basis that the taxpayer has in his or her IRAs, and the denominator of the fraction is the total balance of all IRA assets as of Dec. 31 of the tax year, plus any amounts that were distributed throughout the year.

Example 3:If an individual who has $100,000 in IRA assets, of which $5,000 is from after-tax contributions, converts $5,000 from his IRA to a Roth IRA, the amount that would be taxed as ordinary income is calculated as follows: $5,000 − ($5,000 × [$5,000 ÷ ($95,000 + $5,000)]) = $5,000 − $250 = $4,750 of taxable income.

This means that only 5% of the conversion was nontaxable, with the remaining 95% taxable. This can make Roth conversions for individuals with significant pretax IRA assets not nearly as efficient as for those who have minimal pretax assets.

However, this strategy can be effective for the following individuals:

• Those who have most or all of their pretax retirement dollars in an employer-sponsored plan, as these dollars are not factored into the calculation to determine the taxability of a conversion from an IRA to a Roth IRA.
• Nonworking spouses who do not have any IRA assets but can make nondeductible IRA contributions based on their spouse’s earned income.³³

Assuming that an individual has nothing in any IRAs prior to any nondeductible contribution to an IRA and subsequent conversion to a Roth, a Roth conversion can be tax-neutral. For example, if he or she makes a $5,500 nondeductible contribution to an IRA (due to income thresholds) and subsequently converts that $5,500 to a Roth IRA, the formula to determine the amount considered taxable would be: $5,500 − ($5,500 × [$5,500 ÷ ($0 + $5,500)]) = $5,500 − $5,500 = $0 taxable income.

In this fashion, an individual has essentially moved dollars that would have been sitting in an after-tax bucket to a Roth IRA, which will grow tax-free if future distributions are qualified. For married taxpayers filing jointly, the calculation to determine the taxability of the conversion is determined separately for each spouse.³⁴

Deadlines for Contributions and Conversions

The deadline for contributions to Roth and traditional IRAs is the due date of the tax return for that year, excluding any extensions. For most individuals, this is April 15 of the following year.³⁵ For example, most individuals who want to make a 2015 contribution have until April 18, 2016, to do so.³⁶

A conversion to a Roth IRA is tied to the traditional monies that are being rolled over. Therefore, a conversion for 2015 must be tied to a distribution that occurs by Dec. 31, 2015. An individual must contribute a distribution from a traditional plan to a Roth IRA within 60 calendar days after the distribution date.³⁷ Therefore, an individual could have a distribution from his or her IRA on Dec. 31, 2015, and as long as the monies are contributed to a Roth IRA within 60 calendar days, the conversion will be considered complete in 2015.

Distributions

As stated earlier, any qualified distribution from a Roth IRA is not includible in gross income. A distribution is qualified if it meets the qualified purpose and qualified distribution period tests.

A distribution meets the qualified purpose test if the distribution is made:³⁸

• On or after the taxpayer has attained age 59½;
• After the death of the taxpayer;
• Due to the taxpayer’s becoming disabled; or
• For a first-time home purchase, limited to $10,000.

The distribution meets the qualified distribution period test if the taxpayer has had a Roth IRA for at least five years, beginning with the first tax year for which the individual made a contribution.³⁹

A nonqualified distribution is treated as first made from all amounts contributed to the Roth IRA, then from any amounts converted to the Roth IRA, and finally, from earnings.⁴⁰ Therefore, individuals can recover their “basis” first, before any earnings are deemed distributed. Earnings distributed as part of a nonqualified distribution are included in gross income. They are also subject to the additional 10% tax unless an exception applies.⁴¹

Distributions from designated Roth accounts are qualified and thus tax-free if they meet the qualified purpose and qualified distribution period tests. However, unlike Roth IRAs, the first-time homebuyer exception does not apply. Also, the five-tax-year period for a designated Roth account is defined as beginning on the earlier of (1) the first tax year for which the individual made a contribution to any designated Roth account under the same plan, or (2) if a direct rollover contribution was made to the designated Roth account from another designated Roth account previously established for the individual under another retirement plan, the first tax year for which the individual made a contribution to that respective designated Roth account. The five-year period is computed on a plan-by-plan basis.⁴²

No ordering rules for designated Roth accounts allow participants to recover their “basis” first. Participants could roll over their designated Roth account funds to a Roth IRA, which would allow the ordering rules to apply.⁴³

Other Considerations

Creditor Protection

In 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA)⁴⁴ was signed into law. It clarified how retirement assets would be treated in federal bankruptcy proceedings under Chapter 11. This law exempts plans under Secs. 401(a), 403(b), and 457, or IRAs under Secs. 408 and 408A from bankruptcy proceedings.⁴⁵

While the exemption is unlimited for retirement plans such as Sec. 401(k)s and Sec. 403(b)s, IRAs (including Roth IRAs) have an exemption of only $1 million. This is adjusted triennially for cost of living and is now $1,245,475.⁴⁶ If a qualified retirement plan is rolled over to an IRA (whether pretax or Roth), it is not subject to the exemption cap.⁴⁷ Individuals and their financial advisers would be wise to consider segregating IRA assets that are due to qualified plan rollovers versus IRA contributions, to avoid any confusion down the line.

In addition to federal law, one must understand the state law where the individual is domiciled. Typically, anti-stacking provisions do not allow a taxpayer to choose between federal and state protections.⁴⁸ However, an exception allows individuals to have protection from bankruptcy under both their state and federal bankruptcy laws.⁴⁹ This affords individuals maximum protection: If they live in a state that has weak bankruptcy protection for retirement assets, they can rely on the protections under the federal statutes. If the individual’s state offers greater protection than the federal protections, the individual can be protected by the state’s statutes.⁵⁰

If a qualified plan’s only participants are partners or a sole proprietor, the plan is not given ERISA⁵¹ status. While this is not a problem for bankruptcy proceedings, as BAPCPA will protect the assets if the plan has received a favorable IRS determination letter,⁵² for other creditor claims, the assets could be at risk. If the plan covers at least one employee who is not an owner, Title I of ERISA will cover the plan and provide additional protection against creditors outside the scope of bankruptcy.⁵³

A recent Supreme Court case clarified that inherited IRAs are not afforded any protection under federal bankruptcy laws.⁵⁴ However, if the individual’s state specifies otherwise, inherited IRA assets could be protected.

The above comments are with respect to bankruptcy proceedings. For general creditor proceedings, individuals must look to their state’s law to determine what protections are afforded to IRA assets.

In addition to being financially responsible to avoid bankruptcy proceedings, individuals should look to secure umbrella liability insurance for protection against civil lawsuit liabilities.

Spousal Rights

If a plan is fully subject to the Retirement Equity Act of 1984,⁵⁵ then, generally, the plan must distribute any benefits to a married employee in the form of a qualified joint and survivor annuity, unless the employee has waived that form of benefit and the employee’s spouse consents to the waiver. While qualified plans such as designated Roth accounts are subject to this requirement, Roth IRAs are not.

Investment Allocation and Asset Location

Individuals who have multiple tax buckets (pretax, Roth, and taxable) should pay attention to asset location. For example, if an individual invests 60% in stocks and 40% in bonds, it would not be ideal to have the bonds in the Roth IRA account, given its tax-free compounding ability and subsequent tax-free qualified distributions. An individual may maximize overall wealth by strategically locating higher-growth assets in the tax-preferred Roth accounts.

Increase in Income Due to Roth Conversion Ripple Effects

Because a Roth conversion generally increases recognized income, taxpayers should consider the effects on all affected taxes and other payments:

• Medicare Part B premiums: Monthly premiums are based on the individual’s reported MAGI two years previously and increase in tiers from $121.80 in 2016 for single taxpayers with an MAGI of $85,000 or less ($170,000 for married couples filing jointly) to $389.80 for an MAGI above $214,000 ($428,000 for married taxpayers filing jointly).⁵⁶
• Increase in taxable portion of Social Security benefits: The amount of Social Security benefits included in taxpayers’ taxable income is based on MAGI.⁵⁷ For a married taxpayer filing jointly, if the MAGI other than Social Security benefits, plus one-half of the Social Security benefits received for the tax year, exceeds $44,000 ($34,000 for a single taxpayer), up to 85% of Social Security benefits received will be taxable.⁵⁸
• Limitation of financial aid for higher education: Although the Free Application for Federal Student Aid (FAFSA) does not require retirement assets to be reported, a conversion will increase the total income that must be reported. Therefore, doing a Roth conversion on Jan. 1, 2016, instead of Dec. 31, 2015, for example, could minimize the impact on any potential financial aid that could be awarded to a student based on the parents’ income for 2015.
• Net investment income tax: Since 2013, the 3.8% net investment income tax is imposed on net investment income exceeding specified amounts.⁵⁹ Increasing a taxpayer’s income with Roth conversions could subject some or all of the taxpayer’s net investment income to this additional tax.
• Increased rate on capital gains and dividends: Also since 2013, adjusted net capital gains that, if ordinary income, would be taxed at a rate of 39.6% are subject to a federal tax of 20% instead of 15%.⁶⁰ Increasing a taxpayer’s income with Roth conversions could thereby increase the tax rate applied to long-term capital gains or qualified dividends.

Legislative Risk

As with any tax planning strategy, there is a risk that Congress could change the laws governing Roth IRAs and designated Roth accounts. Some of the potential changes are:

• Subject earnings within a Roth after a specific date to income tax;
• Continue to consider qualified distributions from Roth assets as tax-free but include them for income purposes to determine Medicare premiums and applicability of other taxes (e.g., net investment income tax, 20% capital gains tax rate, etc.);
• Limit Roth conversions to pretax dollars;
• Require nonspouse inherited Roth IRA distributions to be made within five years, thus limiting the additional tax-free compounding that could occur over the beneficiary’s lifetime;
• Impose limits on the total value of assets that can accumulate in Roth vehicles; or
• Require minimum distributions from Roth IRAs.

The last four items were included in President Barack Obama’s proposed 2016 budget.⁶¹

One would hope that any legislative changes would apply prospectively, not retroactively. The fact that individuals who have been able to take advantage of Roth conversions and contributions and designated Roth accounts are likely to be more affluent and more influential with Congress may impede any changes from being applied retroactively.

Conclusion

Roth assets can be valuable as part of strategies for overall tax diversification, wealth transfer, or retirement income. While potentially valuable to some, they could be inappropriate for others, depending on their estate planning goals, the likelihood of lower tax brackets in retirement or lower tax brackets of beneficiaries compared with those of the current owners, and a lack of ability to pay the resulting income tax liability from assets outside retirement assets.

Regular Roth IRA contributions are limited to a relatively small annual dollar amount, but continued over many years, compounding of investments can be powerful. The same is true for nondeductible IRA contributions and subsequent Roth conversions. Designated Roth accounts allow taxpayers to save almost four times as much as can be contributed to a Roth IRA.

Individuals can also convert assets to Roth IRAs, choosing to pay income tax now on the converted amounts to have future growth occur in the preferential Roth environment. The different conversion methods available include converting assets from a traditional IRA to a Roth IRA, converting assets within a qualified retirement plan to a designated Roth account within the plan, and converting assets directly from a qualified retirement plan to a Roth IRA. The law has evolved over the past several years to increase taxpayers’ ability to move assets into Roth IRAs via conversion.

An individual with both an IRA and a qualified retirement plan has additional strategies available. He or she can directly roll any after-tax monies in the qualified plan to a Roth IRA to avoid the cream-in-the-coffee rule and get assets into Roth vehicles with potentially no corresponding income tax liability. If an individual has an IRA with both pretax and after-tax dollars, he or she can roll the pretax dollars into the qualified retirement plan and then convert the remaining dollars in the IRA, which, if done correctly, results in no income tax liability.

Other considerations in deciding whether to put additional assets into Roth vehicles include asset location, ripple effects due to higher taxable income, and the lower amount of credit protection afforded to contributory IRAs, compared with qualified retirement plans or segregated IRA rollover plans. The elephant in the room is the potential legislative risk. Individuals should work closely with their professional advisers, including accountants, attorneys, and financial advisers, to review the overall risks in the context of the client’s individual situation.  

Footnotes

¹Taxpayer Relief Act of 1997, P.L. 105-34.

²Sec. 408A(d)(3)(A).

³Sec. 408A(d)(1).

⁴Sec. 408A(c)(5); Regs. Sec. 1.401(k)-1(f)(4)(i).

⁵Secs. 408(b)(3) and 408(a)(6).

⁶Sec. 408A(c)(4).

⁷Secs. 408A(c)(2) and (3).

⁸Secs. 72(e)(8)(A), 72(e)(8)(B), and 72(e)(5)(D).

⁹The rule that an individual who receives a distribution from an account that contains both pretax and after-tax contributions must recognize in income a pro rata portion of each.

¹⁰Sec. 402(c)(2).

¹¹Sec. 408(d)(3)(H); Secs. 402(c)(8)(B)(iii), (iv), (v), and (vi).

¹²Regs. Sec. 1.408A-4, A-7(a).

¹³Secs. 408A(c) and 219(g)(7)(A); Notice 2015-75.

¹⁴Regs. Sec. 1.408A-6, A-14(b); Sec. 408(a)(6).

¹⁵Secs. 402(a) and 402(b)(2).

¹⁶Secs. 402A(a)(1) and 402A(d)(1).

¹⁷Regs. Sec. 1.401(k)-1(f)(1)(i).

¹⁸Sec. 402A.

¹⁹Secs. 401(a)(9)(A) and 402A.

²⁰Sec. 401(a)(9)(C).

²¹Sec. 408A(d)(3)(A).

²²Regs. Sec. 1.408A-4, A-7(a).

²³Sec. 408A(c)(3)(B)(i), before amendment by the Tax Increase Prevention and Reconciliation Act of 2005, P.L. 109-222; Regs. Sec. 1.408A-4, Q&A 2.

²⁴Sec. 401(a)(9)(A).

²⁵Sec. 501(c)(3).

²⁶Sec. 2055(a).

²⁷Sec. 402A(c)(4) and Notice 2010-84.

²⁸American Taxpayer Relief Act of 2012, P.L. 112-240.

²⁹Notice 2008-30, A-6; Notice 2009-75.

³⁰Secs. 408A(e), 402(c)(8)(B), and 457(e)(1)(B).

³¹Notice 2008-30, A-6.

³²Secs. 72 and 408(d)(2); Regs. Sec. 1.408A-4, A-7(a).

³³Sec. 219(c).

³⁴Instructions to Form 8606, Nondeductible IRAs.

³⁵Regs. Sec. 1.408A-3, A-2(b); Sec. 219(f)(3).

³⁶Because Emancipation Day, April 16, falls on a Saturday in 2016, it will be observed on April 15, thus deferring filing deadlines otherwise on that date to the following Monday, April 18, except for taxpayers residing in Massachusetts and Maine, for whom that Monday is Patriot’s Day, further deferring their deadline to April 19. See Sec. 7503 and Rev. Rul. 2015-13.

³⁷Regs. Sec. 1.408A-4, A-1(b)(1); Secs. 402(c)(3)(A) and 408(d)(3).

³⁸Secs. 72(t)(2) and 408A(d)(2).

³⁹Sec. 408A(d)(2)(B).

⁴⁰Sec. 408A(d)(4).

⁴¹Sec. 72(t); Regs. Sec. 1.408A-6, A-5(a). For more on the exceptions to the 10% penalty, see Poyzer and Yoder, “How to Avoid the 10% Additional Tax on Early Retirement Distributions,” 221-1 Journal of Accountancy 46 (January 2016).

⁴²Regs. Sec. 1.402A-1, A-4.

⁴³Sec. 408A(d)(4).

⁴⁴Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, P.L. 109-8.

⁴⁵11 U.S.C. §522(d)(12).

⁴⁶To be readjusted effective April 1, 2016. 11 U.S.C. §522(n) and 11 U.S.C. §104.

⁴⁷11 U.S.C. §522(n).

⁴⁸11 U.S.C. §522(b)(1).

⁴⁹11 U.S.C. §522(b)(3)(C) and Hamlin, 465 B.R. 863 (B.A.P. 9th Cir. 2012).

⁵⁰Gladwell v. Reinhart, No. 09-4028 (10th Cir. 4/24/12).

⁵¹Employee Retirement Income Security Act of 1974.

⁵²11 U.S.C. §§522(b)(4)(A) and (B).

⁵³Patterson v. Shumate, 504 U.S. 753 (1992), and 29 C.F.R. §§2510.3-3(b) and (c)(1).

⁵⁴Clark v. Rameker, 134 S. Ct. 2242 (2014).

⁵⁵Retirement Equity Act of 1984, P.L. 98-397.

⁵⁶Centers for Medicare & Medicaid Services, “Part B Costs,” available at www.medicare.gov.

⁵⁷Sec. 86.

⁵⁸Sec. 86(c)(2)(B).

⁵⁹Sec. 1411.

⁶⁰Secs. 1(h)(1)(D) and (3).

⁶¹Office of Management and Budget, Analytical Perspectives, Budget of the United States Government, Fiscal Year 2016.