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A tax freight train is bearing down on your retirement. To protect yourself, you'll have to harness The Power of Zero.
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Hello there. This is David McKnight. Welcome to The Power of Zero show. Thanks for joining us on our weekly exploration of The Power of Zero paradigm. Today, we are going to talk about 15—that's actually going to be divided between two podcasts—we're going to discuss 15 things that you should know about Roth IRAs that maybe you don't know about Roth IRAs. Roth IRAs seem, on the surface, to be very simple propositions, you use after-tax dollars, that money grows tax-free, you take the money out tax-free, but there are a number of pitfalls that can foil this wonderful tax-free alternative for you. I think we can get through probably the first 8 today and then next week we'll talk about 9 through 15.
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First of all, let's define what a true tax-free investment is. A true tax-free investment is going to meet two basic tests. The first test is that they have to be free from every type of tax that we're talking about. When I say free from every type of tax, we’re talking free from federal tax, free from state tax, free from capital gains tax. I often like to pick on municipal bonds because municipal bonds hold themselves out to be tax-free, but when you really dig into it, they're not really tax-free because they're not free from those three taxes we've talked about. For example, municipal bonds are free from federal tax but they're not always free from state tax. You have to buy them from the state in which you live. If you were to buy municipal bonds in the form of a mutual fund, and that mutual fund was to appreciate in value and you sold it at it again, you would have to pay capital gains tax on that mutual fund. Municipal bonds aren't truly tax-free. The second thing I'm looking for in a true tax-free investment is it can't count as provisional income, it can't count against the thresholds which cause Social Security taxation. When you take interest off your municipal bonds, that does count as provisional income, it could potentially cause your Social Security to be taxed.
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Roth IRAs, on the other hand, are free from every single one of those taxes we've talked about; free from federal tax, free from state tax, free from capital gains tax so long as you're 59 1/2 when you take the money out. We'll talk about some exceptions here in a second. Also when you take money out of your Roth IRA, it does not count as provisional income, it does not count against the thresholds which cause Social Security taxation. Roth IRAs are truly tax-free. By the way, when I say Roth IRAs, I'm talking traditional Roth IRAs, Roth conversions, Roth 401(k)s. Anything with the word Roth in front of it is to be embraced as a true tax-free investment.
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Now that we've established that Roth IRAs are desirable, admirable, and something that we should have as part of our portfolios and part of our tax-free retirement plan in retirement, let's talk about all of the bugaboos, gotchas, and all of those different pitfalls that you can fall into.
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First of all, you can't make unlimited amounts of money into a Roth IRA. This is not a rich person's investment. I'm talking about a traditional Roth IRA, what do I mean by that? What the IRS is going to do is look at your modified adjusted gross income. If your modified adjusted gross income for a single person is between $122,000 to $137,000—that's 2019 numbers by the way—or if as a married couple, you’re between $193,000 or $203,000, your ability to contribute to a Roth IRA gets phased out. In other words, if you're below those thresholds, you can contribute the full amount, but as you move upward in that threshold, the amount that you can contribute to a Roth IRA starts to get reduced until, for example, with a married couple, if you get beyond $203,000, you can no longer make any Roth contributions at all. This is important to contemplate.
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Obviously, we've spoken in other settings that if you make too much money, there are other ways to contribute money to tax-free accounts. You can do what we call a backdoor Roth where you make after-tax contributions to an IRA, it’s after-tax because you no longer qualify for the deduction so it's after-tax, you immediately convert it to a Roth IRA and the money ends up in the same place. If you want to know what the bugaboos are with that particular scenario, you can look at The Power of Zero, I talk all about the bugaboos there. But the point is you can also contribute money to an LIRP which is also a tax-free vehicle. But it's important to recognize that if you make too much money, the traditional Roth IRA is not an option for you.
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That was number two. Number three, anyone of any age can contribute to a Roth IRA so long as you have earned income. I'll give you an example—and there are some limits here—let's say you have earned an income of $3,000, the most you could contribute to your Roth IRA that year would be $3,000. If you had $12,000 of earned income, you could contribute, not $12,000, but whatever the limit for the Roth IRA is in that year based on your age. We'll get to what those contribution limits are here in a second. You have to have earned income if you want to contribute to a Roth IRA. For example, if you're in retirement, you’re drawing from a pension, Social Security, taking RMDs from your IRA, you cannot contribute to a Roth IRA. The only exception to that—and I realize, you guys are getting a lot of other little side bonus details about the Roth IRA—the only exception to that is if you have alimony. For example, if you're retired, you're not working, you don't have earned income, you've taken money out of your pension, Social Security, RMDs from your IRA, and you have alimony, that actually qualifies you to contribute to a Roth IRA. Little-known detail, pretty obscure, but true nonetheless.
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Number four, things you should know about a Roth IRA, contribution limits. This is surprising because I get to give my workshops all across the country, I routinely ask rooms full of people, “What are Roth contributions for 2019?” and this is even rooms full of financial advisors, mind you, and I get all sorts of crazy guesses. This is something that we should know whether we're advisors or just preparing for retirement as part of the general public. If you're younger than age 50, for a traditional Roth IRA contribution in 2019, it’s $6,000 per year. If you are over age 50, you have a catch-up provision which throws an extra $1,000 in there so you can do $7,000 for you, $7,000 for your spouse. Their earned income is calculated per household. If you have $12,000 of earned income in your household, you could do $12,000 between the two Roth IRAs. If you have $14,000 of earned income, you can do $14,000 into your Roth IRA, $7,000 for each of you. Let's talk about the Roth 401(k). Roth 401(k) has different contribution thresholds. For someone that's younger than 50 in 2019, you can do $19,000 per year. For someone who's older than 50, you can do $25,000 per year, a nice round number there.
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Now let's get to number five because there are some interesting things that can be done here. Number five of little known details about the Roth IRA is that you can do both a traditional IRA and a Roth 401(k) all in the same year. If, for example, you're above age 50, you can do a traditional Roth IRA where you put in $7,000, you can do a Roth 401(k) where you're putting in $25,000, which is for a total of $32,000, and guess what, your spouse who's over age 50 can do the exact same thing. You can each put in $32,000 per year, for a total of $64,000, into Roth IRA types of accounts. Now, these are after-tax dollars, you want to evaluate what the tax consequences are of doing so, but that's an important consideration.
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Number six. Roth 401(k)s, unlike traditional Roth IRAs, do not have income limitations. If you have a Roth 401(k) that's available to you at work, you're not constrained by income limits. This is a great alternative for people who do not have a traditional Roth IRA available to them because of their income thresholds. You can make more than that $203,000 of modified adjusted gross income as a married couple and still contribute to a Roth 401(k). That's an important option for people who make lots and lots of income.
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Number seven. Roth conversions do not have income limitations. I often make this example; if Bill Gates somehow had been able to accumulate $10 million into an IRA and yet his modified adjusted gross income was $10 million in a given year, that does not prevent him from converting all of that money in that year. In fact, I would suspect that the IRS loves it when rich people do Roth conversions and that money gets taxed of their highest marginal tax bracket. I would imagine that they love it. If you are at a high marginal tax bracket, you really have to evaluate whether you want to be paying tax at 37%, thrown another, let's call it 8%, for a total of 45%, does it make sense to do Roth conversions now? Maybe it does because maybe you have so much money in your IRA that if you don't convert it, required minimum distributions alone will put you in a high marginal tax bracket. You just have to be very, very careful that this is an alternative that's available to pretty much everybody out there, there are no income limitations, you just have to really ask yourself, “Is it worthwhile?”
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Getting into some obscure, nonetheless, important type of stuff here, number eight: Roth conversions do not count towards your modified adjusted gross income threshold of $203,000. Remember what we said, we said that you cannot contribute to a Roth IRA if your modified adjusted gross income is greater than $203,000 as a married couple, $137,000 as a single person. If you, in any given year, were to convert $100,000 to your Roth IRA, that $100,000 conversion does not count towards that modified adjusted gross income threshold of $203,000. This is obscure but it's an important thing, because a lot of people say, “Hey, look, if I'm going to be doing all these Roth conversions, you're going to eliminate my ability to do a traditional Roth IRA contribution in that year,” and that's just not the case. That's an important but obscure rule that will likely come into play if you are doing Roth conversions in any given year.
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That's all we have time for today. Be sure to tune in next week and we will go through the remaining things that you need to know about the Roth IRA. Once again, if you want to subscribe to our show, you can do so through iTunes, YouTube, Pandora, Spotify, any of a dozen different places, and of course, we have resources at davidmcknight.com if you want to find someone to help you navigate all of these pitfalls to help you get to the 0% tax bracket. Thanks for being with us and we will look forward to talking to you next week.
