7/29/13 – 4:38 PM – Roth IRA Strategies

While I was out West last week to see clients in NM, CO, and WY, (I love that part of the country) I was asked if contributions to a SIMPLE retirement plan reduce the amount one can contribute to either a traditional IRA or Roth IRA. The answer is that it does not. One can max out a SIMPLE ($12,000/year – $14,500 if over age 50) and still contribute up to $5,500/year per person to a traditional IRA account or Roth IRA, plus an additional $1,000/year each if over age 50.

A married couple where only one has a SIMPLE can thus contribute a total of $23-$27,500/year between the one SIMPLE and two IRAs, depending on their ages. Over ten years, assuming 7% growth, that is worth $363,000-$434,049. At a 10% return it is $426,217-$509,607. Not half bad. That’s in addition to the second spouse’s retirement plan and any other investing. If the IRAs are Roth IRAs, then wow – a good portion is nontaxable at retirement.

Over the income limit for Roth eligibility?
If you are over the income limit for being eligible to make a Roth contribution, simply make the contribution to your traditional IRA and then complete a form to transfer that contribution to your Roth IRA. You will owe tax on the conversion amount but after your Roth is 5 years old, you can withdraw money without tax, invest without tax, and have no requirement to take money out at age 70.5.

When a Roth IRA owner dies, if the beneficiary is a spouse they can just transfer it to their Roth IRA. If it is a non-spousal beneficiary like a son or daughter, they can choose to open an inherited Roth IRA account and roll in the decedent’s Roth IRA. If there is more than one beneficiary, they split it according to the percentages listed on the decedent’s IRA.

How to let your descendants invest tax-free
The beneficiary must take out money from the Roth over their remaining lifespan. However, assuming that the initial Roth contribution by the decedent was at least 5 years prior to any request to take money out of the inherited Roth IRA, there is no tax on the distributions, nor any penalty. If they do not take all the money out before their own demise (they lived shorter than their life expectancy) the Roth gets inherited by a third generation with the same rules as the second. A family can conceivably pass along at least a portion of a nontaxable account for many years, depending on their lifespans.

The Roth IRA can be a good college savings account
Another Roth IRA great strategy is to help grandkids go to college or have money for their first home down payment. Just name the grandkids among your Roth IRA beneficiaries. If they have inherited your Roth by the time they either go to college or get married, they have a tax-advantaged, very flexible investment account. There is no tax or penalty on the distributions over their remaining lifespan, going by the IRS table.

However, if withdrawals exceed the amount shown in the table there is no penalty for that withdrawal for higher education or first home purchase but part of the excess distribution may be taxable. There would normally be tax on the growth portion of the excess distribution, though not the contribution portion. That sounds confusing, but the rule is that the contributions are always considered the first thing to be distributed, so there is no tax on distributions until the contribution amount is used up.

This strategy can be a party taxable alternative to using a 529, UGMA account, or Coverdell Educational Savings Account, the traditional vehicles for funding college, each of which has drawbacks, such as loss of parental control at age age 18 or 21 in a UGMA or Coverdell and lack of investment flexibility in a 529.