Q&A: How a Roth IRA rollover can cause unforeseen problems

Dear Liz: I have been contributing to my young adult children’s Roth IRA accounts for the past few years to get them started on retirement savings. My oldest just left her first job to go back to graduate school. Since her income will be low this year, I advised her to roll her defined contribution plan with her former employer into her Roth IRA to consolidate her retirement savings. Will this conversion affect the maximum amount that I can contribute to her Roth beyond the usual rules on maximum contributions?

Answer: A conversion could do more than affect her ability to contribute to a Roth. It also could inflate her tax bill, reduce her eligibility for financial aid and affect any health insurance subsidies she’s receiving. A conversion could still be a smart move because Roth IRAs offer tax-free withdrawals in retirement, but she should understand all the implications before following your advice.

The amount your daughter converts from her 401(k) or other defined contribution plan would be considered a taxable distribution and treated as income. That could affect her eligibility for tax breaks, such as education tax credits and Affordable Care Act subsidies, as well as her ability to contribute to a Roth. (In 2023, the ability for an individual to contribute to a Roth phases out between modified adjusted gross incomes of $138,000 to $153,000.)

Also, to be eligible to make a contribution, she must have earned income at least equal to the amount she (or you) plan to contribute. Retirement plan distributions aren’t considered earned income so she would need wages, salary, tips, bonuses, commissions or self-employment income to qualify.

The conversion could affect her financial aid in future years. Federal aid calculations are based on tax returns from two years prior, so her 2023 tax return could affect her aid if she’s still in school during the 2025-26 academic year.

Also, she needs to figure out how she would pay the tax bill on the conversion. Converting a regular retirement account to a Roth can make sense if someone expects to be in a higher tax bracket later, but the math starts to fall apart if the retirement account itself has to be raided to pay the tax.

Your daughter should consult a tax pro who can review her situation and provide personalized advice.

Q&A: Don’t do this with your retirement funds — unless you want to pay tax

Dear Liz: I recently switched jobs and realized that I have multiple 401(k) accounts from prior employers over the years that need to be consolidated. When I reached out to my current employer’s 401(k) administrator to understand the rollover process, they said I would actually need to have a paper check mailed to me for each prior employer and then arrange to mail the checks to them. Liz, we are talking about four checks totaling a very substantial amount of money! They said there is “no other way” to process the rollovers. I cannot understand why we are still dealing with such an archaic process in this day and age. Should I be worried or should I just go ahead and take care of this now since I don’t seem to have much say in the process?

Answer: You should definitely be worried, and you also shouldn’t assume that your employer’s 401(k) administrator understands the options at other companies. Getting a check in the mail from an old plan is not only unsafe but triggers a 20% withholding requirement.

If you want to avoid taxes and penalties on the missing 20%, you’d have to come up with that money out of your own pocket. (If you didn’t deposit the check with the new plan or in an IRA, you’d owe taxes and potentially penalties on all of the money.)

When you contact the old plan’s administrators, ask if they can do a “direct rollover” to your new 401(k) account. Often, the transfer can be made electronically.

Even if the old plan uses a paper check and the U.S. mail to deliver the funds, you can avoid the 20% withholding requirement if the check is made out to your new account rather than to you.

Q&A: Here’s a retirement tax trick: the mega backdoor Roth IRA

Dear Liz: I am a 32-year-old married father of two. My income is high enough to contribute to my kids’ 529 and custodial brokerage accounts. I’ve been able to max out my 401(k), health savings account and backdoor Roths for my spouse and myself. Next, I’m debating between starting a life insurance retirement plan (LIRP) or making after-tax 401(k) contributions because my plan allows mega backdoor Roth conversions. What are your thoughts on LIRP versus mega backdoor Roth?

Answer: Mega backdoor Roths are such a sweet deal for higher-income workers that you probably should take advantage if you want to put aside more tax-advantaged money for retirement.

For those who are unfamiliar: Roth IRAs allow tax-free withdrawals in retirement, but only people with incomes under certain limits can contribute directly to a Roth. The ability to contribute phases out for married couples filing jointly with modified adjusted gross incomes of $204,000 to $214,000.

There’s no income limit on conversions, however, so people with higher incomes can contribute to a traditional IRA and then convert the contribution to a Roth IRA in what’s known as a backdoor Roth. Conversions typically trigger income taxes on any pretax contributions or earnings, so this tactic works best if the person doesn’t have a large existing IRA.

The mega backdoor Roth takes this strategy to a new level.

Some employer 401(k) plans allow participants to make after-tax contributions that can then be converted to a Roth. The amounts that can be contributed and converted are substantial. Although the pretax limit for contributions is $20,500 for workers under 50 in 2022, the total amount that can be contributed by employees and employers to a 401(k) is $61,000.

The amount you can put in after tax would be reduced by any company match you get. Assuming there’s no match, you could contribute $20,500 to the pretax plan and an additional $40,500 to the after-tax plan this year.

A mega backdoor Roth would allow you to build up a substantial fund of tax-free retirement money without the costs and other potential disadvantages of a LIRP, which requires you to buy a permanent life insurance policy. With a LIRP, you would use the cash value of the policy to hold investments that you could access tax free through withdrawals or loans.

LIRPs can make sense if you otherwise need permanent life insurance, but many people need only term insurance, which is much less expensive.

If you’re still interested in a LIRP, consult with a fee-only, fiduciary financial advisor first to ensure you understand how these work and determine if they’re a good solution for you.

Q&A: How your health insurance costs could rise because of a Roth IRA conversion

Dear Liz: With the recent stock market correction, I am considering doing a Roth conversion on an existing IRA now that it is worth less. I can handle the accompanying income tax hit. But while I see plenty of ink spilled on how a Roth conversion can increase Medicare premiums, what about Affordable Care Act costs? Is it the same story there: Will a one-time income spike this year due to Roth conversion impact what I pay all next year for ACA health insurance?

Answer: Potentially, yes. Roth conversions count as income for Affordable Care Act subsidies, so a large enough transaction could increase the premiums you pay.

A conversion allows you to transfer money from a regular IRA or 401(k), which would be taxable in retirement, to a Roth IRA, which would be tax free. If you expect to be in a higher tax bracket in retirement, conversions can make sense — you’re paying income taxes at the lower rate now, rather than the higher rate later. But obviously higher health insurance premiums would offset some of that benefit.

A tax pro can help you model conversions of different sizes to see the effects on all your finances, not just your tax bill. It’s possible that a partial conversion could help you take advantage of the current downturn without dramatically increasing your health insurance costs.

Q&A: Inherited IRA taxes

Dear Liz: I have about $16,000 in a Roth IRA that I plan to leave to my daughter. When she collects this on my death, does she pay tax on the withdrawals?

Answer: No. She would have to pay taxes on withdrawals if the money were in a regular inherited IRA, but not if the money is in a Roth. She will be required to withdraw the money within 10 years, though. Congress eliminated the so-called “stretch IRA” for most inheritors, so non-spouse beneficiaries can no longer stretch withdrawals over their own lifetimes.

Q&A: IRS changes on required withdrawals

Dear Liz: When informing me of my required minimum distribution for 2022, my brokerage has apparently used a distribution period that differs from the one used in past years. This results in a distribution amount that’s noticeably smaller. I recall there was some talk of revising the IRS tables, but has this been done?

Answer: Yes. The IRS has updated the life expectancy tables used to calculate how much people must withdraw from their retirement accounts to reflect longer lifespans. That’s good news for people who withdraw only the minimums each year, since their required distributions will be smaller and the rest of their balances can continue to grow tax deferred.

Q&A: How contribution rules differ for IRA and 401(k) accounts

Dear Liz: I recently changed jobs. Typically I max out my 401(k) contributions each year. I contributed $20,700 to my previous company’s plan before quitting. Eligibility for my new company’s 401(k) doesn’t kick in until after 12 months of continuous employment, so I won’t be able to access this benefit until 2023. Can I set up an IRA or Roth IRA to reach the $27,500 limit for people 50 and older? I am married, filing jointly and our combined income exceeds $214,000.

Answer: Please talk to your company about fixing this outmoded requirement, which is costing its workers enormously in lost matching funds and compounded returns. Most companies have much shorter waiting periods, and the most enlightened employers enroll workers immediately. It’s hard enough to save adequately for retirement without an arbitrary yearlong delay.

The limits for contributing to workplace plans are separate from those for IRAs and Roth IRAs. For 2022, the limits for 401(k)s are $20,500 for people under 50 and $27,500 for people 50 and older. The contribution limits for IRAs (regular or Roth) are $6,000 for people under 50 and $7,000 for people 50 and older.

If you had access to a workplace plan at any point during the year, your ability to deduct your contribution would phase out with modified adjusted gross income between $109,000 and $129,000 if you are married filing jointly, said Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting. The phaseout is between $68,000 and $78,000 for single taxpayers.

Normally when you can’t deduct an IRA contribution, you’re better off contributing to a Roth IRA. Contributions to a Roth aren’t deductible but withdrawals are tax-free in retirement.

However, the ability to contribute to a Roth IRA phases out with modified adjusted gross incomes between $204,000 and $214,000 for married joint filers and between $129,000 and $144,000 for single filers.

If you can’t contribute directly to a Roth, you could consider what’s called a “back door” Roth contribution, in which you contribute to a regular IRA and then convert the money to a Roth. Although direct Roth contributions have income limits, Roth conversions do not. However, you are required to pay income taxes on a typical conversion, so this maneuver works best if you don’t already have a large pretax IRA.

Q&A: How to start an IRA for your new Gen Z college graduate

Dear Liz: My son is about to graduate from college and, as a present, I want to use $10,000 to start an IRA for him. But which is better? A Roth or a standard IRA?

Answer: Congratulations to both of you! Starting a retirement account is a great idea, but you should be aware of the numerous rules that limit who can contribute and how much.

Let’s start with the annual contribution limit, which for 2022 is $6,000 for people under 50. (People 50 and older can make an additional $1,000 “catch up” contribution.) Also, your son needs to have earned income — such as wages, salary or self-employment income — that is at least equal to the size of the contribution you want to make. In other words, he needs to earn $6,000 for you to contribute $6,000. If he’s about to start a full-time job, that probably won’t be an issue, but if he’s not working, or working only part time before starting graduate school, that might further limit how much you can contribute.

For all of those reasons, a Roth IRA contribution may be best. He won’t get an upfront tax deduction but withdrawals in retirement will be tax free. He can withdraw Roth contributions at any time without taxes or penalties, so the Roth can serve as a de facto emergency fund. Obviously, it’s better to leave the money alone to grow, but having access to the cash could be helpful while he builds a regular emergency fund.

Q&A: Leaving IRAs to charity

Dear Liz: In responding to the reader who asked how to plan around the tax consequences of leaving a traditional IRA to a family member, I wish you had mentioned the tax benefit of naming a charity as the beneficiary of a traditional IRA. There is no tax on the distribution of a traditional IRA to a charity. The consequence is that the income is never taxed (on the front end or back end) and a charity benefits from the IRA owner’s generosity.

The reader was primarily concerned with bequeathing assets to children and grandchildren after the Secure Act of 2019 did away with “stretch IRAs” for most non-spouse beneficiaries. One way to do that while also benefiting a charity is the charitable remainder trust that was mentioned in the column. These trusts require some expense to set up and aren’t a good option if the IRA owner isn’t charitably minded.

If someone’s primary goal is to benefit the charity, however, then qualified charitable distributions or outright bequests are certainly an option. Qualified charitable distributions, which can begin at age 70½, allow someone to donate required minimum distribution amounts directly to a charity; the distribution isn’t counted as taxable income to the donor.

Q&A: Retirement account distribution rules

Dear Liz: My husband is 71 and retired. We have started withdrawing from one of his retirement funds but I am unsure if there is a minimum amount that needs to be withdrawn per year. We have a few retirement funds in different places. Do we have to withdraw from each or just a minimum per year no matter where?

Answer: Required minimum distributions from most retirement accounts typically must begin when someone turns 72. The withdrawals must be made by Dec. 31 each year, but your first one can be delayed until April 1. If your husband turns 72 next year, for example, then the first withdrawal wouldn’t be due until April 1, 2024. Your husband would need to take a second distribution by Dec. 31, 2024.

Required minimum distributions are calculated using the tables in IRS Publication 590-B, Distributions From Individual Retirement Arrangements (IRAs). IRA owners have to calculate the minimum withdrawal separately for each IRA they own, but they’re allowed to draw the total amount from one or more of the IRAs. People who have 403(b) accounts are also allowed to take the total amount from one or more 403(b) contracts after calculating the amount separately for each one.

The rules are different for other types of retirement plans. People who have 401(k) and 457(b) plans must calculate and take minimum withdrawals separately from each of those plan accounts. No distributions are required for Roth IRAs during the owner’s lifetime.

Your brokerage typically can help you calculate required minimum distributions, or you can talk to a tax pro. A tax pro or fee-only financial planner also could help you decide if it makes sense to consolidate your accounts. At your stage of life, you probably could benefit from simplifying your finances and having fewer accounts to monitor.