This is the first in a two-part series on Roth IRAs. This first part will look at the basics of Roth IRAs. The second part will look at more advanced planning strategies.
An Individual Retirement Account (IRA) is a savings vehicle in which a deduction may be taken upon contribution (with limitations). The maximum contribution in 2021 is $6,000, and those age 50 and over may contribute an additional $1,000. While the assets are in the IRA, the income is not taxable. However, when distributions are taken in retirement, those distributions are included in taxable income.
A Roth IRA is almost the reverse of a traditional IRA. A taxpayer contributing to a Roth IRA does not get a deduction for the contribution. The earnings grow tax-free. And when the distributions come out, they are generally not taxable.
A taxpayer only qualifies to contribute to a Roth IRA if their taxable income is within certain limits. Married taxpayers filing a joint return may contribute the full amount if their income is below $198,000 in 2021. There is a phaseout and then the taxpayer cannot contribute anything if their income is $208,000 or higher. For an unmarried taxpayer, they may make a full Roth IRA contribution if their income is below $125,000 in 2021. There is a phaseout up to $140,000 and then no contribution is allowed.
While eligibility to contribute to a Roth IRA depends upon the taxpayer’s taxable income, anyone may convert their IRA to a Roth IRA. When they do a conversion, the amount of the traditional IRA is income taxable.
Let’s look at a quick example: John normally has income of $300,000 per year. He was furloughed until 2022 due to the pandemic. He has no income in 2021. He has a traditional IRA of $50,000. He could convert his traditional IRA to a Roth IRA and would pay tax at relatively low rates since his income is lower in 2021.
If a taxpayer doesn’t qualify to contribute to a Roth IRA, they may be able to contribute to a traditional IRA (deductible or nondeductible) and then convert that IRA to a Roth IRA.
One of the key factors in converting (or contributing) to a Roth IRA is whether the tax rate at the time of conversion (or contribution) will be lower than the expected tax rate at the time of distribution.
The next article in the series will examine other planning strategies with Roth IRAs.
Stephen C. Hartnett, J.D., LL.M.
Director of Education
American Academy of Estate Planning Attorneys, Inc.
9444 Balboa Avenue, Suite 300
San Diego, California 92123
Phone: (858) 453-2128