Tax Strategies for Individuals
You may withdraw money from a Roth IRA at any time; however, taxes and penalty could apply depending on the timing of contributions and withdrawals.
Qualified Distributions
Since all your investments in a Roth IRA are after-tax, your withdrawals, whenever you make them, are often tax-free. But the best kind of withdrawal, which allows earnings, as well as contributions and conversion, amounts to come out completely tax-free, are qualified distributions. These are withdrawals meeting the following conditions:
1. At least, five years have elapsed since the first year a Roth IRA contribution was made or, in the case of a conversion since the conversion occurred and
2. At least one of these additional conditions is met:
- The owner is age 59 1/2.
- The owner is disabled.
- The owner has died (distribution is to estate or heir).
- Withdrawal is for a first-time home that you build, rebuild, or buy (lifetime limit up to $10,000).
A distribution used to buy, build or rebuild a first home must be used to pay qualified costs for the main home of a first-time home buyer who is either yourself, your spouse or you or your spouse’s child, grandchild, parent or another ancestor.
Non-Qualified Distributions
To discourage the use of pension funds for purposes other than normal retirement, the law imposes an additional 10 percent tax on certain early distributions from Roth IRAs unless an exception applies. Generally, early distributions are those you receive from an IRA before reaching age 59 1/2.
Exceptions. You may not have to pay the 10 percent additional tax in the following situations:
- You are disabled.
- You are the beneficiary of a deceased IRA owner.
- You use the distribution to pay certain qualified first-time homebuyer amounts.
- The distributions are part of a series of substantially equal payments.
- You have significant unreimbursed medical expenses.
- You are paying medical insurance premiums after losing your job.
- The distributions are not more than your qualified higher education expenses.
- The distribution is due to an IRS levy of the qualified plan.
- The distribution is a qualified reservist distribution.
Part of any distribution that is not a qualified distribution may be taxable as ordinary income and subject to the additional 10 percent tax on early distributions. Distributions of conversion contributions within a 5-year period following a conversion may be subject to the 10 percent early distribution tax, even if the contributions have been included as income in an earlier year.
Ordering Rules for Distributions
If you receive a distribution from your Roth IRA, that is not a qualified distribution, part of it may be taxable. There is a set order in which contributions (including conversion contributions) and earnings are considered to be distributed from your Roth IRA. Order the distributions as follows.
- Regular contributions.
- Conversion contributions, on a first-in-first-out basis (generally, total conversions from the earliest year first). See Aggregation (grouping and adding) rules, later. Take these conversion contributions into account as follows:
- Taxable portion (the amount required to be included in gross income because of conversion) first, and then the
- Nontaxable portion.
- Earnings on contributions.
Disregard rollover contributions from other Roth IRAs for this purpose.
Aggregation (grouping and adding) rules.
Determine the taxable amounts distributed (withdrawn), distributions, and contributions by grouping and adding them together as follows.
- Add all distributions from all your Roth IRAs during the year together.
- Add all regular contributions made for the year (including contributions made after the close of the year, but before the due date of your return) together. Add this total to the total undistributed regular contributions made in prior years.
- Add all conversion and rollover contributions made during the year together.
For years prior to 2018, add any recharacterized contributions that end up in a Roth IRA to the appropriate contribution group for the year that the original contribution would have been taken into account if it had been made directly to the Roth IRA. Disregard any recharacterized contribution that ends up in an IRA other than a Roth IRA for the purpose of grouping (aggregating) both contributions and distributions. Also, disregard any amount withdrawn to correct an excess contribution (including the earnings withdrawn) for this purpose.
On October 15, 2016, Justin converted all $80,000 in his traditional IRA to his Roth IRA. His Forms 8606 from prior years show that $20,000 of the amount converted is his basis. Justin included $60,000 ($80,000 – $20,000) in his gross income. On February 23, 2017, Justin makes a regular contribution of $4,000 to a Roth IRA. On November 7, 2023, at age 65 Justin takes a $7,000 distribution from his Roth IRA.
- The first $4,000 of the distribution is a return of Justin’s regular contribution and is not includible in his income.
- The next $3,000 of the distribution is not includible in income because it was included previously.
Distributions after Owner’s Death
Qualified distributions after the owner’s death are tax-free to heirs. Nonqualified distributions after death, which are distributions where the 5-year holding period wasn’t met, are taxable income to heirs as they would be to the owner (the earnings are taxed), except there’s no penalty tax on early withdrawal. However, an owner’s surviving spouse can convert an inherited Roth IRA into his or her own Roth IRA. This way, distribution can be postponed, so that nonqualified amounts can become qualified, and the tax shelter prolonged.
Roth IRA assets left at death are subject to federal estate tax, just as traditional IRA assets are.
Converting from a Traditional IRA or Other Eligible Retirement Plan to a Roth IRA
The conversion of your traditional IRA to a Roth IRA was the feature that caused most excitement about Roth IRAs. Conversion means that what would be a taxable traditional IRA distribution can be made into a tax-exempt Roth IRA distribution. Starting in 2008, further conversion or rollover opportunities from other eligible retirement plans were made available to taxpayers.
Conversion Methods
You can convert a traditional IRA to a Roth IRA. The conversion is treated as a rollover, regardless of the conversion method used.
You can convert amounts from a traditional IRA to a Roth IRA in any of the following three ways.
- Rollover. You can receive a distribution from a traditional IRA and roll it over (contribute it) to a Roth IRA within 60 days after the distribution.
- Trustee-to-trustee transfer. You can direct the trustee of the traditional IRA to transfer an amount from the traditional IRA to the trustee of the Roth IRA.
- Same trustee transfer. If the trustee of the traditional IRA also maintains the Roth IRA, you can direct the trustee to transfer an amount from the traditional IRA to the Roth IRA.
Conversions made with the same trustee can be made by redesignating the traditional IRA as a Roth IRA, rather than opening a new account or issuing a new contract.
Prior to 2008, you could only roll over (convert) amounts from either a traditional, SEP, or SIMPLE IRA into a Roth IRA. You can now roll over amounts from the following plans into a Roth IRA.
- A qualified pension, profit-sharing or stock bonus plan (including a 401(k) plan),
- An annuity plan,
- A tax-sheltered annuity plan (section 403(b) plan),
- A deferred compensation plan of a state or local government (section 457 plan), or
- An IRA.
Any amount rolled over is subject to the same rules for converting a traditional IRA to a Roth IRA. Also, the rollover contribution must meet the rollover requirements that apply to the specific type of retirement plan.
There is a cost to the rollover. The amount converted is fully taxable in the year converted, except for the portion of after-tax investment in the traditional IRA. So you must pay tax now (though there’s no early withdrawal penalty) for the opportunity to withdraw tax-free later, an opportunity that can extend to your heirs.
How Withdrawals Are Treated
The Basics
Rollovers are transfers of funds from one plan to another (from one company or Keogh plan to another, from a company or Keogh to an IRA, or from one IRA to another, or from an IRA to a company or Keogh plan.
Rollovers are usually distributions from a company or Keogh plan that are put into an IRA. You might do this (1) to transfer control of the funds from your employer to yourself or (2) because your employer forces the distribution when you leave so as to close its books on your plan participation. In your own Keogh plan, you might make the rollover as part of a decision to terminate your plan or your business.
A rollover to your own IRA can give you flexibility in dealing with the funds (for example, so you can invest in options or create a separate IRA for each beneficiary) that would not be available for funds left in your employer’s plan. Rollovers can be of the entire retirement account or only part of the account.
Rollovers can be made from one IRA to another. Apart from Roth IRA situations, these are usually done to expand investment options or to create several IRA accounts. Rollovers also can be made from one pension, profit-sharing or 401(k) plan to another or between types of plan. This might happen if you change jobs or set up a new Keogh plan because of starting a new business after you retire.
Rollovers from company or Keogh plans preserve the retirement plan tax shelter while postponing retirement distributions, thereby often prolonging the tax-free buildup of retirement funds. They have other consequences, some undesirable:
Federal law grants a person no rights in his or her spouse’s IRA. Thus, a plan participant’s rollover will strip the participant’s spouse of rights the spouse had under the plan from which the assets are being removed. In the case of a pension plan, the spouse has a measure of protection because the spouse must approve the transfer that will forfeit his or her rights. However, no such approval is required in the case of 401(k)s or profit-sharing plans. Thus, a rollover from such plans can eliminate spousal rights. (Employers sometimes provide spousal rights that federal law does not require.)
A rollover will eliminate the chance of lump sum tax relief, unless the IRA was just a conduit for the movement of funds between retirement plans.
In some cases, a rollover from an IRA to a retirement plan can extend the tax shelter period. IRA distributions must begin at age 72, but distributions from a retirement plan can be postponed beyond that until the participant retires, unless he or she is an owner of the business.
A rollover from an IRA to a retirement plan could also get greater creditor protection than if left in an IRA.
Tax Planning
Rollovers are tax-free when properly handled, but consider these qualifications and exceptions:
- After-tax investments can be rolled over from a company or Keogh plan to an IRA and, in some cases, to defined contribution plans, but not to defined benefit plans.
- You can’t roll over amounts you’re required to withdraw after reaching age 72 or amounts you’re due to receive under a fixed annuity.
If you do the rollover yourself-personally withdrawing funds from one plan and moving them to another-the plan you’re withdrawing from must withhold tax at a 20 percent rate on the withdrawal. To avoid tax on the 20 percent withheld, you’ll have to come up with that amount from elsewhere and add it to the rollover IRA. (The tax withheld can be taken as a credit against the year’s tax liability.) On the other hand, a direct rollover (having the funds transferred directly from the transferring plan to the receiving plan) avoids withholding.
If you do the rollover yourself, the withdrawn funds are taxable if they don’t reach the rollover destination within the deadline (generally, 60 days). Therefore, the least risky way to roll over funds is a direct rollover.
Where the plan holds specific assets for your account, a rollover may (1) transfer the specific asset or (2) sell it and transfer the cash.
The rollover is not tax-free if cash is withdrawn, used to buy investment assets, and the new assets are then transferred to the new plan.
Undoing a Conversion to a Roth IRA
The information in this section only applies to taxable years beginning after December 31, 2017.
Under tax reform (Tax Cuts and Jobs Act of 2017), if a contribution to a regular IRA has been converted into a contribution to a Roth IRA, it can no longer be converted back into a contribution to a regular IRA. This provision prevents a taxpayer from using recharacterization to unwind a Roth conversion.
Since everyone recognizes that conversion is a high-risk exercise, the law, and liberal IRS rules provide an escape hatch: You can undo a Roth IRA conversion by what IRS calls a “recharacterization.” This move, by which you move your conversion assets from a Roth IRA back to a traditional IRA, makes what would have been a taxable conversion into a tax-free rollover between traditional IRAs. Re-characterization can be done any time until the due date for the return for the year of conversion.
If your assets are worth $180,000 at conversion and fall to $140,000 later, you’re taxed on up to $180,000, which is $40,000 more than you now have. Undoing-re-characterization-avoids the tax, and gets you out of the Roth IRA.
One reason to do this, dramatized by a volatile stock market, is where the value of your portfolio drops sharply after the conversion.
Can you undo one Roth IRA conversion and then make another one a reconversion? Yes, but only one time and subject to the following requirements: Reconversion must take place in the tax year following the original conversion to Roth IRA, and the reconversion date must also be more than 30 days after the previous recharacterization transfer from the Roth IRA back to the traditional IRA.
Withdrawal Requirements
You are not required to take distributions from your Roth IRA once you reach a particular age. The minimum distribution rules that apply to traditional IRAs do not apply to Roth IRAs while the owner is alive. However, after the death of a Roth IRA owner, certain of the minimum distribution rules that apply to traditional IRAs also apply to Roth IRAs
Also, unlike traditional IRAs (but like other tax-favored retirement plans), a Roth IRA owner who continues working may continue to contribute to the Roth IRA.
Retirement Savings Contributions Credit (Saver’s Credit)
Also known as the saver’s credit, this credit helps low and moderate-income workers save for retirement. Taxpayers age 18 and over who are not full-time students and can’t be claimed as dependents, are allowed a tax credit for their contributions to a workplace retirement plan, traditional or Roth IRA if their modified adjusted gross income (MAGI) in 2023 for a married filer is below $73,000. For heads-of-household MAGI is below $54,750 and for others (single, married filing separately) it is below $36,500.
These amounts are indexed for inflation each year. The credit, up to $1,000, is a percentage from 10 to 50 percent of each dollar placed into a qualified retirement plan up to the first $2,000 ($4,000 married filing jointly). The lower the MAGI is, the higher the credit percentage, resulting in the maximum credit of $1,000 (50 percent of $2,000). Both you and your spouse may be eligible to receive this credit if you both contributed to a qualified retirement plan and meet the adjusted gross income limits.
The saver’s credit is available in addition to any other tax savings that apply. Further, IRA contributions can be made until the April 15 tax return due date of the following year and still be considered in the current tax year.
Use in Estate Planning
Though Roth IRAs enjoy no estate tax relief, they are already figuring in estate plans. The aim is to build a large Roth IRA fund largely through conversion of traditional IRAs-to pass to beneficiaries in later generations. The beneficiaries will be tax exempt on withdrawals (of qualified distributions) and the Roth IRA tax shelter continues by spreading withdrawal over their lifetimes.
Long-term planning with Roth IRAs. If you would be allowed a deduction for a contribution to a traditional IRA, contributing to a Roth IRA means surrendering current tax reduction for future tax reduction (to zero) for qualified distributions. This can be presented as an after-tax return-on-investment calculation involving assumed future tax rates. The higher the projected tax rate at withdrawal, the more tax Roth IRA saves.
Comparable considerations apply to conversions to Roth IRAs. Here the taxpayer incurs substantial current tax cost (directly or indirectly reducing the amount invested) for future tax relief to the taxpayer or an heir. So the return on investment resulting from conversion increases as projected future rates rise.
A key element in making such projections is the possibility that current and future federal deficits will lead to future tax rate increases a factor which would tend to encourage current Roth IRA investment and conversion. On the other hand, there’s the question whether Roth IRA benefits currently promised will survive into future decades.
Highly sophisticated planning is required for Roth IRA conversions. Consultation with a qualified advisor is a must. Please call if you have any questions.
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