The Roth Rulebook

The Roth Rulebook

 

When preparing for retirement, it can be important to save money in different types of accounts to give you flexibility when it comes time to spend those funds. One of the most powerful and misunderstood types of accounts is the Roth. A Roth account is an after-tax retirement account that can be in the form of an IRA or an employer-sponsored plan such as a 401(k). The after-tax component means you pay tax on the front end when receiving the income, and in exchange, you can receive tax-free growth and tax-free withdrawals if you follow the rules of the Roth. There are three components to consider: contributions, conversions, and earnings. Contributions and conversions refer to the principal amount that you contribute or convert, while earnings refer to the investment growth in the account. There are contribution and eligibility limits set by the IRS each year, but today we will focus on withdrawing funds from a Roth IRA to maximize the after-tax benefit.

 

Roth Contributions

After you contribute to a Roth IRA, you can withdraw that contribution amount (principal) at any time without paying taxes or the 10% penalty. That is an often-overlooked fact that can come in handy.

Example: Ted is 38 years old and decides to open his first Roth IRA. He contributes $5,000 to the account immediately after opening it. Two years later, Ted finds himself in a financial bind and needs $5,000 for a car repair. One of the possible solutions for Ted is that he could pull up to $5,000 from his Roth IRA without paying any tax or penalty.

 

Roth Conversions

A Roth conversion is when you move funds from a pre-tax account such as a traditional IRA. You will owe income tax on the amount that you convert. This can be a powerful strategy to take control of when and how much you pay in taxes. There is no limit to how much you can convert.

When it comes to withdrawing money used in a Roth conversion, five years need to have passed or you need to be at least 59.5 years old to withdraw the conversion penalty-free. It is important to remember that each conversion has a separate 5-year clock.

Example: Beth is 50 when she executes a $40,000 conversion from her IRA to her Roth IRA in January 2020. In March 2025, Beth finds herself needing $40,000 for a home renovation. One of the possible solutions is that Beth could pull up to $40,000 from the conversion that she did over five years ago even though she is under 59.5.

 

Earnings

When it comes to withdrawing earnings from growth that has occurred after contributing or completing a conversion, you must wait until age 59.5 and five years need to have passed since you first contributed or completed a conversion. If you don’t follow both of those rules, then you could have to potentially pay income tax on the growth and a 10% penalty.

Example: With our previous examples above with Ted and Beth, even though they can withdraw their contribution and conversion respectively, neither of them can touch the earnings in their Roth accounts until they are 59.5 and have satisfied the 5-year rule.

 

Other Important Details

There are a few other exceptions that allow a person to avoid the penalty and/or income tax, such as a death, disability, or first-time home purchase.

For ordering rules, when a withdrawal is made from a Roth IRA, the IRS considers that money to be taken from contributions first, then conversions when contributions are exhausted, and then finally earnings.

 

Strategies 

  • Have a thorough understanding of the rules before withdrawing any funds from a Roth account.
  • Speed up the 5-year clock.
    • You can technically satisfy the 5-year clock in less than five years. You can make contributions for a previous year until the tax filing date (typically April 15th, but as of this writing, it may be April 18th in 2022). This means that a contribution on April 1st, 2022, could be designated to count toward 2021, and the clock will count as starting on January 1st, 2021. This shaves 15 months off the 5-year clock! Note: Conversions must be complete by the calendar year’s end (12/31), but you can still shave 11 months off the 5-year clock.
  • Start the 5-year clock now!
    • Even a $1 contribution or conversion starts the clock for you to be able to harness tax-free gains, so start as soon as possible.
  • After the passing of the SECURE ACT in 2019, most non-spousal IRA beneficiaries must now fully distribute inherited IRAs within ten years. This means that an inherited Roth IRA owner could potentially allow the inherited Roth to grow tax-free for up to ten more years and then withdraw those funds tax-free. If it fits into an individual’s financial plan, this can be a tremendous tax strategy to take advantage of.

 

Roth accounts can be incredible but also very confusing. As advisors, we figure out the best way to use these accounts to your advantage in terms of maximizing growth and minimizing taxes. If you have any questions about how you can best utilize a Roth account, please don’t hesitate to reach out to us. We are always happy to help you and those you care about!

 

 

 

Disclosure: The material is presented solely for information purposes and has been gathered from sources believed to be reliable; however, Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Nothing in these materials is intended to serve as personalized tax and/or investment advice since the availability and effectiveness of any strategy is dependent upon your individual facts and circumstances. Merriman does not provide tax, legal, or accounting advice, and nothing contained in these materials should be relied upon as such.

Breaking Down the Barriers to Sustainable Investing

Breaking Down the Barriers to Sustainable Investing

 

Wow—2020 was a year unlike any that we have ever experienced. In addition to a global pandemic, events throughout the year exposed many causes that need great support. At Merriman, we are about much more than just the numbers. We aim to have a deep understanding of our clients in order to help them incorporate their values in all aspects of their lives. This led to us having conversations with families about climate change, social issues dealing with race and gender, how to help neighbors and struggling communities, and how to make individual voices heard by large corporations and governments, amongst many other important topics. During the year, did you feel sad, confused, shocked, or overwhelmed by any of these? I know that I sure did, so you are not alone. There is hope, and you can take action in ways that you may not have previously considered. It doesn’t take a large financial or time commitment. You can incorporate your values and support causes through sustainable, responsible, and impact (SRI) investing. Equally important, you can implement an SRI strategy without having a negative impact on your investment returns or retirement goals. It may even lead to the opportunity for outperformance. I want to use this article to break down the barriers to sustainable investing.

It is helpful to first look at some data. In September 2019, Morgan Stanley conducted a study with 1,000 individual investors that they surveyed in two-year increments starting in 2015. Then they published the white paper Sustainable Signals: Individual Investor Interest Driven by Impact, Conviction and Choice. I want to take a moment to highlight two graphs from that white paper:

 

 

Chart 1: Interest in Sustainable Investing

Source: Morgan Stanley, Sustainable Signals white paper, 2019.

 

 

 

Chart 2: Perceived Barriers to Adoption

Source: Morgan Stanley, Sustainable Signals white paper, 2019.

 

The first chart shows that there is a significant interest in sustainable investing, and that interest continues to grow. The second chart shows the perceived roadblocks that prevent investors from choosing sustainable funds. This explains why currently the actual implementation and use of sustainable funds is much lower than the interest levels show. Below are the reasons why those perceived barriers shouldn’t stop you.

 

I’d like to share a story to address the investment performance roadblock. In 2007, I went to Costa Rica as part of a school group called The Eco-Explorer’s Club. Our mission for the trip was to protect sea turtles from poachers and predators during the turtle’s nesting season. The trip was a success, and it was one of the greatest things I have ever been a part of. I remember being filled with so much joy that we had made a positive impact for the wildlife there and also for the wonderful people of Costa Rica. Tourism intended to support conservation efforts is a large part of their economy and provides many jobs. That is when I first made the connection that it is possible to simultaneously support planet and profit. The best of both worlds. Investment funds are able to achieve this as well, as companies increase their revenue by adopting sustainable practices, cutting costs, and listening to client demands.

 

The next roadblock is thought to be lack of investment products. That was true at one point in time, but it is no longer the case. There are hundreds of publicly traded mutual funds and ETFs available that thoroughly integrate environmental, social, and governance factors into their investment processes and/or pursue sustainability-related investment themes and/or seek measurable sustainable impact alongside financial returns. We are big fans of the DFA Sustainability Funds.

 

The third and fourth roadblocks go hand in hand. It is true that it requires time to understand sustainable investments and to stay current. That is why there are professionals such as us to help. You don’t need to do this alone. We are here and available to help you get the best plan in place. You can schedule a conversation directly on my calendar by clicking HERE.

 

After reading this article, I encourage you to click the link above for a virtual coffee chat or to forward this article to a friend who may be interested. Thank you.

 

 

Reference: https://www.morganstanley.com/content/dam/msdotcom/infographics/sustainableinvesting/Sustainable_Signals_Individual_Investor_White_Paper_Final.pdf

 

Disclosure: The material is presented solely for information purposes and has been gathered from sources believed to be reliable, however Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Merriman does not provide tax, legal or accounting advice, and nothing contained in these materials should be relied upon as such.

How to Optimize Your Accounts After The SECURE Act

How to Optimize Your Accounts After The SECURE Act

 

The Setting Every Community Up for Retirement Enhancement (SECURE) Act passed in late 2019, creating significant retirement and tax reforms with the goal of making retirement savings accessible to more Americans. We wrote a blog article detailing the major changes from this piece of legislation, which we recommend reading prior to this series.

We’re going to dive deeper into some of the questions we’ve been receiving from our clients to shed more light on topics raised by the new legislation. We have divided these questions into six major themes; charitable giving, estate planning, Roth conversions, taxes, stretching IRA distributions, and trusts as beneficiaries.  Here is our second of six installments.

 

In light of the SECURE Act, should I convert my IRA to a Roth IRA, and if so, how much of it should I convert?

The answer is maybe. First, some old Roth conversion strategies may still hold true. If you are in an especially low tax bracket for a few years (e.g. you are retired and no longer bringing in employment income, but you haven’t started taking social security yet), then a Roth conversion may make sense for you. It would likely be a good idea to convert as much as possible during those lower income years without pushing yourself into the next bracket. The idea is to pay the least amount of tax possible on that tax-deferred money so more makes it into your pocket. In light of the SECURE Act, there are now additional considerations due to the elimination of the stretch IRA for most non-spouse beneficiaries. These beneficiaries will now have to withdraw inherited IRAs down completely within 10 years, which could have major tax ramifications for them. A Roth conversion might make sense if all the following criteria are met:

  1. You will not need your IRA for your own retirement needs.
  2. You can afford to pay the tax bill out of pocket or with non-retirement assets.
  3. You want to leave the money to someone other than your spouse, your minor child, someone not more than 10 years younger than you, or someone who is chronically ill.
  4. The beneficiary will likely be in a higher tax bracket than you are now.

Example: Gertrude dies in 2020 and leaves her IRA to designated beneficiary Suzie, her granddaughter. Suzie is not an eligible designated beneficiary because she is more than 10 years younger than Gertrude and not her minor child. The balance in the inherited IRA must be paid out within 10 years after Gertrude’s death, which means a large tax bill for Suzie as she is in her prime working years. Had Gertrude converted that IRA money to a Roth, the taxes would have been paid at Gertrude’s much lower bracket, and thus Suzie would have received more money when all is said and done. With the Roth IRA, Suzie must still abide by the 10-year withdrawal rule, but now she can let that money grow tax free in the Roth until year 10 and then withdraw it without paying taxes.

 

I’m still working. Should I be contributing to a Roth IRA / Roth 401(k) / taxable account instead of a pre-tax account now?

It depends, and there are a lot of factors to consider. To start, please see the question and answer directly above and consider whether an IRA or Roth account makes more sense for you today. The analysis will consider your current tax bracket, your estimated future tax bracket, whether or not you will need the money for your own retirement, and who your beneficiaries are.

If you are nearing retirement while in your prime working years, it likely makes sense to contribute to a pre-tax account versus a post-tax account. You are potentially in your highest tax bracket now, so getting the tax break with a pre-tax contribution is generally more valuable. After retirement, when you are in a lower tax bracket, you may decide to make Roth conversions at that time to take advantage of the lower rates.

Taxable accounts are another story completely. Due to their flexibility, having a taxable account is beneficial whether you are also contributing to an IRA or a Roth. If you plan on leaving money to non-spouse heirs, then a taxable account can be a great way to do so. There is no contribution limit on these accounts and there will be a step up in basis upon your death. This will eliminate capital gains as the account passes on to your heirs and they will not have to deal with the forced 10-year withdrawal rule.

Again, this is a loaded question with many moving parts and will be very specific to each individual. It would be best to speak your advisor about which type of account makes the most sense in your situation.

 

As with all new legislation, we will continue to track the changes as they unfold and notify you of any pertinent developments that may affect your financial plan. If you have further questions, please reach out to us.

 

First Installment: I’m Planning to Leave Assets to Charity – How Does the SECURE Act Change That?

Second Installment: How to Optimize Your Accounts After the SECURE Act

Third Installment: Must-Know Changes for Your Estate Plan After the SECURE Act

Fourth Installment: How to Circumvent the Demise of the Stretch: Strategies to Provide for Beneficiaries Beyond the 10-year Rule

Fifth Installment: The SECURE ACT: Important Estate Planning Considerations

Sixth Installment: Inheriting an IRA? New Rules to Consider

 

 

Disclosure: The material provided is current as of the date presented, and is for informational purposes only, and does not intend to address the financial objectives, situation, or specific needs of any individual investor. Any information is for illustrative purposes only, and is not intended to serve as personalized tax and/or investment advice since the availability and effectiveness of any strategy is dependent upon your individual facts and circumstances.  Investors should consult with a financial professional to discuss the appropriateness of the strategies discussed.

The Importance of Having an Emergency Fund

The Importance of Having an Emergency Fund

Life can throw you curveballs and if you aren’t prepared financially, these curveballs can turn into major problems. That’s why it’s so important to have a savings buffer, also called an emergency fund. An emergency fund is a cash account that you keep separate for life’s unexpected events. It can help prevent additional stress when these events occur. (more…)

6 Tips for a Powerful Financial & Fitness Year

6 Tips for a Powerful Financial & Fitness Year

Co-written with Dan Kleckner, Co-Owner of Kutting Edge Fitness

 

Merriman’s Finance Tips

Tip #1 – Build up at least three months’ worth of emergency cash

When you have unexpected expenses, like those associated with a job loss or a major house repair, an emergency fund can help fill the gap so you don’t have to turn to credit cards or withdraw from a retirement account. Holding three months’ worth of expenses in an emergency fund at the bank is a good start. You should increase this fund over time as your income and living expenses grow. (more…)