Ask Liz Weston

Get smart with your money

Roth IRA

Don’t rush to pay taxes

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Dear Liz: I am a CPA and fairly knowledgeable about investing, but I have a question about my IRAs. I am 58 and my husband is in his mid-80s. We both are retired with federal pensions and no debt other than a mortgage. My plan is to start taking money annually from my traditional IRA in two or three years. I want to reduce the required minimum distribution I will need to start taking at age 701/2 and lessen the tax impact at that time. Should I put these annual withdrawals in my regular investment account or should I put them in the Roth IRA? My goal is to lessen the tax impact on my only child when he ultimately inherits this money. Does my plan make sense?

Answer: Your letter is proof that our tax code is too complex if it can stymie even a CPA. Still, it’s hard to imagine any scenario where you’d be better off accelerating withdrawals from an IRA and putting them in a taxable account.

A required minimum distribution “is merely a requirement to take the money out anyway,” said Certified Financial Planner Michael Kitces, an expert in taxation. “All you’re doing by taking money out early to ‘avoid’ an RMD [required minimum distribution] is voluntarily inflicting an even more severe and earlier RMD on yourself.”

In other words, you’d be giving up future tax-advantaged growth of your money for no good reason.

What might make sense, in some circumstances, is moving the money to a Roth. You can’t make contributions to a Roth if you’re not working, because Roths require contributions be made from “earned income.” What you can do is convert your traditional IRA to a Roth, either all at once or over time. You have to pay taxes on amounts you convert, but then the money can grow tax-free inside the Roth and doesn’t have to be withdrawn again during your lifetime, since Roths don’t have required minimum distributions. Whether you should convert depends on a number of factors, including your current and future tax rates and those of your child.

“In other words, if your tax rate is 25% and your child’s is 15%, just let them inherit the [traditional IRA] account and pay the lower tax burden,” said Kitces, who has blogged about the Roth vs. traditional IRA decision at http://www.kitces.com. “In reverse, though, if the parents’ tax rate is lower … then yes, it’s absolutely better to convert at the parents’ rates than the child’s. In either scenario, the fundamental goal remains the same — get the money out when the tax rate is lowest.”

If you do decide to convert, remember that the conversion itself could put you in a higher tax bracket.

“It will be important not to convert so much that it drives up the tax rate to the point where it defeats the value in the first place,” Kitces said. “Which means the optimal strategy, if it’s to convert anything at all, will be to do partial Roth conversions to fill lower tax brackets but avoid being pushed into the upper ones.”

Are Roths safer than other IRAs?

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Dear Liz: I found your recent discussion of Roth IRAs informative. But I’ve been told that one of the main advantages of a Roth vs. a traditional IRA is that a Roth is a safer investment when it comes to creditors trying to attack it. How can that be? Is one type of IRA safer than another?

Answer: The short answer is no.

Employer-sponsored retirement plans, including 401(k)s and 403(b)s, typically have unlimited protection from creditors in Bankruptcy Court. The exceptions: The IRS and former spouses can make claims on such plans.

Individual retirement accounts, including IRAs and Roth IRAs, lack the protection afforded by the Employee Retirement Income Security Act, or ERISA. But the bankruptcy reform law that went into effect in 2005 protects IRAs of all kinds up to a certain limit (which in April rose to $1,245,475).

Short of bankruptcy, the amount of your IRAs or Roth IRAs that creditors can access depends on state law.

If there’s any chance you’ll be filing for bankruptcy or the target of a creditor lawsuit, you should talk to an experienced bankruptcy attorney about your options.

Is a Roth worth losing a tax deduction?

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Dear Liz: Everyone talks about Roth IRAs and how beneficial they are. But I am self-employed, my husband contributes 16% toward his 401(k), our house is paid off, and we no longer have dependents to deduct on our 1040 tax return. My contribution to my traditional IRA is the only tax deduction we have left. Should I consider a Roth anyway? If so, why?

Answer: A Roth would give you a tax-free bucket of money to spend in retirement. That would give you more flexibility to manage your tax bill than if all your money were in 401(k)s and traditional IRAs, where your withdrawals typically are taxable. Also, there are no minimum distribution requirements for a Roth. If you don’t need the money, you can pass it on to your heirs. Other retirement funds require you to start taking money out after you turn 701/2. If you need to crack into your nest egg early, on the other hand, you’ll face no penalties or taxes when you withdraw amounts equal to your original contributions.

So is it worth giving up your IRA tax deduction now to get those benefits? If you have a ton of money saved, you want to leave a legacy for your kids and you’re likely to be in the same or a higher tax bracket in retirement, the answer may be yes. If you’re like most people, though, your tax bracket will drop once you retire. That means you’d be giving up a valuable tax break now for a tax benefit that may be worth less in the future.

You may not have to make a choice, however, between tax breaks now and tax breaks later if you have more than $5,500 (the current annual IRA limit) to contribute. Since you’re self-employed, you may be able to put up to $51,000 in a tax-deductible Simplified Employee Pension or SEP-IRA. At the same time, you could contribute up to $5,500 to a Roth (assuming your income as a married couple is within or below the phase-out range for 2013 of $178,000 to $188,000).

This would be a great issue to discuss with a tax pro.

Using a Roth for college: hazards and benefits

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Dear Liz: My husband and I have been putting 5% and 6%, respectively, into our 401(k) accounts to get our full company matches. We’re also maxing out our Roth IRAs.

The CPA who does our taxes recommended that we put more money into our 401(k)s even if that would mean putting less into our Roth IRAs. We’re also expecting our first child, and our CPA said he doesn’t like 529 plans.

What’s your opinion on us increasing our 401(k)s by the amount we’d intended to put into a 529, while still maxing out our Roths, and then using our Roth contributions (not earnings) to pay for our child’s college (assuming he goes on to higher education)?

Our CPA liked that idea, but I can’t find anything online that says anyone else is doing things this way. I can’t help but wonder if there’s a catch.

Answer: Other people are indeed doing this, and there’s a big catch: You’d be using money for college that may do you a lot more good in retirement.

Contributions to Roth IRAs are, as you know, not tax deductible, but you can withdraw your contributions at any time without paying taxes or penalties. In retirement, your gains can be withdrawn tax free. Having money in tax-free as well as taxable and tax-deferred accounts gives you greater ability to control your tax bill in retirement.

Also, unlike other retirement accounts, you’re not required to start distributions after age 70 1/2. If you don’t need the money, you can continue to let it grow tax free and leave the whole thing to your heirs, if you want.

That’s a lot of flexibility to give up, and sucking out your contributions early will stunt how much more the accounts can grow.

You’d also miss out on the chance to let future returns help increase your college fund.

Let’s say you contribute $11,000 a year to your Roths ($5,500 each, the current limit). If you withdraw all your contributions after 18 years, you’d have $198,000 (any investment gains would stay in the account to avoid early-withdrawal fees).

Impressive, yes, but if you’d invested that money instead in a 529 and got 6% average annual returns, you could have $339,000. At 8%, the total is $411,000. That may be far more than you need — or it may not be, if you have more than one child or want to help with graduate school. With elite colleges costing $60,000 a year now and likely much more in the future, you may want all the growth you can get.

You didn’t say why your CPA doesn’t like 529s, but they’re a pretty good way for most families to save for college. Withdrawals are tax free when used for higher education and there is a huge array of plans to choose from, since every state except Wyoming offers at least one of these programs and most have multiple investment options.

Clearly, this is complicated, and you probably should run it past a certified financial planner or a CPA who has the personal financial specialist designation. Your CPA may be a great guy, but unless he’s had training in financial planning, he may not be a great choice for comprehensive financial advice.

IRA distribution could go into Roth

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Dear Liz: You recently answered a reader who wondered whether he could delay mandatory distributions from his traditional IRA because he was still working. You said correctly that he could delay taking required minimum distributions from a 401(k) but not an IRA. But as long as the questioner is working full time and meets the other tests, he could contribute to a Roth IRA. That would allow him to re-invest part or all of the required distribution. Tax would have to be paid on the distribution, but the money could continue to be invested in an account that isn’t taxed on the earnings annually.

Answer: That’s an excellent point. Withdrawals from IRAs, SEPs, SIMPLE IRAs and SARSEPS typically must begin after age 701/2. The required minimum distribution each year is calculated by dividing the IRA account balance as of Dec. 31 of the prior year by the applicable distribution period or life expectancy. (Tables for calculating these figures can be found in Appendix C of IRS Publication 590, Individual Retirement Arrangements.)

Anyone who has earned income, however, may still contribute to a Roth IRA even after mandatory withdrawals have begun, as long as he or she doesn’t earn too much. (The ability to contribute to a Roth begins to phase out once modified adjusted gross income exceeds $112,000 for singles and $178,000 for married couples.) There are no required minimum distribution rules for Roth IRAs during the owner’s lifetime. As you noted, the contributor still has to pay tax on the withdrawal, but in a Roth IRA it could continue to grow tax free.