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Roth accounts & planning strategies

January 2018 | Christopher M. Petillo, CPA, JD, CELA
In my opinion, both the IRA and Roth 401(k) are sorely underutilized and often overlooked. When properly funded, they can prove to be an essential part of your estate plan.

What is a Roth account?
A Roth IRA is a “pay some tax now, but none later” opportunity. You pay tax on the money that comes out of your paycheck to go into the account, and forego an income tax deduction in the year of contribution. But, here’s the kicker – all future withdrawals are tax-free, subject to certain restrictions.

I can hear the naysayers now. “But I’m in a higher bracket now than I will be in retirement!” Maybe yes, maybe no. If you are hoarding your retirement dollars in pre-tax accounts, you may pay a significant tax in retirement while handcuffing your access to the money if you need it before the age of 59 ½.

Consider this, though. If you need money before age 59 ½, you can tap into your Roth account and take out your initial contributions without tax and without penalties (having said that, please don’t spend all of your retirement money before reaching retirement age if you can avoid it).

As an example, Jodi is under age 59 ½ and recently lost her job. Her monthly rent/mortgage and other bills amount to $2,500 per month. Jodi would like to withdraw $15,000 from her retirement account as a cushion for the next few months until she is established in a new job.

If Jodi takes the $15,000 from her traditional IRA or a hardship withdrawal from her 401(k), she will be subject to tax PLUS a 10% penalty because she is under 59 ½.

If she is in a 28% Federal income tax bracket (plus the 10% penalty and an 8% state income tax bracket), she would need to withdraw $27,778 in order to net $15,000 after losing 46% to taxes and penalties. However, if she takes the $15,000 from her original Roth contributions (without touching the earnings in her Roth), there would be NO tax and NO penalty.

Are you already retired?
Congratulations. You have saved up your acorns and are ready for a happy and healthy retirement. If your retirement accounts are pre-tax accounts, though, please do not fall into any of the following traps.

“I do not want to take money out of my retirement account because I do not want to pay taxes. I do not want to take money out of my retirement account because I do not want to lose my guaranteed rate of return. I do not want to take money out of my retirement account because (insert other objections here).”

Many clients come in with health retirement accounts and panic at the idea of ever taking more than the Required Minimum Distribution for IRS purposes. You may want to rethink your retirement accounts; after all, the money is supposed to be used during your retirement.

Depending on where you live, your pre-tax IRA may be subject to hefty withdrawal rules should you need long-term care in the future. As an example, Joe, 85, has $480,000 in his Traditional IRA/TDA/insert pre-tax account. He now needs care and is considering his long-term care options.

Joe lives in an area where Medicaid requires that he take monthly distributions based upon the single life expectancy table (and not the more lenient IRS RMD table).

For purposes of determining his Medicaid eligibility, Joe may be treated as having income of approximately $6,850 per month just from his retirement account. That amount, plus his pension (ex: $2,000) and Social Security (ex: $1,150), means that $10,000 per month may be exposed to the costs of long-term care should Joe need such care now or in the future.

If Joe is married, can’t he transfer just the Traditional IRA/TDA money to his spouse? No he cannot, not without paying income taxes on the whole $480,000 in the tax year of the withdrawal. However, if he instead had his money in a Roth account, he could withdraw the money (tax-free) and could implement planning such as exempt transfers to a spouse or to a child with a disability.

If you have any questions about the matters discusses in this article, please contact your Legal Service Plan’s National Legal Office at 800-292-8063 or 631-231-1450.