Roth To The Rescue

The Roth IRA turns 10 years old in 2008, and chances are that some of your clients are among the 17 million Roth IRA owners who would happily celebrate if a birthday party of sorts were thrown. But you probably have an equal number of clients who either wouldn't care, or wouldn't know about the anniversary. Maybe they earn too much to contribute to a Roth IRA account, or are simply unaware of how valuable the vehicles can be during their Golden Years — particularly every April 15.

That's a shame, because a Roth IRA can substantially reduce a retiree's tax bill. Here are three reasons your clients nearing retirement will thank you later if you encourage them to put money into their Roth IRAs right now:

1. MANIPULATING THE TAX CODE

   Sure, you and most of your clients recognize and appreciate the fact that after age 59 ½ distributions from Roth IRA accounts are typically tax-free. But because of the progressive nature of the tax code, that lack of taxation can provide a “1 + 1 = 3” benefit.

   Say your clients are a 65-year-old couple, with the $1,000,000 they hold in IRAs as their only source of income. All other factors being equal, if they decide to withdraw $100,000 a year from those accounts, their federal income tax bill will reach about $13,000, according to the “Tax Estimator” at www.hrblock.com.

   But if their million-dollar nest egg is instead made up of $800,000 in IRAs, and $200,000 in Roth IRAs, and the clients pull $80,000 from the former and $20,000 from the latter, their federal income tax liability for that year will be less than $8,300.

   Withdrawing from both an IRA and a Roth IRA, then, cuts their tax bill to just over 8 percent of their income from 13 percent. Basically, their ability to tap a Roth IRA saves them $5,000 in federal taxes in just one year — almost enough to pay the cable bill.

2. “WAIT, SOCIAL SECURITY IS TAXABLE?”

   Technically, no. That is, unless your clients who are collecting these checks have “combined income” of more than $25,000 for single filers, or $32,000 for married people filing jointly. The formula for calculating combined income is to take adjusted gross income, plus one-half of Social Security benefits, and then add in any non-taxable interest income.

   So whether it's capital gains, pension checks, IRA withdrawals or even interest from tax-free bonds (!), almost every source of retirement income can make Social Security payments taxable — and at the client's highest marginal rate.

   The nice thing is that distributions from Roth IRAs aren't counted in the “combined income” formula. So a retired couple could get $68,035 in after-tax income by collecting $25,000 in Social Security benefits, withdrawing $25,000 from the IRAs and just $19,000 from Roth IRAs. The federal tax bill in this case would be a measly $800 or so.

   That same couple, sans Roth IRAs, would have to take another $6,000 from their IRAs to get the same net of $68,035 — and would incur a federal income tax bill of about $7,000.

3. WHY 70½ IS AN UNHAPPY BIRTHDAY

   As your older clients are painfully aware, the IRS mandates (with language that could only be created by a government entity) that withdrawals from IRAs commence by April 1 of the year after the IRA owner turns 70 and “a half.”

   The goal, of course, is for Uncle Sam to start collecting taxes on the long-sheltered gains that have hopefully accumulated in the accounts.

   But according to a recently-released survey conducted by the Investment Company Institute, 70 percent of IRA owners don't anticipate withdrawing money from the accounts until the IRS forces them to. Roth IRAs ride to the rescue of those who would just as soon delay or avoid paying taxes on those swollen retirement accounts.

   First, there is no mandatory withdrawal age for money held in Roth IRAs; the accounts can multiply unencumbered by taxation as long as the owner lives and breathes. More importantly, moving money from IRAs to Roth IRAs now can lower the amount that is required to be withdrawn from the IRA (and taxed) each year after the client turns 70 ½.

   Say you have a 60-year-old couple with $1,000,000 in IRAs. If left alone, and assuming your financial genius can earn them a 7-percent return annually, when it's time to begin the RMDs, the value of the IRAs will have nearly doubled to about $2,000,000. That amount could require the clients to withdraw about $73,000, which, if taken today, could put the clients squarely in the 25-percent federal tax bracket.

   By the time they hit their eighties, the RMD alone could be taxed at the top rate. But if the clients use the next 10 years to move, say, half the money out of their IRAs and into Roth IRAs, their RMD on the remaining amount would likely be taxed at the lowest rate at the outset, and remain in the lower brackets for as long as the clients, uh, remain.

   Next month we'll discuss strategies you can use to help clients get money into Roth IRAs, regardless of whether their current income exceeds the eligibility limits. But in the meantime, the best way to mark the 10th birthday of the Roth IRA is to get eligible clients to make deposits to the accounts before April 15.

Writer's BIO: Kevin McKinley
CFP© is Principal/Owner of McKinley Money LLC, an independent registered investment advisor. He is also the author of the book Make Your Kid a Millionaire (Simon & Schuster), and provides speaking and consulting services on family financial planning topics. You can reach him at [email protected]

ROTH IRA SAVES ON TAX DAY

Withdrawing income from an IRA and a Roth IRA can save your clients a lot of money in taxes.